22 March 2021
Insurance companies are operating in a "lower for longer" interest rate environment, where yield is hard to come by, and at a time when accounting and regulatory frameworks are shaping investment decisions. Climate change has risen rapidly up the agenda as a mounting awareness of climate-related risks accompanies a sharpened regulatory focus.
We believe climate-aware investing can be an opportunity for insurers to mitigate against an emerging and significant risk factor. This is essential for investors targeting predictability of cashflows alongside high resilience to market risks.
- Fixed income returns and climate resilience are two of the most prominent investment themes for UK insurers
- Climate-aware fixed income investing aims to mitigate against the current and future, physical and transition risks of climate change as well as aligning portfolios to the 2015 Paris Agreement
- Managing climate-related risks could increase predictability of income from asset cashflows, and potentially prevent downgrades and defaults from climate-related exposures
What are 'climate-aware' portfolios?
Insurers are rightly questioning how each component of their investment strategy will be impacted by climate change as part of their overall approach to managing climate-related financial risks across the firm. Climate-aware investing aims to:
- Mitigate the risks to investment portfolios from a range of temperature scenarios
- Help limit the global temperature rise to 1.5-2.0°C above pre-industrial levels by 2100 – investors can target this through aiming for zero greenhouse gas emissions by 2050 ('Net Zero')
Climate-aware portfolios will typically have explicit climate objectives, such as reducing carbon emissions by 50% by 2030 and 100% by 2050, in line with the Institutional Investors Group on Climate Change (IIGCC) framework.
We believe there are two types of issuers that can help achieve these objectives:
- Issuers that currently have low greenhouse gas (GHG) emissions and/or positively contribute to climate change mitigation
- Issuers that may have a high current level of emissions but have a robust and credible future decarbonisation plan. These companies are crucial to the impact goal of targeting net zero emissions by 2050.
Investing in these should help insurance companies to deliver a carbon intensity pathway such as that shown in Figure 1.
Figure 1: Reducing emissions – the task ahead for companies and investors
What are the risks of climate change on credit portfolios?
Climate-related risks are of uncertain magnitude, irreversible and uneven. They present in two main forms:
- Physical risks relate to the impact of climatic events if temperatures continue to rise. They might include extreme weather, such as a flood causing supply chain issues, or more chronic risks such as higher disaster insurance costs for companies
- Transition risks arise from the shift to a low carbon world and include the abrupt introduction of regulation, shifts in consumer demand, technological changes and investor sentiment. For example, the ban on sale of petrol and diesel cars in the UK from 2030
"Climate change is reshaping the long-term investment landscape. The time has come to act."
These risks could materially impact an issuer's balance sheet and access to capital markets, both key inputs in credit ratings and risk analysis. It is also clear that there is enormous investor, political and regulatory momentum in climate-aware investing. This momentum alone, irrespective of how the physical risks will affect asset prices, justifies the integration of climate risk into our analysis due to the material financial impact it could have on credit portfolios.
From the end of 2021, UK insurers will be required by the Prudential Regulatory Authority (PRA) to embed an approach to managing climate-related financial risks1. We have already seen several large insurers and other asset owners publish and start to implement climate strategies. The cost of borrowing for climate laggards could start to rise as investors fully appreciate the risks that climate change poses – being a 'first-mover' in the climate transition could potentially make the difference in terms of executing fully and cost-efficiently.
It is critical for UK insurers to consider, and attempt to mitigate against, any risk that could cause volatility and a potential loss of capital.
How can a climate-aware, credit portfolio mitigate against these risks?
We view both environmental, social and governance (ESG) investing and climate-specific investing as methods to protect portfolios against 'tail' risks such as climate change or controversies. The fundamental ESG research undertaken by our credit analysts seeks to build a layer of risk mitigation and is included across all of our portfolios.
When looking at credit portfolios, we aim to improve the predictability of income and ultimately create resilience to market shocks in a range of market and temperature scenarios. One way to measure this resilience is by using climate value at risk to assess the potential impact on a portfolio in different temperature scenarios. We believe it is important to first reduce the magnitude of the impact of climate change compared to a traditional universe and second, to ensure that the impact on portfolios in either a 'hot' or a 'cool' scenario are not dramatically different, for the purpose of minimising the range of potential outcomes.
Climate-aware investing should help, and not hinder, the overarching financial objective of insurers, which is to pay their policy holders and make a positive return on capital.
Complementing existing insurer objectives
A climate-aware strategy need not simply invest in bonds with the lowest 'temperature' or lowest carbon emissions, irrespective of price. On the contrary, we advocate climate strategies that complement an insurer's existing objectives in terms of portfolio-level risk and return characteristics. Climate-aware investing should help mitigate against the risks of a range of temperature scenarios while protecting the world in which your policy holders and other stakeholders live.
We believe integrating climate considerations into the investment process should not lead to reduced returns – the world is moving towards a lower carbon economy and the path of technological and regulatory development will require insurers to significantly progress this over time in any case. The early stages of the transition present an opportunity for insurers to mitigate against emerging risks and enhance sustainable profitability in the future.
Insurers who integrate climate objectives alongside – not in isolation to – other financial objectives should be able to successfully achieve both their climate and long-term return goals.
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