July 1, 2015

From an 'Unknown' to a 'Known': Managing Climate Change Risk

 “……as we know, there are known knowns…….there are known unknowns……but there are also unknown unknowns……”.

Donald Rumsfeld, Former US Secretary of Defence

“The pace of consumption, waste, and environmental change has so stretched the planet’s capacity that our unsustainable lifestyles can only precipitate catastrophes….”.

Pope Francis

Categorizing Risks

While the language may be a bit tortured, Donald Rumsfeld’s 2002 observation about the possibility of WMDs (weapons of mass destruction) in Iraq makes an important point. Not all risks (or uncertainties) are the same. The really dangerous ones are in the ‘unknown’ category, or what Nassim Taleb called ‘the black swans’, with the 2008/09 Global Financial Crisis (GFC) a vivid example still fresh in our minds. This Letter raises the question where climate change fits on the unknown/known risk scale. Pope Francis’ recent pronouncements on the topic (cited above) suggest it is rapidly moving from the unknown to the known end of the scale.

Psychoanalysts point out there is even a fourth unknown/known risk category beyond the three Rumsfeld mentions: the ‘unknown known’. It covers situations where we know about a reality, but pretend not to. This fourth category came to mind reading through the new 108-page Mercer study “Investing in a Time of Climate Change” (June 2015).i While the study will undoubtedly be useful to investors who currently treat climate change risk as a ‘known unknown’, it also has the potential to impact investors who continue to treat climate change risk as an ‘unknown known’ (i.e., pretend it doesn’t exist). In our view, the structure of the study, and the detailed analyses carried out within that structure, makes ‘plausible deniability’ an increasingly untenable stance to maintain.

The goal of this Letter is to share our ‘take’ on the action implications of the Mercer study from both ‘unknown known’ and ‘known unknown’ risk management perspectives.    

Risk and Pension Management

Looking through prior Letter titles, we had to go back to March 2011 to find one primarily focused on risk management in a pensions context ("Risk Management Revisited"). The motivation at that time was to conduct a post-GFC review of risk management. After a brief walk through portfolio and capital markets theory, the Letter made four key points:

  • Be clear about whose risks you are managing: In a world of principals and agents, this is a critical question to address. In a pensions context, the focus must be plan stakeholder risks and not manager risks. Within stakeholder risks, intergenerational risk sharing is an especially challenging issue to address. Specifically, are the interests of future stakeholders fairly represented in the decisions made   today?
  • Make the 'Ex Post'/'Ex Ante' distinction clear: Simply put, assuming the past will always be a good guide to the future is a sign of intellectual laziness. While the future sometimes echoes the past, it does not repeat it. Visualizing   possible futures is hard, but necessary work.
  • Time-horizon matters: how much short-term changes in portfolio value matter is a key question to address. Investors who can answer 'they don't matter to us' have an important comparative advantage by being able to focus on the longer-term generation of growing cash-flows and wealth.  
  • Good governance matters: effective pension organizations have clearly-stated investment beliefs and live by them. This in turn requires strong governance processes that ensure this actually happens in practice.

 More recently, the December 2014 Letter revisited these same key points from the perspective of   fiduciary duty ("The Evolving Meaning of 'Fiduciary Duty': Is Your Board of Trustees Keeping Up?"). As, in a somewhat different context, did the April 2015 Letter titled "Investing for the Long-Term: From Saying to Doing".

Still more recently (at the Rotman ICPM Discussion Forum in June, 2015), Harvard Business School's Luis Viceira shared preliminary findings from his research on the impact of time-horizon on the benefits of portfolio diversification. His work is supporting the intuition that while short-horizon return correlations have indeed increased materially since the 2008/09 GFC period, long-horizon return correlations have not.

Why? Because short-term return correlations are largely driven by the degree to which capital value changes are correlated, while long-term return correlations are largely driven by the degree to which investment cash-flow changes are correlated (e.g., changes in coupon, dividend, and rent payments). There is no evidence the correlations of these cash-flow changes have been rising.

The New Mercer Climate Change Study

This important distinction between short- and long-horizon risks is a good transition path to the Mercer climate change study. In essence, the study is about possible rates of conversion out of today's fossil fuels-driven economy into an economy with materially lower net carbon emissions, and the investment risks and opportunities arising from that conversion process. To address these questions, the study posits three possible 2015-2050 scenarios:

  • Transformation: strong climate change mitigation puts us on a path to limiting global warming to 2â—¦C above pre-industrial-era   temperatures this century.
  • Coordination: substantial climate change mitigation limits global warming to 3â—¦C above pre-industrial-era temperatures this century.
  • Fragmentation: sees only limited climate-mitigation action and a lack of coordination, resulting in a 4â—¦C or more rise. The study   further splits this scenario into a Lower- and Higher-Economic Damages sub-scenarios.

With these scenarios in place, the study draws on a series of integrated assessment models to project plausible interactions between climate science, economics, costs, and mitigation/adaptation strategies. Through these processes, three investment risk factors are monitored:

  • Technology: the interplay between technology and the path to a low-carbon economy. Speed, scale, and success of low-carbon technologies, coupled with the extent of transformation/disruption of existing sectors, or the development of new sectors, are the key   metrics for this factor.
  • Resource Availability / Impacts: weather-driven impacts on the valuation of investments. These impacts can be chronic (e.g., driven by long-term changes in temperature or precipitation), or acute (e.g., driven by extreme or catastrophic events).
  • Policy: international, national, and local measures (e.g., laws, regulations, targets, mandates) intended to reduce climate change risk by increasing the cost of carbon and/or incentivizing use of low-carbon alternatives.  

This structure is then applied to assess the investment implications for asset classes and industry sectors over time on a scenario-by-scenario basis. These implications were found to be material and scenario-dependent. Here is a summary of the key findings:

On the whole, the climate impact on long-term public and private equity returns is projected to be marginally negative.

  • Real estate, infrastructure, and emerging market equity are expected to benefit from the Technology and Policy factors.
  • Agriculture and timber show the widest ranges of scenario-driven impacts (i.e., from positive in ‘Transformation’ to negative in ‘Fragmentation’).
  • The energy (especially coal and oil) and utilities (especially electric) industries have negative sensitivities to the Policy factor, and also to the Resource Availability/Impacts factor.  
  • The renewables and nuclear industries have positive sensitivities to the Policy and Technology factors.

In a ‘So What/Now What?’ section, the Study   addresses the implications of these key findings.

‘So What/Now What?’

The action implications come in five parts:

  • Climate risk is inevitable, but being prepared can improve investment outcomes: uncertainty about the future should not be a barrier to action. Good governance is important here. It starts with realistic investment beliefs that encompass climate change risk. The Study clearly points to investment policy implications at the asset class and industry levels.
  • Be clear about who is accountable for what in the investment decision-making process: a clear accountability line from the board through the investment chain will have to be drawn. Implications for how risk budgets are allocated and how investment results will be benchmarked need to be decided.    
  • Certain asset classes deserve particular attention: the study pointed to real estate, infrastructure, emerging markets equity, renewables, nuclear, agriculture, timber, energy, and     utilities as deserving special attention. The three scenario structure forces attention on judging their probabilities of occurrence, and feeding those judgments back into investment policy decisions.
  • Achieving the ‘Transformation’ scenario has materially positive investment implications relative to the ‘Fragmentation’ scenario: this means collaboration efforts towards achieving the ‘Transformation’ outcome have a potentially large payoff. Arguably, the Study findings suggest such efforts amount to the required exercise of fiduciary duty.ii
  • Climate risk is more complex and longer-term than most other investment risks: traditional economic and financial risks related to       inflation, the course of the business cycle, interest rates, etc., are typically analyzed in 3-5 year timeframes. The longer-term risks associated with climate change (e.g., sea-level rise, water availability, carbon price developments) usually fall outside this timeframe. Conscious effort will be needed to bridge the shorter- and longer-term time frames for risk management and mitigation of this diverse combination of investment risks.  

The Study concludes that all this adds up to an action catalyst for the people and organizations it calls “future makers”, and a wake-up call for the people and organizations it calls “future takers”.

Risk Management Revisited

There are interesting and important parallels     between the four key points we made in our cited March 2011 Letter “Risk Management Revisited”, the new Mercer Study on climate change, and its implications for risk management. For example:

  • Be clear about whose risks you are managing: specifically, the focus must be plan stakeholder risks and not manager risks. The Mercer Study makes a convincing case that climate change risks translate directly into plan stakeholder risks. In a macro sense, the Transformation scenario is an outcome well worth championing in collaboration with like-minded investors. In a more micro sense, a strategy of divesting from high-carbon emission investments doesn’t require a moral justification. There is a far simpler ‘high risk/low return prospects’ justification.  
  • Make the 'Ex Post'/'Ex Ante' distinction clear: our own work on developing investment return expectations over the last three decades has been based on the explicit premise that the past is not a good guide to the future, and that visualizing possible futures is hard, but necessary work. The Mercer Study was clearly conducted with those realities in mind. A good deal of time and effort went into building the scenarios, the integrated assessment models, and identifying the relevant risk/return factors.
  • Time-horizon matters: we noted that investors who can ignore short-term capital value fluctuations have an important comparative advantage by being able to focus on the longer-term generation of growing cash-flows and wealth. This makes ESG (Environmental, Social, and Governance) considerations of primary importance to these investors. The Mercer Study throws new light on these considerations.  
  •  Good governance matters: we noted that effective pension organizations live by clearly-stated investment beliefs, and that this in turn requires strong governance processes. The Mercer Study offers multiple examples of this reality. For example, the ‘So What/Now What?’ section noted that the Boards and senior managements of pension organizations have critically important roles to play in converting the findings of the Study into organizational accountabilities and actions. Our February 2015 Letter “Does Better Governance Produce Better Outcomes?” confirms a positive association between good governance and good outcomes.

From ‘Unknown’ to ‘Known’

In conclusion, the Mercer Study adds considerably to investor knowledge about the risk and return implications of climate change. It need not be an ‘unknown’ any longer. For climate change deniers, ‘plausible deniability’ about the existence of climate change and its potential impact on future investment returns is becoming an increasingly untenable stance to maintain.

Keith Ambachtsheer



  1. The Mercer Study can be accessed by just googling its title on the internet. The Study was supported by 16 institutional investors managing a collective $1.5 trillion.
  2. A powerful new example of collective action is the case of 886 Dutch citizens suing the Dutch Government for insufficient action on climate change. They demanded new standards requiring a 25% reduction in carbon emissions in five years. The judge decided in favor of the plaintiffs. Similar actions are being contemplated in other countries. The other notable target for collective action at this time is COP21, the next UN conference on climate change scheduled for December in Paris.



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