'Climate change is a new risk driver that many pension funds or institutional investors don't take into account in their own models,' says climate risk specialist.
Climate change is a complex financial risk. Its immediate impact on weather patterns and the various societal responses to a changing climate will influence GDP growth, inflation and ultimately, financial markets.
An inaugural climate report released by Ortec Finance has found that Canadian pension funds are among the funds most vulnerable to climate change, second only to US pensions. Climate risk specialist at Ortec and author of the report Doruk Onal says Canadian pension funds are expected to experience profound impact from both transition and physical climate risks.
He argues that due to “a heavy reliance on high-risk assets like equities and alternatives,” these funds could see their investment returns decline by as much as 44 per cent by 2050 if their climate policies are not addresses. That figure is derived from Ortec Finance’s high warming stress scenario. Additionally, Ortec argues that both equity and alternative investment returns are particularly vulnerable to long-term physical risks, especially in regions prone to climate-related events such as floods, wildfires, and extreme weather.
“Climate change is a new risk driver that many pension funds or institutional investors don't take into account in their own models,” he says. “With the current models pension funds have, you must match the liabilities that the pension payments make. Depending on how climate change unfolds, there's a chance pension funds may not be able to match their liabilities and make the required pension payments."
The uncertainty around climate change's trajectory is a key concern. Onal outlines two starkly different scenarios: the ambitious Paris Agreement goal of net-zero emissions by 2050, and a business-as-usual path where emissions and temperatures continue to rise unchecked. In the net-zero transition, Onal warns of the potential for a "disruptive and drastic" shift away from fossil fuels that could trigger a financial crisis. "If governments change policies and move away from fossil fuels quickly, those assets will become what we call “stranded assets”, and investors holding them would be in a very difficult spot," he highlights.
Conversely, the business-as-usual scenario brings heightened physical risks, such as the increasing frequency and severity of extreme weather events. Onal points to the example of a California utility company, PG&E Corp. that defaulted and filed for bankruptcy due to devastating forest fires, a harbinger of the types of climate-driven losses pension funds may face.
Ortec anticipates that unrestrained increases in carbon emissions in the absence of further discernible decarbonization will increase levels of physical risk, leading to severe financial impacts by the mid-2030s. In a worst-case scenario, returns in the portfolios of the top 30 Canadian pension funds could decline by up to 44 per cent in 2050.
Significantly rising temperatures, as explored in the high-warming scenarios in the report, lead to an increase in extreme weather events and adversely affect agricultural, labour, and industrial productivity. This has a profound and widespread impact on economies, collectively reducing asset performance across all asset classes.
Whereas climate related risks in the transition scenario are more short-term, the physical risks are more long-term, ultimately influencing future risks on investments, explains Onal.
“Emissions continue to increase, temperatures continue to increase, and the risks are not immediately visible, so it takes quite a bit of time for these physical risks to develop and be observable,” he says. “It’s tricky because pension funds are very big. On the one hand, they're investing in legacy industries, like fossil fuel industries, or industries that aren’t transitioning. The emissions coming from those investments are creating these climate risks in the long term for the pension fund portfolio.”
Transition risks, however, are “expected to be the dominant climate risk driver during the 2025–2030 period, as physical risks associated with climate change take longer to materialize,” Ortec’s report notes.
Despite these looming threats, many pension funds have been slow to recognize and address climate risk. Onal attributes this partly to the novelty of the issue, as well as the conservative nature of these large institutional investors.
"In financial risk management, you prepare for risks you've faced in the past," he says. "Climate risks are quite recent, so it takes time for them to become integrated into pension fund thinking." Additionally, the models used to assess climate risk are still relatively young and evolving rapidly, leaving pension funds hesitant to act.
The decline in investment returns has serious implications. For pensioners, reduced returns could lead to lower retirement benefits and financial insecurity. Sponsors, including corporations and government bodies, might face increased contributions to cover shortfalls, impacting their financial health. Employees and employers could also be affected by lower pension fund performance, leading to potential adjustments in retirement planning and expectations.
Onal asserts that pension funds will have to take a step-by-step approach to manage this risk. This includes conducting comprehensive climate risk assessments, continuously monitoring climate scenarios, and preparing portfolios for potential disruptions. Addressing physical risks, transitioning investments, and enhancing overall climate risk management will also be crucial, he says.
