As countries around the world grapple with extreme weather events, climate change has become a major economic risk. Several possible climate scenarios loom on the horizon, and every single one poses risks not only to governments and individuals, but also to liability-aware institutional investors such as pension funds and insurance companies.

A recent in-depth article published by TD Asset Management Inc. argues that to manage these risks, institutional investors need to have a process in place for incorporating the various climate scenarios into modeling that is specific to their plans.

Climate Scenarios

The article explores three possibilities about how climate objectives could evolve by 2050: net zero, delayed transition and current policies. These three possibilities - which are part of a longer list of climate scenarios - were developed by the Network for Greening the Financial System (NGFS). NGFS is a collection of central banks and supervisory agencies working with an academic consortium to develop climate scenarios for analyzing climate-related risks to the economy and financial system.

The net zero scenario assumes that global warming would be limited to 1.5°C through immediate policy action and a moderate use of technology, and we would reach global net zero CO₂ emissions by 2050. This scenario leads to the lowest temperature and the lowest physical risk, which results in a moderate transition risk.

The delayed transition scenario assumes policy action is delayed until 2030. This scenario has a similar temperature outcome to the scenario where below 2°C is reached in 2050, but the transition timeline is delayed and shorter. This results in higher transition risk since policy action would need to be more stringent to achieve the same climate goal.

The current policies scenario assumes that the only climate policies are the ones currently implemented and no new climate policies are introduced. This scenario leads to the highest temperature, which results in the highest physical risk, but it has the smallest transition risk.

Translating Economic Scenarios into Liability-Aware Metrics

Through a set of projections, the article explores how these three different climate scenarios would impact top-of-mind factors for liability-aware institutional investors, such as the 10-year Government of Canada bond rate, the 10-year Corporate A credit spread and Canadian equity returns.

The article then translates these possible economic outcomes into metrics aligned with investor objectives. Specifically, it projects how the assets, liabilities and funded ratio of a hypothetical pension plan with a portfolio of 50% fixed income and 50% equities¹ would fare under the three NGFS scenarios.

The projection reveals that various climate scenarios and their corresponding economic outcomes have considerable influence on the valuation of a plan's assets, liabilities and funded ratio.

For more information, read the full article.

¹ _{Market value of assets have been determined based on a hypothetical portfolio with target weights of 50% FTSE Canada Universe Bond Index, 25% S&P/TSX Composite Index, and 25% MSCI World Ex-Canada Index. Projected asset values were determined assuming monthly rebalancing to target weights and returns based on TDAM's internally developed Capital Market Assumptions.}

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