This paper builds on the insights and outputs of the technical paper When, what and how, and presents a framework that institutional investors can utilise as part of their response to an IPR outcome. 

It will help prepare investors for an IPR and the implications it will have for further adapting and shifting SAA processes and portfolio construction techniques. It forms the basis for further work on an IPR intended research programme.

The potential implications of an IPR for SAA is significant, both in terms of likely portfolio upside and downside, with a public-policy-driven (versus market-driven) outcome. Institutional investors would need to review their SAA processes, frameworks and baseline assumptions to adequately respond to an IPR. In an environment where policy-makers undertake urgent and forceful action to reduce global emissions in a way that is not fully anticipated by the market, institutional investors would need to take decisive and pre-emptive action to ensure that investment portfolios and processes are sufficiently prepared.

While the focus of the paper is on the alignment of investment portfolios with managing an IPR (rather than a theory of change objective), it is expected that the suggested actions and SAA frameworks, as described, will orientate global investment portfolios towards outcomes that favour low-carbon versus high-carbon activities across the real economy.

The paper sets out a framework for embedding an IPR climate transition into SAA and portfolio construction processes, combining top-down with bottom-up analysis. It sets out the pillars of SAA processes, and the associated IPR actions that these might necessitate, emphasising, in particular, the need to be forward looking, to stay focused on the long term, to utilise scenario analysis and to link these pillars through to implementation and portfolio construction.

Figure 8: Pillars of Strategic Asset Allocation Processes and IPR Actions

Figure 8: Pillars of Strategic Asset Allocation Processes and IPR Actions

The paper identifies specific pre-emptive actions that institutional investors could take (in Phase I) to prepare for, and minimise the potential damaging impact of, the IPR transition (Phase II) These include:

SAA targets and ranges

  • Increase ranges around existing asset class allocations to provide more leeway for significant moves towards the upper and lower boundaries during times of high volatility (such as Phase II of the IPR transition);
  • Increase SAA targets to unlisted assets to ensure sufficient leeway exists to allocate capital to low-carbon opportunities in unlisted assets; and
  • Engage with policy-makers where regulatory constraints prevent or limit the allocation to low-carbon assets (including restrictive liquidity requirements and lack of unified definition of low-carbon activities).

Sub-asset class allocations

  • Add more regions and sectors into the SAA portfolio mix to identify and capture the areas where the greatest climate transition is expected to occur; and
  • Add a new low-carbon sub-asset class bucket into the SAA portfolio mix using emerging taxonomies as the basis for the definition of low-carbon activities.

Portfolio construction

  • Review mandate design to ensure that low-carbon transition risks and opportunities are part of the incentive structure and performance review process (for active mandates), and part of the index construction (for passive mandates); and
  • Review manager selection and review processes to ensure that managers have the appropriate skills and expertise to identify the low-carbon opportunities and minimise the risks.

SAA processes and portfolio construction: where top-down meets bottom-up

Institutional investors could prepare for, and respond to, an IPR across the three primary layers of decisionmaking, as summarised below. Starting with the longterm (5 years or longer) % allocation to asset classes, moving down to defining sub-asset classes that need to also consider regional, sector and unique beta allocations, followed by implementation, in terms of mandate design, manager selection and index construction decisions. These are the mechanisms by which institutional investors could translate their investment beliefs and policies around climate-related impacts into specific actions, linking the top-down (beta) decisions around asset class ranges/targets and sub-asset class allocations with bottom-up (alpha) decisions related to mandate design, manager and asset selection/review and portfolio style analysis.

SAA processes and portfolio construction

In addition to reviewing the overall asset class assumptions, institutional investors would also consider the implications of an IPR for their sub-asset class allocations by considering the following issues:

Regional allocation

Does your regional allocation of assets reflect the potential climate-transition risks and opportunities that an IPR will produce (e.g., China and India)?

  • Institutional investors would consider the extent to which different regions will prosper or decline under an IPR outcome (including sovereign risk), and how best to prepare for this process now (in Phase I) in order to capture the maximum upside, whilst minimising the downside risks of Phase II.
  • It is at this stage that consideration of factors such as an economy’s investment needs to support the low-carbon transition process, alongside capabilities and technology pathways, will be crucial to identify not only the regions and markets that are likely to prosper in a rapid transition outcome, but also to identify those that are likely to suffer and decline.

Sector allocation

Is your portfolio positioned to capture the inevitable sector transformation?

  • The IPR outcome is likely to produce significant impacts at the sector level that institutional investors would need to consider as part of managing exposures at the sub-asset class level. While asset allocation decisions are typically not specific to sectors of the economy, it would be vital for institutional investors to pre-emptively consider their exposure to (and within) sectors to ensure that they have the appropriate diversification in place to capture the upside and limit the downside at the portfolio level in the lead up (and during) an IPR.
  • For actively-managed mandates, this would mean closer scrutiny over portfolio holdings to ensure that exposure in the high-carbon sectors is being appropriately managed to reduce the risks, whilst the opportunities are also being captured.
  • For passive mandates, low-carbon and fossil-fuel-free indices could be utilised to better position the portfolio in terms of risk/return exposure for an IPR (alongside engagement with companies to also reduce the broader, economy-wide risks).

Create a low-carbon sub-asset class allocation

Would a low-carbon ‘bucket’ provide greater portfolio diversification?

  • Forceful policy actions and technology shifts that occur in an IPR could justify the development of a sub-asset class allocation within an SAA framework focused entirely on ‘low-carbon’ beta. Much like the sub-asset allocations that some institutional investors make to small/large cap, value/growth or other betas to enhance portfolio diversification, the establishment of a low-carbon sub-asset class category could be an explicit way for institutional investors to capture the beta that can be attributed to assets with specific characteristics that drive significantly divergent risk/return outcomes compared to the broad market.
  • Further research on the justification and application of a low-carbon sub-asset class category will focus on the appropriate definition of low-carbon activities, the appropriate metrics within these definitions that best encapsulate beta impacts (e.g., % revenue, cash flows, capex), as well as analysis of the financial performance of a low-carbon allocation under future climate transition scenarios.
  • Analysis will also engage with institutional investors to examine the practical implications of establishing such a sub-asset class categorisation, as well as exploring the appropriate governance structures to support such a shift. Finally, the link between a low-carbon sub-asset class allocation and portfolio construction, in terms of manager and asset selection and review criteria, and portfolio analysis techniques would need to be examined.

Portfolio construction (mandates and manager selection)

This is where institutional investors further translate their investment beliefs and policies around climate-related impacts into specific actions, linking the top-down (beta) decisions around asset class ranges/targets and sub-asset class allocations to bottom-up (alpha) decisions related to mandate design, manager and asset selection/review and portfolio style analysis.

  • Specifically, the climate transition and IPR outcomes have further implications for portfolio construction decisions and techniques, including mandate design, manager selection and review processes, and portfolio style analysis. This would also support engagement efforts with underlying managers, as well as decisions around replacing managers or appointing new mandates.

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    The inevitable policy response: SAA and portfolio construction

    September 2018

The inevitable policy response to climate change