A Climate-Resilient Reserves Portfolio

MAS, as Singapore’s central bank, manages the official foreign reserves (OFR). In doing so, MAS aims to provide good long-term returns, while being resilient across market conditions. Climate change introduces risks, but also opportunities, for the reserves. Hence, managing the financial impact arising from climate change aligns fully with our responsibility to safeguard the reserves portfolio from long-term risks and to seize opportunities where appropriate. We aim to build a climate-resilient reserves portfolio through three channels - analysis, actions and accountability.

Analysis: Climate Scenarios and Signposts

Climate change presents unique investment risks and opportunities

The effects of climate change and societal response to climate risks could trigger market re-pricing of assets and in turn affect portfolio returns. 

Climate change can result in physical risks that can damage physical infrastructure, halt production of goods and services or disrupt supply chains of companies that we invest in.

Climate change also entails transition risks, where the actions taken by governments and the private sector to tackle issues related to climate change can significantly impact – both positively and negatively – the performance of various sectors. For example, heavy carbon taxes can significantly impact earnings, raise the cost of capital, and reduce the availability of financing and risk underwriting for companies especially in carbon intensive sectors, while benefitting alternatives such as renewable energy and low carbon transportation. 

Climate risks and opportunities are challenging to measure accurately

Emissions pathways and the pace of global warming associated with climate change remain uncertain. Additionally, the policy choices that governments make today and in the coming years can impact behaviours of households and companies for decades, the pace of transition and even the trajectory of climate change effects like global warming and rising sea levels. These, in turn, result in second-order effects like systemic financial risks or adverse societal responses to climate policies, and subsequent challenges in modelling these effects. 

This cone of uncertainty is exacerbated by the long time horizon over which climate risks can potentially escalate if an orderly transition does not continue apace. It is therefore difficult to rely on traditional risk models that determine the severity of a risk factor based on probabilistic risk distributions over shorter-term periods of up to a few years. 

The methodologies for modelling physical and transition impact to financial asset prices are at a nascent stage of development. There is significant progress that can still be made in the area of data availability and quality. Nonetheless, efforts to better understand the key risk drivers allow us to distil actions that can, and should be, taken despite the uncertainties. 

Scenario analysis

To deepen our understanding of possible investment implications of climate change, MAS has partnered GIC, Singapore’s sovereign wealth fund, and engaged industry-leading consultants to conduct climate scenario analysis on MAS' portfolio.

Our analysis focused on three main climate scenarios – Paris Orderly Transition, Delayed Disorderly Transition and Failed Transition. These scenarios cover a range of transition and physical risk impacts and shocks that can manifest over both short and long term horizons, and enable us to assess the resilience of our portfolio to the impact of climate change and take appropriate portfolio actions where necessary. Each of the three scenarios is associated with a plausible temperature pathway determined by drivers such as global carbon prices and adoption rates of low-carbon technologies. 

While scenario analysis does not predict or forecast climate outcomes, it provides a range of potential future climate states. The varying degree of changes in global and regional temperatures within each scenario result in differing physical risk impact. This, in turn, depends on assumptions such as the relationship between temperature changes on labour and agricultural productivity and the extent of physical asset damage caused by the effects of temperature increase e.g. rising sea levels and extreme weather events.
The table below summarises the scenarios:
Scenario Description Global Warming by 2100
Paris Orderly
Transition
 
Early and ambitious policy measures (e.g. more aggressive carbon taxes and renewables subsidies) and high adoption rates of low-carbon technologies limit greenhouse gas (GHG) emissions. 1.5°C 
Delayed Disorderly Transition Climate actions are not adopted until a spike in extreme weather events globally prompts governments to take decisive but abrupt actions to limit GHG emissions. These sudden and disruptive policy changes are introduced in a single year, in 2025, to decarbonise the economy at an aggressive pace required to achieve Paris goals.  1.5°C - 2°C 
Failed Transition Limited policy measures and low adoption rates of low carbon technologies result in accelerating climate change. The impact of climate-related physical risk is mostly priced in by 2040 as markets awaken to the reality of an irreversible climate calamity.  Close to 4°C 

Key findings

1. Climate change can impact the MAS portfolio negatively. However, this is mitigated by the well-diversified nature of the portfolio with fixed income instruments accounting for the largest allocation.

Equities are more impacted compared to bonds and cash. Equity returns are more sensitive to (i) changes in macro-economic factors (e.g. GDP) due to climate change and (ii) changes in companies’ earnings caused by climate-related variables such as carbon prices, oil and gas demand and clean technology deployment.

Sovereign bonds are relatively less impacted by climate change. Nevertheless, physical and transition risks are still present, potentially lowering portfolio returns compared with a scenario without any climate change impact.  

Across all three climate scenarios, the portfolio continues to grow and generate meaningful returns over the longer-term horizon given positive asset class returns and economic growth drivers that more than offset the negative impact of climate change.

2. Physical risk has a higher impact on the portfolio, compared to transition risk. The most damaging effects of physical risk manifests much later, especially in the absence of climate mitigation, while transition risk would be a more immediate risk to manage.

The impact to the portfolio due to physical risk is larger than that of transition risk, especially in the Failed Transition scenario.

The impact of physical risk, however, becomes more pronounced only much later when global temperatures start to rise significantly.

Transition risk impact, although less severe, is a more immediate risk to manage from an investment perspective. Climate policies and actions to transit the economy to a more sustainable future are expected to occur well before the most damaging physical effects of global warming materialise.

3. There is a wide dispersion of transition risk impact and a nimbler set of portfolio actions is required to maximise portfolio returns.

The transition risk impact varies across the scenarios. Even within the same scenario, the transition impact can vary significantly depending on the sector and the country. 

Within a single sector, impact can vary depending on the actions of specific companies. For instance, the transition to a low carbon economy poses the greatest risks to carbon intensive sectors. Nevertheless, there remain opportunities for companies (e.g. renewable energy companies within utilities) to pivot successfully to a low carbon economy. The ability to seize these opportunities will vary based on their individual circumstances and actions.

Given the differentiated impact across countries and sectors and within sectors, a nimbler set of portfolio actions would better enable the portfolio to capture upside opportunities, while reducing climate downside risks.

Climate Signposts

Climate signposts provide continued ex-ante insights on the likely climate policy direction and expected temperature pathway, based on the latest current available data and evidence.

If appropriately chosen, these signposts can inform our judgment on which scenario will likely materialise, so that appropriate portfolio actions could be taken in a timely and effective way.

MAS is studying carefully how climate signposts can be incorporated into our decision-making process.