UK pension fund investment returns could reduce by 30% in a high warming stress scenario

Research by Ortec Finance, a leading provider of technology and risk management solutions for financial institutions, has found that transition risk is the most significant climate risk facing the investment portfolios of the top 30 UK pension funds in the short term.

Doruk Onal, climate risk specialist at Ortec Finance and author of the report, said: “A disorderly transition to net zero could negatively impact UK pension fund returns by up to 14%** within the next five years.”

The long-term outlook for UK pension funds under a failed transition is even more severe, though. “If we fail to transition to a low-carbon economy, the impact of climate related physical risks on UK pension fund returns could result in up to 30%*** declines by 2050,” he added.

To reach these findings, Ortec Finance applied seven possible climate scenarios to a reference portfolio* of 30 UK pension funds. The scenarios ranged from reaching net zero by 2050 to high warming where average global temperature rises reach 3.7 degrees by the turn of the century.

Real estate and equities are the two most vulnerable asset classes for the UK pension funds considered in this analysis. Real estate is particularly exposed to long-term physical risks because UK pension funds currently hold real estate in regions highly vulnerable to physical risks. Equities, on the other hand, are vulnerable to short-term transition risks, particularly if the transition occurs in a rapid and disruptive manner.

Severe physical risks could slash returns in both real estate and equities, which together comprise almost 30% of an average top 30 UK pension fund portfolio, by around 63%*** by 2050. “In this high warming stress scenario, the increasing frequency of extreme weather events affecting agriculture, labor and industrial productivity, will have a profound impact on economies and assets,” he added.

In the longer term, it is anticipated that unrestrained increases in carbon emissions in the absence of further discernable decarbonization will increase levels of physical risk further, leading to severe financial impacts by the mid-2030s. In a worst-case scenario, returns in the portfolios of the top 30 UK pension funds could decline by 6%*** within the decade, increasing fivefold to 30%*** by 2050.

While short-term investment returns for a top 30 UK pension fund could decline by 14% as a result of low-carbon policies and decarbonization activities, this reduction is less than half of the potential decline of up to 30% in a scenario where active decarbonization does not occur in the near future. Losses are likely unavoidable in all scenarios, but the extent of these losses will depend on the time horizon in which they occur.

For more detail and statistics, please refer to the full report.

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*Reference portfolio represents the average allocation of a top 30 UK pension fund by AUM.
** Figure derived from Ortec Finance’s Net Zero Financial Crisis Scenario Stress
****Figure derived from Ortec Finance’s High Warming Scenario Stress