Neuberger Berman: Climate-integrated strategic asset allocation

Provide a short overview of the practice, process or product that is being proposed for the award, including a description of how it is an innovative approach to ESG incorporation and its coverage within your firm.

Neuberger Berman’s Climate-Integrated Strategic Asset Allocation (Climate-Integrated SAA) framework serves to incorporate climate risks and opportunities into top-down portfolio construction for multi-asset portfolios. It can also include carbon emissions constraints for net-zero committed portfolios.

The framework consists of two building blocks: a corporate bond and equity methodology and a sovereign methodology. Our corporate methodology leverages a third-party Climate Value-at-Risk (Climate VaR) metric, which is the present value of future policy risk costs, technology opportunity profits, and extreme weather event costs, expressed as a percentage of a security’s market value. Our unique approach converts the Climate VaR metric into security-level expected return impacts via a proprietary methodology, which we then use to adjust our capital market assumptions. For sovereigns, our in-house framework deploys similar climate scenarios as those informing Climate VaR to translate the expected impact of climate change on macro-financial factors such as GDP growth, debt/GDP ratio, and inflation. The modelled changes to these macro-financial factors are converted into estimated impacts on a sovereign security’s yield and expected returns. Individual security assumptions are aggregated at benchmark level, allowing us to create a climate-optimised portfolio that also optimises on client-specific fundamental objectives such as yield, duration, and volatility.

Describe why you decided to undertake this approach.

According to the International Finance Corporation, researchers estimate that strategic asset allocation decisions can drive more than 90% of the variation in portfolio returns.

Investors already incorporate their views on monetary policy and macroeconomic or geopolitical risks into strategic asset allocation (SAA) by generating forward-looking capital market assumptions. The fundamental difficulty involved in generating those capital market assumptions is amplified by the emergence of novel and difficult-to-measure ESG risks – particularly climate risks, which are much less likely to be reflected in any historical data and more likely to be analysed from a “bottom-up” perspective at the security level. We believe that the impacts of climate change are growing in severity and frequency, and are likely to affect businesses in two major ways: through physical risks to assets and through business risks associated with the transition toward global net-zero emissions. The systemic and rapidly evolving nature of climate risks demands an expanded approach that informs broad asset allocation decisions as well as security selection. Under pressure from frameworks such as the Taskforce on Climate-related Financial Disclosures (TCFD) and the Institutional Investors Group on Climate Change’s (IIGCC) Net Zero Investment Framework, a growing portion of our clients has begun to question how ESG factors, in particular climate-related inputs, might be integrated into their long-term, “top-down” SAA models. Noting the limited options our net-zero committed clients had to meet this challenge, we embarked on our own journey to create a cutting-edge granular Climate-Integrated SAA framework.

Provide a practical example of how you have applied your approach to an investment (security/issuer/sector/asset class/portfolio).

In general, quantifying the results of our Climate-Integrated SAA happens in two steps. First, we run an optimisation using our intermediate capital market assumptions and then apply climate costs derived from our proprietary methodology ex-post. These climate costs lower the efficient frontier: for a given level of volatility, estimated return is lower relative to the optimisation that does not take climate-related costs (and gains) into account. Second, by drilling deeper into our high-level asset classes, we see that climate impacts can vary significantly across asset classes and sectors. Wide dispersion in climate costs suggests an opportunity to enhance estimated risk-adjusted returns by integrating climate costs into the optimisation ex-ante. Our optimisation also allows the relative weight of a sector within an asset class to vary within a specified range. Thus, an SAA optimisation that fully integrates climate costs ex-ante can mitigate losses incurred due to climate costs.

In practice, we applied climate-integrated SAA to inform asset allocation for our Japan-based Climate Transition Multi-Asset Credit strategy, a relative value strategy that invests across credit and equity while each tranche manages towards a net-zero goal. Our model assesses the relative value of climate impacts on different fixed income and public equity asset classes. By applying climate costs to the optimisation ex-post, risk-adjusted returns fall by 39 basis points, but optimising on climate-adjusted capital market assumptions ex-ante can recover up to 22 basis points. In the climate-optimised portfolio, we see a broad shift away from US government bonds and ex-US developed market equities, and into US large cap equities. At the sector level, there is a rotation away from carbon-intensive sectors such as energy, and into low-carbon intensity sectors such as communications. As climate and macroeconomic variables evolve, so does the recommended strategic allocation for the portfolio. On top of these SAA results, our investment teams make tactical decisions based on the market environment while managing towards their individual net-zero targets.

Provide an example of the outcomes, outline the benefits and challenges associated with the introduction of this initiative, and state what you have learned from this approach that can be applied more broadly. How might you intend to develop the process or practice?

Our Climate-Integrated SAA is a flexible framework that can be adapted across various vehicles, asset classes, and geographies. We have already created case studies on how it can be applied to the specific balance sheets of UK and German insurers, as well as Australian superannuation funds. There are several benefits associated with its introduction. First, SAA is typically the focus of the CIO or a dedicated SAA team, which have historically been less engaged on ESG factors. Traditional capital market assumptions have generally ignored climate factors, and our framework provides an opportunity to deepen ESG integration in this area. Furthermore, SAA is meant to provide a model to assess uncertainty; hence it is naturally aligned with forecasting a range of climate scenarios. Once an overall framework for incorporating climate risk has been determined, we believe it can be used for additional asset classes in a consistent manner. The results of our Climate-Integrated SAA can inform discussions regarding potential hedges or climate resilient portfolios. Finally, SAA is generally reviewed each year, which allows for changes in climate risk modelling to be incorporated on a regular basis.

Nevertheless, there are still limitations to any climate-integrated SAA with respect to the accuracy of long-term integrated assessment models, which were primarily constructed to evaluate how human development and societal goals affect climate change. Furthermore, given the quantitative nature of SAA, we faced several challenges regarding the availability of climate data for financial assets with broad coverage across climate risks (i.e., acute/chronic physical risks and transition risks) as well as across climate scenarios. This was most apparent as we expanded our framework to sovereign debt, where climate-related measurement frameworks are only just emerging. In the absence of an existing solution, we combined two distinct datasets – a climate study for physical risks and Network for Greening the Financial System (NGFS) scenarios for transition risks – and through a proprietary methodology, we translated these macro-related climate impacts to model the expected effect on future sovereign yields.

We are working to expand our framework beyond corporate securities and sovereign debt. Starting with private equity, we have estimated climate costs for private markets companies by using public market proxies and appropriately adjusting for differences in sector allocations, corporate leverage, weighted average cost of capital (WACC), and control ownership. Over time, we would seek to cover additional asset classes, including infrastructure, real estate, and hedge funds, to deepen climate integration across a client’s entire portfolio. Finally, we are also focused on offering our clients more holistic net-zero solutions by creating a bottom-up net-zero alignment indicator system that complements our top-down SAA.