Bondholders not immune in climate scenario modelling
Climate scenario modelling firm Ortec Finance sees physical risk from the impact of climate change as the main threat to institutional investment in its updated 2025 climate scenarios and is warning that bondholders could share potential equity market losses in the event of a sharp market repricing.
Ortec sees physical risk as a result of rising temperatures and emissions as the most serious threat to asset performance and the financial system in the range of climate scenarios that it models for financial institutions.
The firm said net-zero by 2050 is no longer a realistic goal and the goals of the Paris Agreement to limit temperature rises to 1.5C by the turn of the century look increasingly unlikely. Under Ortec's most ambitious scenario, the world will not reach net-zero until around 2055 and temperatures will hit 1.6C by 2100.
Ortec said the world is currently seeing a delayed transition and the implications are not yet fully priced, which could cause a major price correction when that happens.
“The transition is priced to some extent, but not fully in line with a successful transition. Physical risks are hardly priced at all and current equity and bond valuations do not reflect a late net-zero trajectory,” said Bert Kramer, head of climate research at Ortec Finance.
“We are quite sure that current valuations do not incorporate this kind of information, so at some stage we do expect a price correction, but when this will happen is highly uncertain."
Ortec Finance provides climate scenarios that help investors and banks to calculate the financial impact of climate change on investment portfolios by quantifying macroeconomic changes and analysing the effect on asset class returns under a range of different climate outcomes.
The firm previously found that equities are more exposed than fixed income in most likely climate scenarios as they depend on longer-term growth expectations and are further down the capital structure and less likely to be repaid.
But the firm’s updated 2025 climate scenarios show that climate change could also influence credit default rates in periods of market disruption similar to the global financial crisis of 2008–09 and a broad market repricing could also see bondholders suffering significant losses.
"Maximum loss in any time period from a corporate bond investment around a stranded asset shock can be more material than what is thought so far. Being a fixed-income investor will not make you immune to a stranded asset shock," Kramer said.
Delayed net-zero
Ortec’s delayed net-zero scenario shows an initial uptick in investment-grade corporate bond defaults in 2030, sparked by a sudden step up in policy action as a new US administration reverses president Donald Trump's rollback of environmental policies and regulation.
"What we currently see is a slowing down of the transition ambition. I now see a delayed transition, not because of the technology but because of the policy side,” Kramer said.
Under the high warming scenario where there is insufficient policy to limit climate change, the impact from 2038 onwards becomes more severe, driven by the wider recognition of the scale of future climate risks.
Ortec finds the implications of a repricing across countries and sectors are closely tied to their exposure to transition and physical risk.
Under the high warming scenario, equity asset performance in the UK and US is expected to decline sharply in the 2030s due to an emerging insurance crisis linked to physical risks associated with rising temperature, and equity prices are expected to fall again more steeply in the late 2030s.
Ortec sees the current gap in projected equity returns due to sector exposures to transition risk as “pronounced” and said it creates opportunities for investors to realign portfolios to mitigate any fallout from the transition.
"Investors should have very well diversified portfolios with a tilt towards sectors and regions that are more resilient or invest in adaptation, so that assets with physical risk implications at least retain most of their value. Sustainable infrastructure could be an example of an asset class that might be relatively robust," Kramer said.
Ortec has seven climate scenarios that simulate a successful low-carbon transition and disorderly or failed transitions. They were designed with Cambridge Econometrics to assess a range of temperature pathways by 2100 and their systemic macroeconomic and financial market outcomes.