Mirko Cardinale, Head of Investment Strategy at USS Investment Management, explains how the scheme updated and separated its frameworks for assessing transition and physical risks.
If you want to get from A to B In unfamiliar territory, you look at a map. But what do you do if the only available maps fail to warn of the hazards that could delay or even derail your journey entirely?
This is the problem facing many asset owners as they plot their path to net zero greenhouse gas (GHG) emissions, as part of their efforts to protect their portfolios and beneficiaries from climate change.
Bodies including the Institute and Faculty of Actuaries (IFoA) have sounded the alarm on the inadequacy of climate scenario analyses that fail to provide institutional investors with the detailed information they need to accurately plan their route to 2050.
“The results emerging from current models are far too optimistic and, in some cases, implausible,” warned the IFoA, in its 2023 report, ‘The Emperor’s New Climate Scenarios – a warning for financial services’.
With the International Panel on Climate Change warning of the need to reduce emissions by almost half by 2030, and physical risks manifesting in real time, the need for actionable short- and medium-term scenarios has grown urgent.
Faced with a clear gap in the market, Universities Superannuation Scheme (USS), which provides pensions to more than 577,000 members across the UK’s universities and higher education sectors, decided to meet the need itself, with the help of the University of Exeter and other third-party experts.
Its 2023 ‘No Time to Lose’ report presented four scenarios for transition, designed to play out the potential consequences for key macroeconomic metrics and adoption of renewable energy from alternative policy choices.
A key feature of the scenarios – which were updated in USS’s recent Task Force on Climate-related Financial Disclosures (TCFD) report – is that they are dynamic, reflecting the interplay of macro forces: extreme weather, financial markets, government policy and technology innovation.
They paint very different pictures of net zero transition, but with some common features. While GDP growth forecasts might vary by 4% between the most orderly and chaotic scenarios, for example, all predict higher inflation.
Common shortcomings
In theory, climate scenario analysis should help investors to understand the financial risks that affect their portfolios under different assumptions around the energy transition and evolution of the climate.
According to Mirko Cardinale, Head of Investment Strategy at USS Investment Management, which oversees the scheme’s £76.8 billion (US$102.9 billion) assets under management, climate scenario analyses have three common shortcomings.
First, the modeling of physical risk and extreme weather events tend to be highly simplified and fail to leverage the latest insights from climate science. The second problem is a tendency to model the path of energy transition in isolation from geopolitical events, such as trade wars, or the development of new technologies, like AI, etc.
A third limitation is the focus of traditional analysis on very long run time horizons “which really compounds the uncertainty”, says Cardinale, who has a remit across the spectrum of investment strategy decisions, from long run decisions on asset liability modelling, to total portfolio management, to day-to-day rebalancing and other tactical investment decisions.
USS’s 2023 report tackled these points head on, setting a foundation for further exploration by the scheme and its partners. “Leading up to 2025 TCFD report, we focused a number on a number of areas where we thought we could improve to end up with a decision-useful framework that we can apply to the investment strategy and the risk management process,” he explains.
Again, there were three elements to the update. First, USS enhanced its modeling of physical risks, partly by developing a highly granular geolocational map to understand how different parts of the world are potentially exposed to different climate hazards and how these vulnerabilities could affect its assets. Second, while maintaining the overall narrative scenario framework, USS updated the narratives to add more depth and dynamism to the trajectories of key macroeconomic and energy system variables.
Finally, USS is seeking to understand how the scenarios affect specific sectors and companies. Going from the macro to the micro is a work in progress, acknowledges Cardinale.
Preparing for diverse scenarios
From the optimistic ‘Roaring Twenties’ to the somewhat apocalyptic ‘Meltdown’, USS’s scenarios outline differing but realistic views on policy actions, responses and interactions with other macro forces, with divergent implications for economic performance, as well as energy demand and supply. How does USS prepare for such different visions of tomorrow?
“If you’re using a traditional approach to strategic asset allocation, where you focus on modeling expected return and risk in one central scenario, it becomes quite difficult to integrate fully the output of the analysis,” says Cardinale. “You need a more flexible approach, which we have developed at USS over the last few years, where you blend quantitative analysis with a layer of judgment.”
The key, he says, is to try to understand the common themes across the scenarios, such as inflation. “The reasons for the underlying inflationary pressures are slightly different across the scenarios, but they all point towards sort of lingering pressures in the next few years from a combination of the energy transition-specific aspects and supply-side shocks. That really helped us derive the practical implications,” Cardinale explains. “We strengthened our focus on inflation protection in our portfolio through a mix of pure inflation hedging assets, but also assets that give us protection, by behaving well in inflationary scenarios.”
In one specific scenario, ‘Boom and bust’, there is a significant downturn – characterised by high inflation, policy conflicts and financial instability – followed by a recovery. “The best thing you can do, rather than try to pinpoint the turning of the cycle, is to be prepared. So we strengthen our focus on resilience to ensure that our portfolio can withstand a severe market shock, while remaining able to reposition our portfolio to take advantage of opportunities should a significant shock arise.”
Platform for dialogue
While climate scenario analysis is primarily a tool for internal understanding financial risks, USS’ work always had the explicit secondary purpose of generating dialogue with external parties, including policymakers, portfolio companies, and other investors and institutions.
“The narrative scenario enabled dialogue both internally and externally. We had a very interesting dialogue with our portfolio managers over the implications of the scenarios for oil demand, and we tried to incorporate the different views in the analysis. Maximising that dialogue can help to enrich the scenarios and become an iterative process,” says Cardinale, noting that USS consulted more than 40 experts from multiple fields for the original ‘No time to lose’ report, and many more since.
To maximise dialogue, USS published the report as a “public good”, hoping to stimulate debate among key decision makers.
“This is a systemic risk. We cannot fully diversify away from climate change. We need to help policymakers and businesses to manage these risks appropriately. So hopefully, the scenarios can provide input into the decisions that policymakers and business need to make,” says Cardinale.
Further, USS intends to use the 2025 updates to its analysis as part of its future engagement with policymakers on the range of policies needed to achieve an effective energy transition.
“You need a targeted approach to different sectors, rather than a one-size-fits-all model where everything is achieved through a single carbon price, because some sectors are more advanced in the energy transition, like the electricity sector the UK, while steel or cement production are much further behind,” he adds.
The updated climate scenario analysis will also inform company engagement once USS has mapped out the revenue-related implications for portfolio companies of alternative scenarios.
“That will help us prioritise our efforts with companies – not necessarily those with the highest emissions today, but those with business models that might be more at risk depending on which scenario is going to play out,” Cardinale explains.
One reason for this secondary use of USS’s climate scenario analyses is its conviction that multiple actors need to make fundamental changes in order to address systemic risks such as climate change.
“Focusing on reducing our carbon footprint, which is what pension funds have done over the last few years, is not enough,” insists Cardinale. “The trajectory of carbon emissions of many pension funds has come down, so carbon intensity is now lower than it was a few years ago. But this has not really helped to make progress in the real world towards the energy transition.”
According to its TCFD report, released in July, the scheme reduced the emissions intensity of its non-sovereign defined benefit assets by 51% by the end of December 2024, from a 2019 base, meaning it is already ahead of its 2030 target. However, this currently only captures the Scope 1 and 2 emissions of USS’s investments. Just under half (47%) of its portfolio emissions are from assets aligned with a pathway well below 2°C.
USS’s response to the slow overall pace of change is a more holistic and systemic approach based on engagement with policymakers and other actors that can help to progress the transition.
“Asset owners are arguably at the top of the food chain, but we can’t achieve [everything] on our own. We need we need businesses and policymakers to play their part as well.”
This systemic approach also involves collaboration with other investors to maximise leverage, says Cardinale. While USS has the influence to engage with the UK, as the country’s largest private sector pension scheme, its voice is not as loud elsewhere.
“Through the networks we develop with other asset owners, we can jointly engage and influence governments around the world. There is a collective responsibility for asset owners to collaborate and to act to influence policymakers towards the outcomes that we all aspiring to, in terms of the best financial interests of our members,” he says.
Physical risks “baked-in”
A key feature of USS’s updated climate scenario analysis is its further separation of its assessment of transition and physical risks to financial returns. This makes sense when the incidence and impacts of extreme weather are already causing widespread financial losses.
“Physical risks are almost independent of the transition scenario. They are ‘baked in’ over the next few years,” says Cardinale.
In its updated assessment, USS has sought to map exposures to acute and chronic physical risks across locations, with a view to understanding the vulnerability of concrete assets tied to portfolio holdings.
“We try to understand the likelihood of a particular event occurring, how that can change because of the climate developments, and the potential impact on economic activity in that particular area,” he adds.
With some physical risks becoming increasingly severe, especially in key emerging markets like Brazil, India and Indonesia, USS is explicitly incorporating physical risk as part of the country risk assessments. Applying the assessment to companies is more challenging, says Cardinale, due partly to ongoing difficulties in accessing reliable data on asset location.
“We really require an in-depth understanding of where physical assets – data centres and production facilities – are located, and which of these are critically important to the business,” he explains.
While USS identifies river floods, wildfires, heatwaves, tropical cyclones, and drought as acute risks, heat stress is ranked as a chronic risk, with negative implications for labour productivity across industries and countries. As well as scientific climate data, the asset owner’s risk assessments have factored in the varying abilities of countries to prepare for and adapt to higher levels of heat stress.
“The exact quantification of the impact is difficult because there are many other factors to play, but it is nevertheless an important variable when thinking about economic prospects of different countries, which will affect the attractiveness of investments in particular countries,” says Cardinale.
Despite the difficulties, the exercise is essential to understanding and acting on risks in the short and medium term. “A number of these physical risks are likely to be manifesting themselves in relatively short order,” he adds. “that’s why our focus has been trying to understand exposures and what, what locations, what countries are more exposed than others.”
Focus on the narratives
While USS’s 2025 updates represent a step forward, the process of refining climate scenario analysis remains iterative. Cardinale’s focus is on improving the ability of the framework’s four core scenarios to reflect impacts on key macro factors, of which climate change is only one, and capturing the dynamics between them.
To that end, USS is building a scenario tracking tool that leverages technologies including AI to analyse news flows and data releases in real time. This will help it understand which elements of its scenario narratives are becoming more or less likely.
“Rather than focusing on precise quantification and arguing about every basis point in terms of estimated differences in return between one scenario and other, it is much more productive to focus on the narratives,” says Cardinale. “It’s important to make them relate to what’s actually happening in the real world, rather than building scenarios for the next 30 or 50 years.”
