Modeling transition and physical risks in pension plan investment strategies: a multivariate normal regime switching approach

In this paper, we conduct numerical experiments to evaluate decarbonization strategies for pension plans using a regime-switching multivariate normal return framework. Our approach distinguishes between climate dynamics and portfolio strategy. The climate dynamics are modeled as a regime-switching process, where the regimes represent exogenous climate risk mitigation strategies. Within each regime, we model sector-specific returns, which incorporate sector and regime dependent effects of transition and physical climate risks. These adjustments are educed from historical data and climate science literature. The portfolio decision concerns the pension plan’s decarbonization strategy. We simulate 30-year wealth paths under three decarbonization strategies. Our results show that the decision to decarbonize consistently outperforms inaction across the climate scenarios considered. These findings persist when investor behavioral biases, including recency bias and climate skepticism, are incorporated. However, significant tail risk persists across all strategies, reflecting the potential for systemic market failure under adverse climate outcomes. Overall, the analysis suggests that pension plan fiduciaries can pursue decarbonization not despite their financial obligations but in alignment with them, provided climate risks are properly integrated into long-term investment modeling.