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15 Jun 2021

How investors are looking at climate change risks and the work still to be done

Luke Baker

Climate change is starting to give portfolio managers sleepless nights as its potential and real effects start to hit home. It is already changing how businesses are operating, governments legislating and every one of us consumes.

And this is getting increasing attention from the investment community now who are looking for increasing amounts of data to support their investment decisions.

Forecasting climate change is incredibly difficult however with climate scientists working with models of such huge complexity and wide ranges of uncertainty. But climate risk is now seen as one of the leading risks to investment portfolios by some of the world's largest investment managers. Just look at BlackRock’s Larry Fink letter to CEO’s each year, climate risk is at the forefront.  

What is climate risk?

Investors are constantly managing investment risk, you will hear the phrase risk adjusted return constantly within the field. Their goal is to drive a high return for an investor whilst taking as little risk as possible. And that risk is measured by looking at all the potential future outcomes and determining the different chances of each scenario.

As we know climate change has multiple possible scenarios this means also that there are multiple possible consequences for investments also. And this is what climate risk is.

But what are these risks actually?

Climate risk is typically broken down into two areas, physical risks and transition risks.

Physical risk is that of the potential for climate related damage to affect the price of companies assets. And we see it on the news now all too often, its natural disasters such as floods, storms, droughts, hurricanes or wildfires. Got a company with a large property portfolio on the beach fronts of Florida, you’re likely to have a flooding issue on your hands. Or if you're invested in a food company that is reliant on corn and wheat from the southern U.S. you’re likely to have significantly increased drought risk.

You’ve then got transition risk, we now know that the entire global economy needs to move towards net zero by 2050 and as a result there are going to be winners and losers. This transition risk could be caused by government legislation, for example in the U.K. where petrol and diesel cars will be banned by 2030. Automobile companies not quickly transitioning to electric vehicles will lose out on an entire market.

It could be consumer trends affecting demand for existing goods and services. This could be food companies who need to react to consumer trends around sustainably sourced food by changing where they source their own produce and the potential increased costs. 

One final risk worth mentioning is liability risk, this is where off the back of events that cause financial harm to companies from climate change the company seeks damages. This is a risk that largely sits with the insurance industry and is an increasingly significant one. 

This sounds complex, how do they do it?

Managing climate risk is incredibly difficult, whether it’s predicting consumer trends, the pace at which governments will legislate change on high emission sectors or predicting the frequency of future disaster events. 

One of the key data points used by investors is that of carbon exposure. This refers to the company's carbon emissions and fossil fuel reserves and is generally used as a measure for transition risk. This data is all collected through an organisation called the CDP group and distributed out to investors to help better understand these risks. The logic behind this is that companies with high emissions are more likely to face additional costs of reducing emissions or paying fines. 

This is not the only input to consider however with individual country climate policy directly impacting the speed at which this transition might take place. This is largely a less well understood area but will increasingly become important for investors to understand as policy change becomes widespread. Here Climate Policy Radar are looking to map the climate policy global ecosystem and help investors and policy makers understand better potential climate policy pathways. Led by an experienced team of policy experts and data scientists expect this will become an increasingly important piece in managing this transition risk.

When we look at physical risk there is significant investment going into improving this understanding also. One particular company is Cervest, who are enabling easy access to climate models for company real estate assets across the globe. The London based company started in 2016 and recently raised a whopping $30mn in funding to help companies and investors manage this physical risk with an initial focus on urban environments.

A long way to go

It is widely accepted that the investment industry still has a long way to go in managing effectively climate risk within portfolios. However with increasingly granular reporting requirements being mandated by governments like the EU and greater use of advanced technologies to help assess such risks the industry is moving in the right direction. In a later article we’ll take a look at the actual levers the finance industry has to go beyond managing risk and instead forcing change.

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