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Adding Climate Risk in Investment Assessments Is No Passing Trend

July 14, 2021, 8:00 AM

When it comes to climate-related investment risk (the “E” in ESG), retail investors’ mild concerns about, say, a future beach house purchase, may be evolving into more nerve-wracking fears of a “great climate repricing” of financial assets.

In May, President Biden issued an executive order calling for government agencies to prepare for climate-related shocks across the financial system―including the value of retirement funds.

With the SEC mandate of climate-related disclosures on the horizon, and seemingly imminent energy and transportation policy overhauls, retail investors will begin to expect their advisers to understand and utilize data on asset-level climate risk.

But the analytics needed to understand the impact of climate change on an investment portfolio are complex and evolving. Retail investors may find it challenging to find an adviser with sufficient climate risk fluency.

Climate Repricing May Be Abrupt

While the most severe physical impacts of climate change will emerge over decades, in a rapid repricing scenario―sometimes referred to by economists as a “Minsky moment”―investors suddenly and collectively “wake-up” to the realities of climate change: Yes, the world will move away from fossil fuels, leaving previously solid companies with stranded assets and untenable business models. Yes, sea levels will rise, and unprepared cities will default on their debt. Yes, companies will pay more to cool their warehouses, steady their supply chains, and insure their factories against fire and flood.

Of course, there will be big winners as well. Solar and wind companies will grow market share. Suppliers to the exploding electric vehicle market will see sales surge. Northern cities that have languished economically will see their tax-base grow as businesses and residents migrate to regions with increasingly inviting climates. These are growth opportunities that no investor wants to miss.

Democratization of Climate Risk Data

Institutional investors have been anticipating these possibilities for years. Long before ESG entered the vocabulary of Main Street investors, pension funds and large thematic asset managers have been screening securities for attributes that may be favorable in a climate-aware economy.

Managers who work in this space have spent years curating the data sources, processes, and staff to balance the climate risks and opportunities within a portfolio―resources to which most advisers haven’t traditionally had access.

But that is changing.

In the last few years, the movement to bring climate-risk “products” to market has opened the door for advisors to start guiding clients toward incorporating this new class of risks and opportunities into their investments.

Companies such as MSCI (Morgan Stanley Capital International) and Moodies/427 now offer products that can assign climate risk metrics to tens of thousands of equity and bond securities—making it possible to incorporate climate insights into allocation decisions and client-adviser conversations.

Climate Risk Quantification

Concerns that the data availability and analytic approaches used for metric-based products are not yet mature hasn’t stopped demand. According to a survey by Task Force on Climate-related Financial Disclosures
(TCFD), over three-quarters of financial market participants use forward-looking climate risk metrics. And a majority (70%) of managers say that the benefits of using these metrics will increase with standardization.

The SEC is expected to announce a framework for climate-risk reporting in the second half of 2021. The TCFD framework is widely seen as a likely template for the SEC rules.

The TCFD focuses on two categories of climate risk: “transition risk” (i.e., the tax, regulatory or reputational burden that may be incurred as the world transitions to a low-carbon economy) and the “physical risks” (damage or business disruptions resulting from e.g. flooding, wildfire, violent winds, rain, and temperature extremes) of climate change.

Traditionally, the reporting of greenhouse gas emissions has been the main pillar of transition risk disclosure. While estimating corporate emissions is far from trivial, there are reporting protocols that have been around for decades, as well as a thriving industry of consultants and reporting platforms to support the process.

In comparison, disclosing physical risk presents a daunting challenge. Each peril requires a specialized and geographically tailored analysis, as well as an evaluation of a firm’s vulnerability to those physical hazards. Currently there are no broadly accepted methods or metrics for quantifying or reporting on the physical risks.

The demand for this data coupled with the general lack of corporate in-house expertise in physical risk assessment has led to an exploding private industry of climate analytics firms focusing on asset level physical risk. As well, existing companies that assess catastrophic risk for the insurance industry have launched climate-aware versions of their traditional products.

Climate Risk Analytics

The industry will be grappling with climate risk for the foreseeable future. This is not a passing trend. Nor is it something that will be solved once and for all. Standards, methods, and products will mature and evolve.

Climate data and its relationship to asset risk is intrinsically dynamic―companies change their behavior, policy/regulatory regimes fluctuate, and technology moves forward. All while the underlying science of climate change itself evolves.

Once mainstream market participants wake up to the risks and opportunities posed by the physical environment and our attempts to manage it, it will become one of the common lenses through which risk is evaluated.

This column does not necessarily reflect the opinion of The Bureau of National Affairs,Inc. or its owners.

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Author Information

Alicia Karspeck is the head of research at FabricRQ, which helps investment advisers and institutions understand and manage ESG/climate risk in their portfolios. She has a Ph.D. in climate, oceanography, and atmospheric science.

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