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Climate change: assessing investment risks

6 minute read

12 November 2019

Climate change is an inevitable trend in an uncertain world. So what are the implications for investors and what can they do to integrate climate change risk into investment strategy?

Climate change

Amid the ambiguity faced in 2020 from a geopolitical, economic, and societal perspective, climate change may be the only certainty ahead of us.

During 2019, global attention to the topic was magnified, not least by Greta Thunberg and public marches, attracting the attention of individuals, companies and politicians. Arguably it now moves beyond climate “change” and should be called a climate “emergency, crisis, or breakdown”.

Time for action

2020 will be a critical year to see whether the championing of action by key stakeholders, not least investors, to limit climate change risk occurs. How financial markets allocate capital affects both investment returns and the planet.

For those who haven’t assessed the implications of climate change on their investments, it is time to start. To help, we briefly outline the growing climate challenge and its investment risks. The next article examines investor implications.

The increase in average temperatures is the primary indicator of climate change and driver of many of its effects. Since 1850, 17 of the warmest years on record have occurred in the last 18 years (see chart). The world is now on average one degree Celsius hotter than it was between 1850 and 1900. An increase of one additional degree to average annual temperatures is seen as the threshold to “severe, widespread, and irreversible” effects of a climate breakdown.

Global warming rises to dangerous levels

Unprecedented threat

In September, 515 institutional investors, managing $35tn in assets, said that climate change poses an unprecedented threat to the global economy and that much more needs to be done by governments to accelerate the low carbon transition and to improve the resilience of our economy, society and the financial system to climate risk.

515 institutional investors, managing $35 trillion in assets, said that climate change poses an unprecedented threat to the global economy.

Climate risks need to be considered

For investors, the question becomes how to identify and consider the climate-related risks in their portfolios. The G20 Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD) has defined four types of climate-related risk.

Transition risk

The first three are broadly seen as transition risks. These result from actions taken to achieve climate targets and transition to a low-carbon economy.

  • Market and technology risks – Market risks include the shifts in supply and demand for certain commodities, products and services as climate change is increasingly a purchasing decision for companies and consumers. And when new technology that supports transition to a lower-carbon, energy-efficient economic system winners and losers will emerge
  • Policy and legal risks – Governments enact climate policies to help deliver their Paris Agreement commitments or to adapt to the effects of climate change. Organisations not prepared for the nature or timing of these changes are exposed to policy risk and its financial costs. As the value of loss and damage arising from climate change grows, legal risk will likely increase further
  • Reputational risk - Customer or community perception of an organisation’s role and contribution to climate change creates a reputational risk for many sectors. Reputational damage can affect a company’s license to operate, ability to attract talent, or, most directly, revenues as consumers switch to alternatives.

Physical risk

Lastly, climate risk includes two types of physical risks which arise due to the continued increase in temperatures and extreme weather events. Physical risks can be event-driven or long-term shifts in climate patterns.

  • Primary physical risks – Climate change will cause direct damage to assets (such as land, buildings, stock and infrastructure) due to the physical effects of climate-related factors like storms, heatwaves, droughts, rising sea levels, flooding or ocean acidification
  • Secondary physical risks – This generates more indirect risks that affect supply chains and extended value chains. For example, availability of key resources, like water, sourcing and quality of raw materials, or rising costs of assets and commodities. Indeed, extended physical damage in a country or region can produce conflict and mass migration due to food and resource scarcity.

We do not suggest that investments are assessed solely through the lens of climate risk. Other risk factors, such as liquidity or inflation, still need to be considered. In some situations, these will outweigh climate risk – notably with shorter investment time horizons and, somewhat ironically, in scenarios where global warming is minimised. However, it is important that climate risks are added to the set of risks considered when making investment decisions.

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