Could your investments go up in smoke?

With the start of the year, wildfires in Australia have led to countless animal deaths, people fleeing from blazes into the ocean and skies darkened by smoke. It highlights how climate change is exacerbating the extent and severity of natural catastrophes.

The effects of the Australian fires have not yet been fully costed or assessed. But, in the three months to 7 January, insurers received more than six times the annual average number of claims received over the prior five years¹. By comparison, Californian utility group Pacific Gas and Electric, which was an A- rated credit in 2017, was the first company to declare bankruptcy, in 2019, pointing to climate change’s effects in respect of the state’s Camp Fire wildfires seen in 2018.

Physical effects from climate change have severe implications for communities, companies and investors. In our Outlook 2020, we highlighted the value of starting to position portfolios for the implications of climate change. To help that process, we now look at the physical risks that climate change produces.

More frequent and severe weather

Weather has always been variable. Extreme weather events have occurred in the past. Yet, these events are becoming more frequent and intense with climate change (see chart).

Physical effects of climate change are driven by the increase in average temperatures along with change in global and local weather patterns. Their impact can be through acute weather events (such as stronger hurricanes due to warmer oceans) or “chronic” longer term changes to trend (for instance, rising sea levels due to a combination of thermal expansion and the melting of land ice). In combination, they can be particularly devastating.

When listed, the range of weather events sounds apocalyptic — storms, heatwaves, droughts, rising sea levels, flooding or ocean acidification. However, the sad reality is that we are experiencing such events today, and with increasing regularity.

Implications of physical risks for companies

With increases in both acute and chronic physical effects, their potential materiality and cost increases too. The Task Force on Climate Related Financial Disclosures highlights potential financial impacts of physical risks to include²:

• Reduced revenue from decreased production capacity (for instance, transport difficulties, supply chain interruptions)
• Reduced revenue and higher costs from negative impacts on the workforce (such as health, safety, absenteeism)
• Write-offs and early retirement of existing assets (for instance, damage to property and assets in “high-risk” locations)
• Increased operating costs (say, inadequate water supply for hydroelectric plants or to cool nuclear and fossil fuel plants)
• Increased capital costs
• Reduced revenues from lower sales/output
• Increased premiums and potentially reduced availability of insurance on assets in “high-risk” locations

Assessing whether the above financial impacts will occur depends on the likelihood of primary physical risks and then any secondary implications. Primary physical risks cause direct damage to assets (such as land, buildings, stock and infrastructure) due to the physical effects of climate-related events.

Secondary physical risks arise as climate change 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. In the extreme, extended physical damage in a country or region can produce conflict and mass migration due to food and resource scarcity.

All sectors of the economy face both types of risks from the physical effects of climate change. The chance, and consequences, of any particular risk and impact will vary by sector, company, and location. The table below summarises some of the physical climate impacts and their effects on a company’s value chain.

Checking portfolios for climate-related risk

With climate change posing greater material financial risks, investors need to consider how to incorporate the physical risks into their portfolios. Assessing physical risks can be approached starting by a sector or geography and/or evaluating a specific company. Vulnerability to these risks goes beyond physical assets and across the value chain, as well as supply chain, customers, and markets. More importantly, resilience depends on company or governmental management, planning, and governance.

Climate change is accelerating and becoming more visible. Weather-related natural catastrophes are causing hundreds of billions of dollars-worth of losses worldwide. Longer term shifts in weather patterns, while not as obvious today, have deeper implications for companies and communities. Whether continued climate degradation can be sufficiently addressed, society faces greater risks. Investors should prepare accordingly.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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