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As one of the defining challenges of this generation, climate change is not just an environmental concern, but also an economic one. The way companies operate, governments regulate and individuals consume is already changing. Not surprisingly, then, certain climatic factors ultimately influence which investments are successful and which are not.
Unfortunately, as with most predictions, it is impossible to forecast climate change trends with 100% accuracy. The weather may get worse than expected or market participants may react differently than hypothesized. These divergent results are examples of climate risk and they have the potential to affect the performance of investments.
What is climate risk?
To understand how climate change can alter our understanding of investment risk, it is important to first learn what is meant by investment risk. Investment risk can be viewed as the possibility that investments will generate an unexpected return result, or the range of possible future investment results. Investment risk can also be interpreted as the known range of possible future results. Imagine you roll a die, and the resulting number is how much your investment would return. The average expected print run is between three and four; however, you could roll a one or a six. This is investment risk.
As we know that there are multiple future climate change scenarios, there are also multiple potential consequences on investments. Even if investors set reasonable expectations about the future climate, there is still the possibility that it will develop differently than expected. This is the climate risk.
Climate risks are generally disaggregated into physical risk and transition risks.one
Physical hazards
Physical risks refer to the possibility of weather and climate-related damage affecting asset prices. A major concern around climate change is the costs associated with increasing frequency and intensity of natural disasters and extreme weather, such as floods, storms, droughts, hurricanes, and wildfires. These impose costs by damaging existing assets, destroying inventory, restricting operations, and disrupting existing demand. Some investments are more sensitive than others when it comes to physical risks. For example, agricultural companies are more exposed to drought-related costs than information technology companies.
Transition risks
Transition risks are the risks that arise from the shift to a low-carbon economy. As the weather continues to worsen, the attitudes of market participants are likely to change. Governments are likely to become increasingly open to taxing emissions and subsidizing. Consumers can shift their demand towards greener products, while companies can change their business models to suit trends. These results fall into a spectrum of transition scenarios, which creates risk. An example of a transition risk is a company that pollutes a lot of carbon emissions and faces the prospect of future regulatory costs, or consumers that switch to companies with a better environmental record.
Market reactions to climate change
When it comes to physical risks, the worst impacts of climate change are easier to understand because they are tangible. The real difficulty arises when trying to predict the magnitude of these costs over the life of a business. The further away from the prediction, the less accurate they are.
The risks of transition are even more up in the air. While physical risks are a function of the variety of climatic and meteorological outcomes, transition risks are functions of how consumers, businesses, and regulators will react to them. This adds an additional layer of unpredictability.
Finally, it is important to note that market reactions are not only functions of the changing climate, but also of the behavioral peculiarities present in investors. For example, it is not yet clear whether investors efficiently factor weather risks into security prices.
Why climate risk is difficult to estimate
It is difficult to estimate the climate risk due to uncertainty around the true distributions of climate risk.
Unlike investment risk, investment uncertainty reflects current and future unknowns. According to the previous example, the uncertainty would be to roll a die without even knowing the numbers that are painted on each side. In this example, an investor would not even know what the possible future results or their probabilities are. The further we try to forecast weather factors, the greater the risk and uncertainty.
Climate science is relatively young field of study. There is still much we do not know about the future of the natural environment, and we know even less about how the market may react to a changing climate.
Although climate science comes to a better understanding of what has generated past weather patterns, there is still much to learn before we can make better forecasts of physical events. The difficulty in forecasting the impacts of transition events is exponentially greater. Estimating how market participants might change their behavior under different future climate scenarios is fraught with uncertainty, as there is limited historical data from which future relationships can be estimated. Furthermore, because climate change trends are likely to structurally change our global economy, the historical relationships between the economy and the climate may not even be the same in the future.
How does the industry measure climate risk?
There are currently several metrics that can be used to measure different types of exposure to climate change.
Exposures to physical risk are often measured by quantitative models using historical relationships between climatic factors, such as temperature or precipitation and safety returns, or by simulations of what the future might look like under certain climate change scenarios.
The most common measure of portfolio climate exposure is carbon exposure. Carbon exposure refers to a company’s carbon emissions and fossil fuel reserves and is generally used to manage transition risk. Companies that emit large amounts of greenhouse gases are more likely to face additional costs of reducing emissions or paying fines. Therefore, many investors use carbon data as a method to manage their portfolio transition risk exposure.
Carbon emissions are greenhouse gas emissions, generally expressed as carbon dioxide equivalents, into the atmosphere. They are generally divided into Scope 1, 2 and 3 emissions. Scope 1 emissions are those that are emitted directly during the production process. Scope 2 emissions are indirect and arise when a buyer consumes electricity, heat or steam that has generated emissions during production. Scope 3 emissions capture a broader range of indirect emissions that occur during upstream and downstream activities in the supply chain (such as transportation or waste disposal).
Fossil fuel reserves are the known and potential fossil fuels that a company has as assets on its balance sheet. The definition of these is simpler than that of carbon emissions. Exposures to fossil fuels are largely concentrated in specific industries, such as the oil and gas sector.
Despite the introduction of these measurement tools and metrics, many still acknowledge that the investment industry is still learning how to fully estimate climate risks.
Are we getting better at measuring climate exposure?
There are reasons to be optimistic about the future of climate change risk management. As time goes on, climate science is getting better at understanding complex weather patterns. Climate economists are also developing a better understanding of the potential impacts of climate on the behavior of market participants.
The academic literature on climate economics and climate finance is also a rapidly developing field. There are also now several large organizations that exist with the primary purpose of improving the quality and availability of data on various climate risk metrics. All of these factors are likely to facilitate the assessment of the climate risk of investments and allow investors to better assess the exposures of their portfolios to climate change.
one A third type of climate risk is liability risk. Liability risks relate to the possibility that parties who have suffered losses from the above types of risks seek compensation from those responsible. These risks are more relevant to the insurance industry as they are spillover risks.
Important information
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MCR-00879 / 03-18-2021
