By Anna Thompson
Climate change, one of the most defining challenges in this century, is a long-term alteration of temperature and weather patterns that define the Earth’s climates. Science tells us that further alteration and warming is inevitable in both the short and long run. Thus, in this uncertain environment, climate change has recently rapidly transformed from being a corporate social responsibility issue to one of top regulatory importance. The Paris Agreement is a legally binding international treaty concerning climate change and was ratified in 2016 by a number of signatories including Australia. As a result of this agreement, the issue of climate change has become more prominent.
A number of regulatory initiatives, such as the Task-force for Climate related Financial Disclosures (TCFD), have been enforced in the past decade. They have had the effect of making asset managers responsible for incorporating climate risk and related considerations into their investment decision making, governance and risk management. Asset managers are now responsible for reporting on the administration, strategy, risk and measures concerning climate risk. Thus, they will want to examine the exposure of their firm to climate risk and ensure the processes for capturing this exposure are current and foolproof.
According to the TCFD, climate risk is ‘a combination of physical and transition risks which may pose financial and reputational damage to financial and non-financial services firms.’ Investment risk is the potential for investment returns to differ from an expected return. With a multitude of possible future climate change scenarios existing, there are multiple possible consequences on investments and therefore climate risk feeds into this investment risk. Reasonable expectations could be set by investors concerning the future climate, yet there is still the risk that it will differ from expectations. Climate risk is typically separated into physical and transition risk.
Climate-Related risks and Financial Impacts
Physical risks concern the possibility of weather and climate-related damage affecting asset prices. For example, a one-off event such as a flood that damages properties or crops, or the impact of long-term effects of climate change. These events impose costs by damaging existing assets, stock, and disrupting demand and operations. Certain investments are more sensitive to physical risks – for example, agricultural companies have a higher risk of drought-related costs than an accounting firm. If portfolios and funds are not created in a way that manages and mitigates this risk, these investments are exposed to increased valuation risk.
Stranded assets are those which are unexpectedly devalued as a result of climate related events. Physical risks materialising, such as climate events destroying particular physical inventories or certain sectors becoming obsolete as a result of a regulatory or societal retreat from activities which contribute to climate change, can result in assets becoming stranded.
Source: Bank of England
As a result, stranded assets pose risks to investments and are often used as the general unit of measurement when debating the possible financial impacts of climate risk. The London School of Economics estimated the value of global financial assets that are at risk from climate change as being US$2.5 trillion, while the Economist estimated it as being US$4.2 trillion. Stranded assets are important in managing financial risk to attempt to avoid loss after an asset has become a liability. Asset managers are expected to be wary of the possibility of investing portfolios or funds in companies or sectors prone to stranded asset risk. However, re-positioning portfolios due to possible stranded assets needs to be adequately explained by asset managers due to the possibility of incurring unnecessary costs for investors and compromising their returns.
As discussed above, there is mounting regulatory pressure on companies to alter their operations and activities in order to mitigate negative environmental externalities. Coupled with heightened social pressure, risks arise as a resulting shift towards a greener, low-carbon economy. This is the transition risk. As climate change worsens, market participants are likely to change their attitudes: governments may become more open to taxing emissions, and consumers may shift their demand towards more environmentally friendly products. This creates transition risk such as:
- The risk of consumers switching to invest in firms with more environmentally-friendly track records;
- The risk of firms with high carbon emissions facing high future regulatory costs;
- Or the risk of media announcements regarding harmful environmental practices that can negatively affect a company’s market value.
Climate risk is persistent and will continue to evolve into the distant future. As a result, institutions must integrate considerations of this risk into their business strategies, and risk management and governance processes in order to not only keep up with the increasing regulations but also ensure their business can survive in the long-term. As climate change is a problem that will persist long into the future, addressing climate risk is something that needs to be integrated into everyday decision-making, rather than being a one-off process.
Sources: NASA, Deloitte, Ernst & Young, AFR, Russell Investments
The authors of this publication are not qualified to provide financial or investment advice and as such the content provided should not be construed in this manner. All information is intended purely for educational purposes and is provided for the personal interest of UNIT members. The opinions expressed within the article do not reflect those of UNIT as an organisation, its partners or its sponsors.