Many of us in the northern hemisphere have just worked through the warmest May on record. No wonder physical climate risk is a hot topic for investors. Poor them. Having recently been made to wrap their heads around the concept of transition risk — the effect of decarbonisation on portfolio returns — they now have to think about exposure to rising sea levels, extreme heat and cyclones.
What is the best approach? It is not unkind to say that even professional investors are struggling to come up with a coherent answer. Partly this is because climatology makes stock picking look easy. Also scientists are flaky at finance and vice versa — so good analysis is hard to find. Another problem is that physical climate risk is seen as a sustainability issue. This confuses things terribly.
So far climate risks appears to be not priced correctly
It is much simpler for investors to view physical climate risk as they would any other risk management input. After all, assets have and forever will be exposed to thunderbolts from the gods. It is true that science is almost unanimous that human activity is raising the stakes. But before worrying about the future, investors need to ask whether today’s climate risks are priced correctly.
That is unlikely. Companies are woeful at disclosing the climate-related risks to their business. Try to find in an annual report the physical location of every warehouse or office. Or the percentage of revenues earned from customers in a hurricane zone. To make matters worse, climate risk does not effect companies in isolation. Whole supply chains were disrupted in the Thai floods of 2011, weighing on technology shares around the world.
So asset values probably understate physical climate risk already. And if the International Commission on Stratigraphy decides the earth has entered the Anthropocene, consensus on man-made climate change would justify a further step-up in discount rates. That would raise the cost of capital and lower equity and credit prices — all else being equal.
Overlaying climate modelling with corporate analysis
To help investors manage the physical climate risk in portfolios dozens of research firms have popped up that overlay climate modelling with corporate analysis. The likes of Four Twenty Seven, for example, rank companies based on their exposures to physical climate risk. It is then possible to create new equity and credit indices that better reflect the real risks to asset prices.
Some argue that underweighting stocks with higher risk scores is unethical as it punishes vulnerable countries that need the most investment to cope with climate change. Indeed, 80 per cent of Asian companies are represented in the worse half of the MSCI World Index when sorted by physical climate risk — according to Four Twenty Seven data — whereas only a fifth of European names are.
Investors need not lose sleep. Eschewing a listed stock — say a carmaker in a flood zone — has in theory no effect on its cost of funding, capacity to invest or share price. Equity capital is permanent. Every seller has a buyer and the price at which they trade is driven by fundamentals. This also holds when a company raises new funds.
Companies should be open about their climate risks
Everything should be done to help vulnerable regions. But physical climate risk is one of many risks. The spread on an emerging market credit could widen due to a deteriorating political situation even when the issuer has limited physical climate risk. Is that unethical too? Of course not. If anything it is unethical that asset owners have been denied the company data needed to assess physical climate risks for so long.
Transparency helps everyone. Fewer surprises reduces the volatility of asset prices and lowers the cost of capital. And the more accurately risk is calculated, the more sophisticated any mitigation response can be. That means better insurance, flood defences and drought resistant crops. Investors win, as do the most vulnerable to climate.
The best response to physical climate risk is to engage. Man-made climate change only increases the urgency. Force companies to disclose how many metres above sea level their factories sit. What about their suppliers? Where do their customers live? Then scientists can get to work cross-referencing this data with climate models. The result should be a safer planet and superior risk adjusted returns.