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How investors are assessing the future cost of climate change risk

an arctic ice sheet breaking up
Published 11 Jul 2024

Quantifying the impact of climate change on physical assets and business models presents a challenge for all investment professionals. Scenario analysis and carbon pricing are central to understanding plausible future outcomes.

When people envisage the impacts of climate change risk, they tend to picture the physical risks: soaring temperatures, rising seas, failing crops, species loss, hunger and strife. Images of island nations disappearing under the waves might come to mind, while worsening heatwaves, droughts, wildfires and floods are already evident. These will collectively take a considerable toll on household income, food security and quality of life around the world (see Figure 1).

But across a diversified portfolio, the transition risk could be thousands of times greater than the physical risk, according to Michael Lebbon, Founder & CEO at Emmi, a firm which helps financial institutions understand and analyze the climate risks of their assets and portfolios.

“Transition risk moves very quickly,” said Lebbon, speaking on CFA Institute’s recent Climate is Collective Webinar about Understanding Climate Scenarios. “If we actually had policies that are aligned to a 1.5°C world today, by some estimates, over half the global value of stock markets could be lost overnight.”

Physical risk, on the other hand, takes hold over a much longer timeframe, giving firms more opportunity to adapt. The worst physical impacts are also likely to be felt in less-developed countries, where there are fewer material financial assets.

Figure 1: The Compounding and Cascading Effects of Climate Change Multiple climate change risks will increasingly compound and cascade in the near term Key Bi-directional compounding Uni-directional compounding or domino Contagion effect on multiple risk Reduced household income Reduced labor capacity Food prices increase Reduced soil moisture and health Reduced food security Food yield and quality losses Increased malnutrition (particularly maternal malnutrition and child undernutrition) Decreased quality of life More frequent and more intense Extreme heat and drought Source: The Intergovernmental Panel on Climate Change

The Taskforce on Climate-Related Financial Disclosures (TCFD) recommends organizations use scenario analysis to develop strategic plans to prepare for transition and physical risk. They can draw on one of more than 100 publicly available climate scenarios or construct their own to anticipate a range of plausible future outcomes based on varying assumptions about policy and technology developments, macroeconomic factors, population growth, greenhouse gas emissions trajectories, and behavioral and societal changes.

Investors use scenarios to assess potential implications of climate-related risks and opportunities, and to inform stakeholders about how the organization is positioning itself in light of these risk and opportunities.

Widely used scenarios within the financial industry are developed by the Network for Greening the Financial System (NGFS), Intergovernmental Panel on Climate Change (IPCC) and International Energy Agency (IEA).

“There’s really no one-size-fits-all. You have to see which scenario best meets your requirements,” said Sonia Gandhi, Senior Director, Education at CFA Institute.

One thing that all the main scenarios make clear is that policy, as it stands, falls short of limiting warming to 1.5°C, which is considered vital to achieving net zero by 2050 (see Figure 2).