How investors are assessing the future cost of climate change risk
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.
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).
Although 145 countries covering close to 90% of global emissions have announced or are considering net zero targets, the Climate Action Tracker assesses the majority of these as insufficient. It states: “We are a long way from converting net zero targets into policies and actions that will result in real-world emissions reductions.”
As the physical effects of climate change risk become increasingly visible, however, many, including the Principles for Responsible Investment – a United Nations-supported network of investors working to promote sustainable investment – believe it is inevitable that governments “will be forced to act more decisively than they have so far”.
Carbon pricing
As policy ratchets up, so will transition risk for organizations and investors. Among the expected measures are higher carbon prices, as regulators seek to hold carbon-intensive businesses accountable for their impact on the environment. Gandhi describes carbon pricing as “one of the most potent tools in combating climate change”.
Carbon pricing can take the form of either a direct tax on emissions or a cap-and-trade scheme, where an overall limit is placed on emissions and businesses buy and sell credits on a mandatory carbon market. Examples of cap-and-trade schemes include the EU Emissions Trading System (ETS), California Cap-and-Trade Program and the Regional Greenhouse Gas Initiative covering 11 Eastern US states.
“With cap-and-trade schemes, the market determines the price of carbon,” said Gandhi. “The limit on emissions is usually gradually lowered over time to incentivize a lower use of carbon intensive processes.”
As that happens, the price of carbon credits would increase. And as pressure to address climate change risk mounts, governments will likely implement and ramp up direct emissions taxes.
For investors, carbon prices provide a valuable reference. “It basically tells you how much people think reducing carbon is worth. And then from there, you can make more informed investment decisions around that price,” said David von Eiff, Director, Global Industry Standards at CFA Institute.
Both the NGFS and IEA net-zero scenarios foresee steep increases in carbon prices up to 2050 (see Figure 3).