Climate change: Risky Business?
WORDS BY LYDIA BRUNTON
Everyone is now fluent in the climate change vernacular. Rising seas, increasing air and sea surface temperatures, melting polar ice caps and changes in the frequency and intensity of extreme weather events paint a morbid future. However, have you considered the potential impact on man made institutions, i.e. financial markets, funds management and superannuation? Without mitigation, climate change could reduce global GDP by 20% by 2100.
Nicholas Stern, an amazing economist from LSE, called climate change “the greatest market failure the world has ever seen.” Whether you agree with this statement or not, climate change is now inevitable. Until recently, there was no universal understanding that climate change could impact financial markets or even be considered as a material risk.
The primary role of efficient financial markets is pricing assets according to their true value. By incorporating all the necessary information including risk and return. Climate risk is the potential damage or devaluation of an asset due to climate change. Market participants, including you, should start to questions the climate risks of investments as it may have a direct impact on your own super. Some examples of climate risk that are associated with assets in most superannuation funds are:
- mining companies shares & ASX index funds including the mining sector- increasing regulation regarding polluting and emissions
- infrastructure – some super funds invest in infrastructure, such as roads and hospitals, that may be exposed to regulatory risk and physical impacts of climate change. E.g. flooding and erosion
Climate change is a large scale, multidimensional and incredibly long term risk. The timing and severity of effects are difficult to accurately model and estimate. Conceptualizing large risks such as this, into smaller investment horizons, i.e. a few years to a decade, is no easy task and presents challenges for companies when measuring their own climate risk. That was until the 2012 Mercer report and last year, the Task Force for Climate-related Financial Disclosure by the IMFs Financial Stability Board classified climate risk into two categories transition risk and physical risks (see the table below), and advised a framework for scenario analysis. Scenario analyses use predictions of physical, regulatory and technology changes due to climate change and the impact on assets.
Disregarding climate risk during the investment decisions in funds management may result misallocation of capital. For example, having a large amount of BHP Billiton shares in mining fossil fuels for energy rather than Carnegie Clean Energy shares in renewable energy may make your superannuation portfolio susceptible to climate risk especially in regards to regulation. Thus, monitoring and disclosure is the only way to tackle climate risk. Considering the materiality of the risk at all stages of the investment process, for all market participants, will minimise the exposure.
The Economist estimates climate change will result in US$4.3 trillion of losses in privately held assets due to damage caused by extreme weather including droughts, floods and storms and lower returns and slower economic growth. And In the worst-case scenario, the losses could reach US$13.8 trillion. Alas, through responsible asset management and sustainable asset selections, i.e. investing in environmentally sustainable and economically transformative opportunities, will create well diversified (i.e. low climate risk) portfolios.