United StatesIn the last half-decade, climate change has made the journey from a peripheral, almost irrelevant issue for financial markets to become a focus issue. While we have known about climate change for more than half a century, the issue didn’t make much conceptual headway, particularly in financial circles, until very recently. Climate change has arrived.
Investors would be well served to see that conceptual journey as an analogue to the impact of climate change itself. There are impacts that are almost unnoticeably gradual, like the water temperature in the famous boiling-frog example. But there are also impacts that occur suddenly and, outside of very short windows, unpredictably, and they can be devastating. Moreover, there are tipping points that could dramatically accelerate the trajectory of climate change that we can foresee, and the really scary thing about those is that they’re not only unpredictable but irreversible, without changes in technology that by today’s standards would be indistinguishable from magic.
What we can do is anticipate the risks that climate change brings and use our investment tools to hasten the transition to a low-carbon future. The alternative is to be more and more vulnerable to a series of increasingly frequent and unpleasant financial shocks.
The economics of climate change
Climate change will likely be expensive to fix, but it will be far more expensive to ignore. After all, investing in things that build low-carbon economies is something that yields returns and dividends; suffering through “natural” disasters and retreating from seacoasts does not.
Studies that have tried to estimate the economic impact of climate change have come up with various estimates, depending on how effective we are at reining in greenhouse gas emissions. Estimates range from more than $4 trillion in present-value losses to the world’s $143-trillion stock of manageable assets, to a reduction in global incomes by approximately 23 percent by 2100,1 to a loss of 5 – 20 percent of global GDP by 2100.2 These and other estimates of the economic impact of climate change are all underestimates,3 not because they are willfully blind, but because many of the consequences of climate change are somewhere between difficult and impossible to forecast.
We must understand what sorts of risks and opportunities climate change creates and incorporate those into the investment toolkits we have. Specifically, we need to find ways to price climate risks and assess low-carbon opportunities.
Climate change creates a number of risks, which are often categorized as transition and physical risks.
Transition risks are created as we move toward a low-carbon economy. There are some firms — the classic examples are companies that extract and produce fossil fuels — whose current business models are flat out incompatible with a low-carbon economy, unless we learn very quickly how to cheaply extract carbon from the atmosphere and put it away for the foreseeable future. Then there are businesses that face significant, but not existential, risks from the transition: big emitters who might face increasing costs from regulations designed to tax or limit emissions, and customers of those emitters who can’t diversify major parts of their supply chains away from carbon-intensive inputs. That’s regulatory risk.
Big emitters, in particular, also face increasing litigation risks, and climate-related litigation is expanding.
Big emitters, in particular, also face increasing litigation risks, and climate-related litigation is expanding.4 In 2019, climate change court cases have been brought in at least 28 countries, with more than three-quarters of those cases brought in the United States. While most still target governments, cases against companies (particularly the big emitters) are rising.
Technology is also part of the transition risk equation. Avoiding a climate catastrophe is certain to require some sea changes in technology. The major contributor to the greenhouse gases now in the atmosphere has been, for many decades, combustion of fossil fuels, which has formed the backbone of two things that help define the difference between developed economies and everyone else — widely available electricity, and personal mobility. Getting fossil fuels out of our electric infrastructure will take a great deal of investment and effort, but the transition is already underway, especially in producing electricity: The US electric power sector has already reduced its carbon intensity by 3% annually since 2008,5 but the kind of decarbonization we need — reaching zero emissions by 2050, as called for in the Paris Agreement — will require far more investment. So, too, will decarbonizing transportation. Nearly every branch of the transportation tree is making some kind of effort to produce zero-emission options, and this is most advanced in cars and light trucks, where electric vehicles are already gaining market share.6 But for air and marine travel, both for people and freight, true zero-emissions solutions are not on the immediate horizon. So where’s the risk? The major technological risks are likely to affect companies that do not invest in the low-carbon transition, or those that depend on there not being such a transition. The International Energy Agency estimates that the rise in electric vehicle market share will displace demand for six million barrels of oil per day by 2040;6 oil companies that do not anticipate that shift may be stuck with stranded assets.
Physical risk is the term that encompasses the risks that businesses, markets and economies face as a result of the things a warming climate does, such as increasing the incidence or severity of floods, droughts, extreme precipitation, fires, tropical cyclones and sea level rise. All of these probably carry price tags in the hundreds of billions over the next several years. For example, one recent study estimated that the cost to protect coastal communities in the United States alone would be more than $400 billion over the next two decades7 — with much of that needed sooner rather than later. By 2100, the world could face annual costs of $14 trillion as a result of rising seas alone,8 but the costs aren’t all in the distant future. Morgan Stanley recently estimated that climate disasters over the past three years cost the world $650 billion.9
The financial impacts of climate change
The risks climate change creates are sobering, for certain. But the opportunities are also large and growing, and in finance, those who price risks more accurately and identify opportunities for growth and transition stand to benefit financially. That, of course, is not the primary reason for financial markets to truly incorporate climate change into daily activity; the overriding reason for that is simply to avoid a climate catastrophe, whose impacts are all but guaranteed to exceed even the high end of the estimates of the economic impact of climate change. But it is still helpful to the low‑carbon transition that there is money to be made on financial markets by recognizing the risks and opportunities of climate change.
Earlier work has shown that climate-friendly investment strategies often show higher risk adjusted returns than respective conventional benchmarks.10 Making more carbon-efficient portfolios has also shown superior returns compared with a portfolio of less carbon-efficient firms.11 The literature probing the financial implications of integrating climate risks and opportunities into investment has expanded, and there are several new threads of promising work in it.
Pricing the risks of climate change: transition risk
There is widespread agreement that financial markets are not accurately pricing all climate risks now. But there is also growing awareness of at least some of those risks, particularly transition risk. One recent paper estimated that by halving exposure to more carbon-intensive sectors, bank losses would be reduced by 30 percent in Europe.12
Another study found that portfolios composed of companies that were more aggressively decarbonized — or less exposed to high-emissions companies — performed better between 2009 and 2018 in both the United States and Europe.13 Again, this speaks primarily to transition risk and shows that there are several paths to decarbonization, most of which performed poorly between 2009 and 2012 and then began to outperform. Notably, portfolios with more aggressive decarbonization performed better, or had higher “decarbonization alphas.” This reflects the rapid growth in financial markets’ awareness of climate risks in more recent years, as well as the growth in climate-related data at the firm level, including emissions data, climate policies, emission reduction targets, and the development of tools that provide insight into the need for and quality of emissions reduction plans, including things like Science Based Targets and the Task Force on Climate-Related Financial Disclosure.
A similar result came from a 2019 paper from S&P Global, which found that carbon-sensitive portfolios (those with lower carbon intensity) outperformed the S&P 500 between 2007 and 2019, with no degradation in financial fundamentals such as Sharpe ratios, average market cap, earnings yield and sales growth.14 Moreover, there were some additional correlations that many investors see as valuable: More carbon-efficient portfolios also have significantly lower water use, air pollution and waste generation compared with the S&P 500.
One of the most easily identifiable transition risks is the existential threat to business models that are simply not compatible with reaching zero emissions by (or before) 2050. Foremost among those business models are those of energy companies — at least as long as they see the energy business as extracting, refining and producing fuels that will be burned by downstream users for energy. For about the past decade, we’ve heard the term “stranded assets” to describe assets that once had positive value, but whose value diminishes rapidly (eventually, to zero) because of the low-carbon transition. Fossil fuel reserves are often regarded as poster children for this concept.
A 2019 paper looked at the impact of proved reserves of oil firms on value. While proved reserves have long been a significant component of firm financial value, growth of those reserves on company balance sheets between 1999 and 2018 had a negative impact on value. Undeveloped reserves — oil fields that have been proven to exist but require major capital investment in order to produce oil — were responsible for that negative impact on value, suggesting that markets are no longer seeing development of fossil fuel reserves as valuable assets.15
There is also evidence that shareholders value climate risk disclosure on the part of companies. Another 2019 paper found when shareholder engagements aimed at climate risk disclosure were successful in convincing companies to disclose more, those companies that did achieved higher valuations.16
Finally, finance has long viewed climate risks as being pertinent only over long time spans — often longer than the typical 3 – 5 year horizon that many financial professionals define as “long term.”17 But recent evidence speaks to a different reality: Deutsche Bank assessed more than five million pages of company announcements released by the approximately 1,600 companies in the MSCI World Index over the past two decades, along with every Dow Jones news piece over the same time period, and found that companies that had positive press and announcements on climate change saw share price outperformance of 1.4 percentage points per year over the MSCI World Index.18
Pricing physical risks
At the moment, there isn’t much in the way of quantitative work linking physical risk with financial outcomes, even though we do know that the financial implications of things like floods, fires, severe storms, droughts and sea level rise are large now and growing ever more ominous. There are several reasons for that.
Transition risks are far easier to spot and forecast than physical risks. We already know that the biggest emitters are more vulnerable to changes in public policy regarding emissions reduction, and those changes in policy don’t happen with no warning, like hurricanes. Similarly, the big emitters are also more likely to be the targets of litigation, and to face reputational risk as people seek to assign blame for catastrophic events.
Physical risk is very different. A company’s physical risk depends at least as much on where it is, and where its suppliers and customers are, as what it does. Even mapping the financially significant assets of many global companies — not to mention the locations of their supply chains and customers — can be challenging. That, sadly, is the easy part. The more difficult part of forecasting physical risk is that doing so requires familiarity with global climate models, which are often families of individual models that link individual models of various parts of the global climate system — the atmosphere, the oceans, the land surface, circulation, clouds and much more. Some of those individual models are global; many are specific to sub-global locations. Familiarity with these disciplines is not abundant in the world of finance.
Progress is being made fairly rapidly, mostly because the alternative to understanding the potential impact of physical risk is to be vulnerable to a large and increasing series of quite unpleasant shocks.
Even if it were, there are many challenges involved in assessing changes in the risk picture that pertains to any specific location on the globe. The resolution, or geographic scale, of global climate models is usually on the order of 150 to 200 kilometers. While that may not be a major stumbling block in assessing some physical risks, it is for others. The city of Twentynine Palms, for example, is about 125 miles (200 kilometers) east of Los Angeles and has an average altitude above sea level of 1,988 feet. It is pretty much intuitively obvious that Twentynine Palms and Los Angeles face a very different risk from sea level rise. In order to make climate models sufficiently scalable to provide meaningful risk data for specific companies and their assets, downscaling the models is required, and this, too, requires a lot of work.
Even with climate modeling competence, understanding the financial implications also requires familiarity with financial and economic forecasting. None of this is straightforward, and very little of it is intuitive in the way that first-order approximations of regulatory risk can be.
Nonetheless, progress is being made fairly rapidly, mostly because the alternative to understanding the potential impact of physical risk is to be vulnerable to a large and increasing series of quite unpleasant shocks. Our ability to assess the influence of climate change on past weather disasters, known as “extreme event attribution,” is growing fast, and it shows that the human fingerprint on extreme weather is ubiquitous.19 We also have the ability to go back to past assessments of physical risk, and see if those predictions have manifested themselves, and the accuracy of past climate forecasts is (perhaps surprisingly to some) high.20 For example, a 2007 report from the United Nations Intergovernmental Panel on Climate Change noted: “An increase in fire danger in Australia is likely to be associated with a reduced interval between fires, increased fire intensity, a decrease in fire extinguishments and faster fire spread … In southeast Australia, the frequency of very high and extreme fire danger days is likely to rise 4 – 25% by 2020.” NASA’s images of Australia in January 2020 show the relevance of that prediction.
Source: Brian Resnick, Umair Irfan and Sigal Samuel, “8 Things Everyone Should Know About Australia’s Wildfire Disaster,” Vox, Updated Jan. 22, 2020.
The other indicator that physical risk forecasting has gone mainstream is the fact that many financial institutions are quickly and publicly building up expertise in understanding those risks. Moody’s recently bought the climate-risk ratings firm Four Twenty Seven.21 Japan’s credit ratings agency, Rating & Investment Information Inc., is expanding its efforts to incorporate environmental factors into its ratings.22 S&P Global is working to incorporate climate risks of all types into its ratings and assessments and recently disclosed that 60 percent of the companies in the S&P 500 Index hold assets that are considered high risk for at least one type of climate-related physical event.23
Central banks are also increasingly vocal about the need to better understand the risks that climate change poses, and the extent to which these pose systemic risks for financial markets. The Bank of England has long been a leader in urging central banks to act to reduce climate risks, or at least understand them better; it is proposing to require banks to conduct stress testing against three climate scenarios.24 Climate risk assessment and disclosure is a theme also espoused increasingly by the European Central Bank and by other members of the Network for Greening the Financial System (NGFS), a group of central banks and financial supervisors aimed at understanding and managing the financial risks and opportunities of climate change. Jerome Powell has affirmed the intention of the US Federal Reserve to join the NGFS.25 The prudential regulator of banks in Australia — whose politics are as divided and often hostile to climate action as those of the US — is increasing its surveillance of Australian banks’ readiness to deal with climate change and recently stated that climate stress testing will be required.26 Investor and financial ignorance of climate related risks, once common, is dwindling quickly.
Summary
The more we understand climate change, the more certain we are that it will affect financial outcomes, in many cases profoundly. While we do not yet have all the tools we need to make reliable forecasts of those outcomes, we know enough to know that we need a better toolkit, and pricing in the risks we can assess is good for portfolio and financial value.
Financial professionals are, after all, in the business of understanding and pricing what is going to happen. We’ve just seen this happen: As this report was being written, financial markets experienced one of their worst weeks since the 2008 financial crisis due to the expected impact of the coronavirus. Those impacts have already been significant. But whatever those impacts are, we don’t expect the impact of the coronavirus to be with us for centuries, at least not as epidemic or pandemic levels. That is exactly what we expect of climate change. It’s time to act, and acting is very much in the interests — financial and other — of all of us on the planet.
1 Burke, M., Hsiang, S. & Miguel, E., Global Non-linear Effect of Temperature on Economic Production, Nature, 2015.
2 Stern Review, The Economics of Climate Change.
3Ruth DeFries, Ottmar Edenhofer, Alex Halliday, Geoffrey Heal, Timothy Lenton, Michael Puma, James Rising, Johan Rockström, Alex C. Ruane, Hans Joachim Schellnhuber, David Stainforth, Nicholas Stern, Marco Tedesco, Bob Ward, “The Missing Economic Risks in Assessments of Climate Change Impacts,” Sept. 20, 2019.
4 Joana Setzer and Rebecca Byrnes, “Global Trends in Climate Change Litigation: 2019 Snapshot,” Grantham Research Institute on Climate Change and the Environment, July 2019.
5 Ashley Lawson, “Decarbonizing US Power,” Center for Climate and Energy Solutions, July 2018.
6 International Energy Agency, “Global EV Outlook 2019,” 2019.
7 Sverre LeRoy, Richard Wiles, Paul Chinowsky, Jacob Helman, “High Tide Tax: The Price to Protect Coastal Communities from Rising Seas,” The Center for Climate Integrity Resilient Analytics, June 2019.
8 Institute of Physics, “Rising Sea Levels Could Cost the World $14 Trillion a year by 2100,” July 3, 2018.
9 Tom DiChristopher “Climate Disasters Cost the World $650 Billion Over 3 Years — Americans Are Bearing the Brunt: Morgan Stanley,” CNBC, Feb. 19, 2019.10 Oliver Oehri, Christoph Dreher, Christoph Jochum, Maximilian Horster, Viola Lutz, Denis Jorisch, and Martin Stadelmann, “Climate-friendly Investment Strategies and Performance,” The Center for Social and Sustainable Products and The South Pole Group, Nov. 7, 2016
11 Soh Young In, Ki Young Park, Ashby H.B. Monk, ”Is ‘Being Green’ Rewarded in the Market?: An Empirical Investigation of Decarbonization and Stock Returns,” Stanford Global Project Center, April 16, 2019.
12 Alessi Lucia, Elisa Ossola, Roberto Panzica, “The Greenium Matters: Evidence on the Pricing of Climate Risk,” University of Milan Bicocca Department of Economics, Sept. 13, 2019.
13 Alex Cheema-Fox, Bridget R. LaPerla, George Serafeim, David Turkington, and Hui Wang, “Decarbonization Factors,” Harvard Business School, Nov. 11, 2019.
14 Temi Oyeniyi and Richard Tortoriello, “The “Trucost” of Climate Investing: Managing Climate Risks in Equity Portfolios,” S&P Global Market Intelligence, Dec. 2019.
15 Christina V. Atanasova and Eduardo S. Schwartz, “Stranded Fossil Fuel Reserves and Firm Value,” National Bureau of Economic Research, Nov. 2019.
16 Caroline Flammer, Michael W. Toffel, Kala Viswanathan, “Shareholder Activism and Firms’ Voluntary Disclosure of Climate Change Risks,” SSRN, Oct. 12, 2019.
17 Mona Naqvi, Brendan Burke, Svenja Hector, Tricia Jamison and Stan Dupré, “All Swans Are Black in the Dark: How the Short-term Focus of Financial Analysis Does Not Shed Light on Long Term Risks,” Tragedy of the Horizon, Feb. 2017.
18 Luke Templeman and Jim Reid, “Climate Change and Corporates: Past the Tipping Point with Customers and Stockmarkets,” Deutsche Bank Research, Sept. 2019
19 Carbon Brief, “Mapped: How Climate Change Affects Extreme Weather Around the World,” March 11, 2019.
20Alan Buis, “Study Confirms Climate Models are Getting Future Warming Projections Right,” NASA Jet Propulsion Laboratory, Jan. 9, 2020.
21Christopher Flavelle, “Moody’s Buys Climate Data Firm, Signaling New Scrutiny of Climate Risks,” The New York Times, July 24, 2019.
22 Responsible Investor, “Climate Could Become ‘Big Risk Factor’ in Credit Ratings, Warns Japanese Agency,” Responsible Investor, July 30, 2019.
23 S&P Global Market Intelligence, “S&P Global Unveils The Big Picture on Corporate Climate Risk at WEF in Davos,” Jan. 22, 2020.
24 Mark Carney, “The UK Is Stress Testing Banks for Climate Risk, Others Must Follow,” The Financial Times, Dec. 18, 2019.
25 Vibeka Mair, “US Fed Set To Join Green Central Banking Group,” Responsible Investor, Jan. 30, 2020.
26 Emily Cadman, “Australia Banks To Face Climate Stress Tests, Regulator Says,” Bloomberg, Feb. 20, 2020.
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