Over the last year, we’ve seen extreme weather events make global headlines, including the German floods and Greek fires. More investors are thinking about climate change, environmental risks and how they might affect their portfolios.

As a risk management challenge, the optimal approach to climate change is one that acts now to reduce the risks, as long as this does not involve disproportionate economic costs.

There are two significant risks associated with climate change – physical risk and transition risk.

Physical risk

Physical climate risks are the most tangible to each one of us, and include flooding, hurricanes and wildfires. According to the World Meteorological Organisation, the number of disasters has increased by a factor of five over the past 50 years and economic losses by a factor of eight. Floods and storms represent 80% of the number of disasters and losses. Meanwhile droughts, extreme temperatures, landslides, and wildfires account for the remaining 20%.

These climate events have an impact on crop yields, disrupt supply chains and increase insurance costs – with a risk of a decline in availability and affordability of insurance provided by the private sector. As a result, investors need to assess how those events might impact companies’ manufacturing process. Such as whether they have contingency plans in place, have diversified their supply chains across regions and countries, and insured those risks.

Transition risk

Climate transition risks are more abstract but can be more costly for an investor as regulatory frameworks change. These include changes in climate and energy policies, a shift away from fossil fuels into low carbon technologies and liability issues. According to Climate Action, current policies, pledges and targets are far from being aligned with 1.5°C warming above pre-industrial levels.

It is near certainty that governments will have to implement stricter climate policies including the introduction of a carbon tax which would penalise the highest emitters.

Market value impact

To illustrate these risks, the 2° Investing Initiative (2DII) developed its PACTA tool. PACTA calculates the magnitude of potential market value losses if governments decide to take drastic policy actions to limit global warming.

The climate relevant sectors are power, coal mining, oil & gas (upstream), auto manufacturing, cement, steel, and aviation. These sectors represent 75% of global greenhouse gas emissions. According to their research, 12% of the FTSE 100 index involved in those sectors (from available data) would lose 60% of their market value under such a scenario. The day of reckoning is coming.

Opportunities

It’s not necessarily all doom and gloom. As someone who creates investment portfolios that aim to have positive social and environmental impact, I’ve seen that investors can play a role in bringing about change, and that can include managing for factors related to transitioning to a low carbon economy.

We’ll be looking at this subject in more depth in our 2021 annual impact report to be published next month.