The Time is Now

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“Managing Carbon Risk: The Time is Now”

Dr Charles Donovan, Director of the Centre for Climate Finance and Investment, Imperial College Business School, Imperial College London

Mr Simon Wilde, Senior Managing Director, Macquarie Capital; Research Fellow and Visiting Lecturer, Imperial College Business School, Imperial College London

As Bank of England Governor Mark Carney highlighted in his 2015 Lloyd’s of London speech, the impact of humanity induced climate change is a “mega risk” with “potentially profound implications for financial stability and the economy”. Whilst the impact of rising greenhouse gas emissions has long been viewed as a serious issue, some commentators were nonetheless surprised to see a central banker intervening.

Since then, we have witnessed the COP21 agreement in Paris, further work by the Bank of England, and carbon risk warnings from major fund managers such as Blackrock. However, many investors continue to struggle with how to address the issues of climate change and associated financial risks. In this article, we seek to define “climate risk” and what it means for institutional investors and financial institutions.

Climate risk is the potential impact on the value of financial assets of both (1) direct physical effects of climate change and (2) the indirect consequences of transitional measures taken to reduce greenhouse gas emissions. An example of direct effects is increasing storm damage from more extreme weather patterns. The insurer Lloyd’s estimates that the effect of Superstorm Sandy on New York property damage was amplified 30% due to sea levels having risen 20cm due to prior climate change, the equivalent of more than $5 billion extra costs. Other direct effects are likely to include substantial changes in agricultural productivity, and supply chain disruptions associated with flooding and extreme heat events.

Large though this impact is, the indirect effects are potentially far greater and more immediate. With regards to transition risks, there are two sides of the coin: the impact of existing and future emissions reduction policies and the ongoing technological disruptions associated with past investments in low-carbon energy.

Likewise, technology is driving major disruption – and presenting opportunities – in energy markets today.  In power generation, the most obvious example is the  “stranding” of thermal assets by low-cost renewables.  In Germany, whose economy is quickly becoming the pre-eminent laboratory for observing the impacts of climate risk, the major electric utilities have already undertaken radical corporate restructuring to separate their carbon-heavy businesses.

But how important is all of this to a well-diversified institutional investor today, particularly in light of possible policy changes by the new US administration?

We argue that it is crucial. Even if a Trump presidency sees a withdrawal from United Nations Framework Convention on Climate Change or reneges on its COP21 commitments, there is a clear path of travel that can be drawn from statements other G-20 countries – most notably the EU and China.  Indeed, it’s easy to agree with President Trump; there has been a ‘Chinese hoax’ about climate change, although it has nothing to do with the science of global warming. The hoax is that by building so many coal-fired power stations at the beginning of this century, China managed to divert the world’s attention from the fact that it was simultaneously building the world’s first clean energy superpower. Research by the Institute for Energy Economics and Financial Analysis [1]  has revealed that China’s investments in green technology overseas amounted to more than $30bn in 2016 alone – far exceeding anything invested by other countries, and marking a staggering 60% year on year rise in spending. Chinese companies are snapping up everything from solar projects to wind farms to hydropower installations and lithium production companies.

Despite these pressures building in the system, the quantum of climate risk remains debatable, as both the extent and timing of physical, technological and policy changes are uncertain. Certainly, more needs to be done to improve climate risk measurement, analysis and risk mitigation options.

Climate risk is a complex issue and there is much more work that needs to be done to fully equip investors with the tools they need to navigate a changing global climate.  In the meantime, investors themselves can demand more and better disclosure, whilst making fuller use of existing information. This requires a commitment to add appropriately qualified staff and embed them in the asset selection and management processes. Collaborative approaches between investors would spread the fixed costs involved. Company-level data requires relevant benchmarks and it is in investors’ own best interest to support their development.  There are examples of good practice such as APG’s Global Real Estate Sustainability Benchmark.

At Imperial College London, some of the issues we will be addressing with investors include:

  • Defining plausible carbon and climate outcomes, allowing scenario analysis across portfolios – a “stress test” approach recommended by the Bank of England;
  • Assessing carbon measurement, benchmarking and risk-management options, to allow carbon risk-adjusted return inputs for asset pricing and portfolio allocation; and
  • Improving the granularity of “green” as an investment attribute across asset classes, and quantifying past performance of green investment strategies.

Twelve months after speaking at Lloyd’s, Governor Carney returned to the issue of climate finance in Berlin, asserting that “with investment in long-term infrastructure assets needing to quadruple, green finance cannot conceivably remain a niche interest”.

We couldn’t put it better ourselves.  With new climate risk disclosure requirements being debated by regulators, investors should be prepared to go on the offensive.  The alternative is to have their fiduciary responsibilities undermined by structural changes in the global economy sparked by climate risk.  Our view of the evidence indicates that these changes are clearly underway.

[1] Institute for Energy Economics and Financial Analysis (2017) China’s Global Renewable Energy Expansion: How the World’s Second-Biggest Economy Is Positioned to Lead the World in Clean-Power Investment.

Executive Education offers a programme on Climate Risk Investment.

Dr Charles Donovan will be speaking at our Imperial Business in the City event on 20 September.

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