The financial sector responds to physical climate risks
Material impacts of climate change
Climate change has emerged as a prominent threat to the financial sector and international economies. According to the National Oceanic and Atmospheric Administration’s National Centers for Environmental Information (NCEI), the United States suffered 16 separate billion-dollar disasters, with a cumulative cost exceeding $300 billion in 2017. Climate impacts can be felt across all asset classes and can affect companies across all parts of the value chain, supply chains, operations and markets. In its 2017 year-end filings, Taiwanese steel producer Yieh Phui Enterprise Co., Ltd. disclosed that Typhoons Meranti and Nepartak caused flooding which impaired its plant and equipment and damaged some inventories beyond repair. The call for more climate-related disclosures is mounting as investors seek to understand climate risks in their investment portfolios.
In its Action Plan: Financing Sustainable Growth, the European Commission emphasizes that “we are increasingly faced with the catastrophic and unpredictable consequences of climate change and resource depletion, [and] urgent action is needed to adapt public policies to this new reality.” Global asset management firms including BlackRock, State Street Corporation, DWS and others, emphasize the need for corporations in their portfolios to demonstrate their response to climate risks. This increasing awareness has led to growing demand for financial risk disclosure and corporate adaptation.
Energy transition risk and physical climate risk both impact markets and companies. Transition risks are the potential large-scale impacts of rapidly decarbonizing our economies and energy systems. The energy sector and energy-intensive industries like steel, cement and manufacturing are the most exposed to this risk. The Energy Transition (ET) Risk Project’s transition risk scenarios based on different levels of climate change mitigation and the 2 Degree Investment Initiative’s (2dii) “Transition Risk Toolbox” measure transition risk.
While it has been the subject of less research to date, physical climate risk is emerging as a prominent concern for investors. Extreme weather events like hurricanes, windstorms and extreme rainfall are expected to become more severe with climate change. These hazards disrupt business operations, lower capacity utilization of manufacturing facilities, decrease revenues, and increase costs. For example, recent flooding in Japan disrupted business operations for auto manufacturers and consumer electronics companies, with industry losses expected to be in the billions USD.
Climate change will also drive prolonged chronic stresses such as sea level rise, increasing temperatures, changes to precipitation patterns and groundwater depletion, which also threaten business operations and reputations. Construction, mining, and manufacturing are often dependent on water and manual labor which makes them particularly vulnerable to decreases in worker productivity and hindered operations during heat stress and drought. Likewise, beverage companies face reputational risks due to their heavy water needs.
Calls for risk disclosure
Shareholder engagement on climate change has grown significantly in recent years and is an important step towards resilience. The Climate Action 100+ includes almost 300 investors managing nearly USD $30 trillion, who have committed to engage with companies on climate change. The group recently added 61 new focus companies, partially chosen based on their exposure to physical climate hazards. Investors are moving beyond encouraging companies to reduce emissions, to highlight the financial risks companies face from physical climate change. Investors can leverage data on corporate risk exposure to build targeted engagement strategies that promote climate disclosure and corporate resilience-building.
Alongside investors’ calls for climate risk disclosure, financial regulators are also increasingly acknowledging this systemic risk. In 2015 Mark Carney, the Governor of the Bank of England and Chair of the Financial Stability Board (FSB), called climate change a threat to financial resilience. Under the authority of the G20, the FSB created an investor-led Taskforce on Climate-related Financial Disclosures (TCFD). Its recommendations, published in 2017, outline voluntary disclosures to guide market participants in their reporting of climate-related risk. The European Bank of Reconstruction and Development (EBRD) convened working groups of financial and corporate leaders to further the TCFD recommendations with concrete metrics for disclosing physical climate risks and opportunities.
In the fall of 2015, France became the first country to pass a law introducing mandatory climate change-related reporting for asset owners and managers with Article 173 of its law on Energy Transition and Green Growth. In March 2018 the European Union laid the groundwork for mandating climate risk disclosure with its regulatory action plan to support the Paris agreement.
Assessing risk in financial portfolios
Understanding investments’ exposure to risk from climate hazards is the first step toward building resilience. Four Twenty Seven assesses physical climate risk exposure in financial portfolios, ranging from listed securities to real assets.
Four Twenty Seven‘s methodology to analyze climate risk in equity portfolios leverages site-specific data on corporate facilities. The equity scoring process assesses the exposure of corporate facilities to cyclones, sea level rise, extreme rainfall, heat stress and drought. This risk is combined with market and supply chain data to create a more complete picture of a company’s exposure to physical climate risk. Site-specific, forward looking analysis allows investors to identify hotspots in their portfolios and highlights sites most in need of resilience-building efforts.
As best practices for physical climate risk disclosure are still being developed, investors and corporations have the opportunity to stand out as early adopters and shape the development of these regulations moving forward.
At Four Twenty Seven, Lindsay analyzes the economic impacts of climate change on corporations and financial markets. Lindsay studied at the Johns Hopkins School of Advanced International Studies (SAIS), focusing on Energy, Resources, and the Environment as well as International Finance and Economics. Previously she worked for the U.S. International Trade Commission, assisting with macroeconomic research on the impacts of international trade on the U.S. economy. She also has experience as Student Coordinator for the Frontiers and Energy, Science, and Technology at SAIS, leading groups of students on international research trips to study the effects of climate change around the world.