Q&A: How can investors assess climate risk?

In a recent Bloomberg survey, 85% of executives said they have started assessing climate risk but taking positions can seem as much fortune telling as data modelling. Edo Schets, product manager for climate finance solutions at Bloomberg LP discusses how investors can assess risk when it comes to ESG.

According to a recent report by the New Climate Economy, transitioning to net zero is set to deliver up to $26tn in investment and job creation opportunities by 2030. But unless investors are using a reliable platform to help them sift through rhetoric and company promises, they are left without a holistic picture to correctly assess opportunities.

For instance, take a cement company that naturally has high carbon emissions. To reduce emissions, this company then launches a project to offset carbon emissions and issues a sustainability-linked bond to finance this project. As a result, this company looks on track to meet both its targets and government legislation and investing in this company’s stock or in this bond suddenly looks pretty favorable to an investment firm.

With climate change affecting every industry and business, investment decisions must now consider ESG commitments, actions and activities. How can data and insights ensure investors make successful decisions?

Why is climate risk so difficult to assess?

Climate-related risks are more difficult to measure than ‘traditional’ financial risks because, rather than looking at historical patterns as is customary in risk management, climate change looks forward. Furthermore, as climate change is a process, not a single event, its impacts evolve and may be very different in the next five to 10 years compared to the next 20 to 30 years.

In 2020, the Australia bushfires are estimated to have cost $5bn and wildfires on the US’ west coast led to damages of $20bn. Floods in Pakistan led to $1.5bn that year, and we are seeing a similar situation in Pakistan today. Climate scientists have shown that, in the best-case scenario, global warming causes rises of 1.5 degrees Celsius by 2100, and physical risks will be bigger than today. So, investors are rightly concerned, but how to manage this risk is very much the issue they are trying to solve for now.

How can investors assess climate change as a financial risk?

Broadly, climate risk can be divided into two interrelated risks: physical risk to assets from flooding and storms, and risk associated with transitioning to a low carbon economy, for example if fossil fuel reserves need to be written off.

Firms with large loan or mortgage portfolios should ask themselves how they will be affected when rising sea levels, droughts, and other adverse conditions become the new normal. Firms with exposures to heavy emitters should evaluate their positions if more stringent regulation comes into force.

From there, there are at least three challenges. The first is to find the right data as climate change is not well reflected in historical data. We therefore rely on scenarios and climate models to understand the risks we are exposed to going forward. The second challenge is, while many areas will be exposed to more severe weather such as extreme heat or rainfall, it is difficult to estimate how these unprecedented events will impact financial valuations. The third challenge is, even if you have the data and models to estimate what could happen, it is hard to know what to do with this information given the huge uncertainties around which future is most likely.

What does the future hold for those assessing climate risk?

Will the future be one where we successfully transition to a low carbon economy – with high transition risk but low physical risk as a result – or will we fail to take sufficient action and face much more severe physical risks? We are working on a solution that looks at all possible futures and provides risk estimates based on the probabilities of all the various outcomes.

However, companies often do not disclose complete data on how they are exposed to climate risk, and when they do, the provision of this data is voluntary and unaudited, and not always reliable. But as new disclosure rules take effect notably with the help of the framework developed by the Task Force on Climate-related Financial Disclosures, the quality, consistency and availability of data will improve.

How will government strategies on climate change impact investors over the next two to five years?

Firms have a variety of reasons for considering climate risk, and regulations are an important piece of the puzzle. Momentum to reduce greenhouse gas emissions is building, with numerous UN initiatives and the creation of the 450-firm Glasgow Financial Alliance for Net Zero. Governments and regulators are increasingly asking financial firms climate questions. The survey we conducted recently showed that regulation and disclosure requirements came in first for 25% of respondents. The Bank of England also asked banks and insurers to evaluate how holdings could evolve if countries limited emissions in line with the Paris agreement, or if intervention is limited and economies instead face physical risk from extreme weather.