How can the financial community better understand the financial impacts of environmental trends?
Climate change and water scarcity will pose serious threats to countries in South and Southeast Asia over the next several decades. These threats, which range from more extreme weather events (like typhoons, floods, and droughts) to more limited water availability, are likely to have significant impacts on the region’s economies and industrial sectors. Gaining a better understanding of how and when environmental risks may impact company performance will help the region’s financial community accurately assess corporate value.
To that end, WRI and HSBC partnered to identify and quantify environmental risks facing key sectors in South and Southeast Asia, culminating in the recent release of three reports on the power, food and beverage, and real estate sectors.
Why is it so difficult to analyze the financial impacts of environmental trends in Southeast Asia? Today WRI releases Analyzing Environmental Trends: Taking the Pulse of Asia’s Financial Community, a working paper that looks at this question and draws on insights gained from the sector reports, as well as feedback from the region’s financial community. The paper frames the key challenges:
A lack of publicly available data relating to both environmental trends (for example, localized water scarcity data) and company-specific exposure to potential environmental risks (for example, the number of corporate facilities in water scarce areas);
Limited contextual analysis –- including examinations of social, economic and political drivers – for framing the complex connections between environmental trends and their financial impacts;
The highly unpredictable nature of environmental trends which limits analysts’ ability to forecast their likelihood and their magnitude.
Lack of Data
The lack of reliable environmental data raises particularly serious concerns in Asia, because this region is predicted to be among the highest impacted by environmental risks such as climate change. There is an urgent need for investors to engage with companies to obtain key data points, such as the specific location of key facilities and the security of a company’s access to key resource inputs such as water. Better information in these areas will help investors fully understand the extent to which environmental risk will impact companies.
Data alone are not sufficient if they are not accompanied by contextual analysis. Contextual analysis entails understanding the extent to which a company or its facilities are: (1) exposed and (2) vulnerable to environmental impacts. A company’s geographical location (or that of its plants/facilities) determines its exposure to physical environmental trends, while the nature of a company’s operations determines its vulnerability to these trends.
To evaluate exposure to environmental trends, the WRI/HSBC research project used geographical information system (GIS) maps. The maps plotted the location of company operations (including facilities and plants) on areas of environmental exposure. In India, for example, 74 GW—over half of existing and planned capacity for major power companies—are located in areas considered to be water scarce or water stressed, which is significant because traditional power plants typically use significant amounts of water.
Arguably the most daunting challenge to assessing the financial impacts of environmental trends is the inherent uncertainty in forecasting both the magnitude of environmental risk and the degree of impact that adverse events would have have on companies. This forecasting ability is further complicated by the difficulty in isolating the impacts of environmental trends on company performance.
The WRI/HSBC research project tackled the challenge of uncertainty by initially engaging with environmental experts and companies in the region to establish qualitative connections between environmental risks and financial value. WRI constructed hypothetical but realistic environmental trend scenarios, which HSBC used as a basis to evaluate how companies would be impacted financially using sensitivity analysis. The primary aim of the research was to establish the connections between environmental risks and company value qualitatively, and then prove that they could also be financially material.
What role can the financial community play in improving understanding of environmental trends?
The WRI/HSBC paper suggests actions aimed at improving the quality of environmental data and at enhancing financial analysis methodologies:
1.Engage with companies to publicly disclose relevant environmental data and provide context for interpretation.
Financial analysis requires data (including resource use and dependencies) at the facility (or local) level as well as the company-wide level. Examples of the type of data required include:
- Location of facilities
- Revenue broken down by product and/or facility
2.Seek out environmental data sources from private data providers, academics, and governments.
The financial community can encourage governments to provide better environmental data at a national level, while working with private data providers to access environmental data at a local level. Examples of specific data that the financial community should seek from governments include:
- Resource (e.g. water) availability data at the smallest scale possible
- Data on local climate impact predictions
3.Apply methodologies that simulate financial uncertainties to environmental trends.
For analysts looking to take their environmental analysis one step further, WRI used the following methods to cope with uncertainty in analyzing the power sector:
Sensitivity analysis: For plants dependent on freshwater resources, conduct a plant level sensitivity analysis of Internal Rate of Return (IRR) impacts of outages and load losses. This will reveal which companies have the highest financial risk tied to disruptions.
Scenario analysis: Develop scenarios around water availability at the river basin level for each plant based on future projections (if available) or key risk factors present at the local level. When combined with the sensitivity analysis above, this provides insight into which plants are most at risk from water constraints and the potential magnitude of financial impact.
Management quality analysis: Assess and rank companies based on their strategies for mitigating water risk. (e.g. the extent of their water management strategies; their utilization of advanced technologies, such as air cooling, to reduce water dependency). Use this information to appropriately adjust conclusions from the sensitivity and scenarios analyses detailed above.
The availability and quality of environmental data in South and Southeast Asia remain limited, despite broad consensus that environmental trends are likely to have negative impacts across the region. This situation makes the need for better disclosure and environmental analysis all the more pressing and illustrates the clear role that Asia’s financial community can play in addressing this important gap.
The Government of Japan, through the International Finance Corporation (IFC), generously provided funding for this research.