Investors are, by necessity, experts at taking calculated risks. They scan the horizon of our ever-evolving world for new and sometimes unexpected economic challenges so that they can put their money where it’s most likely to grow. Today, financial institutions are facing one economic challenge that will fundamentally change the way we do business—climate change.
Climate change is a risk that, while significant, is oftentimes misunderstood by the financial community. A warmer world introduces new, complex and interwoven layers of risks ranging from physical, financial, regulatory and reputational. So WRI and the UNEP Finance Initiative (UNEP FI) worked with more than 150 participants from the financial sector to create the Carbon Asset Risk Discussion Framework, a tool to help financial institutions undertake the difficult task of identifying and understanding climate-related risks to their portfolios.
The framework also aims to dispel common myths associated with climate change and investment risks, including:
Myth 1: The physical impacts of climate change are the primary climate risks that investors face.
Climate change can spell disaster for businesses and their investors and banks. Imagine coastal properties battered by storm surge, or crops withering in a dry, relentless heat. Yet while these physical risks should be taken seriously, investors must also consider non-physical risks.
Companies face non-physical, climate change-related financial risks – called “carbon risk” – in four areas: government regulation, economic markets, technology and public opinion. As the global economy transitions to a low-carbon path over the coming years, businesses may face challenges in some or all of these areas, depending on their business model and ability to adapt. When these risks threaten negative financial returns for investors and lenders, this is called “carbon asset risk.”
Take, for example, the unexpectedly rapid growth of the renewable energy market. Twenty-five years ago, renewable energy was three to four times as expensive as fossil fuel electricity. Against expectations, costs have dropped by half or more, and most new energy sources being developed today are renewable. Businesses and investors that continue to rely heavily on a demand for fossil fuels may find themselves less and less competitive with companies that have transitioned to renewable energy.
Myth 2: Reducing the carbon footprint of my portfolio automatically reduces my carbon asset risk.
Some experts are turning to carbon footprinting, or measuring the emissions across an investor’s portfolio, to assess a portfolio’s exposure to risk. While footprinting can help reveal where exposure to carbon asset risk may lie, it cannot predict risk. To know whether or not an individual investment is risky, investors must consider other risk factors such as product and service diversification, geographic location of investees, liquidity and duration of investment products, and local regulations. For example, an equity investment in an emerging market is likely to be exposed to risk from regulations at a later date than an equity investment in a developed market company.
Myth 3: When companies face climate change-related risks, those risks are automatically transferred to the investor or lender.
There is no one-size-fits-all assessment of carbon asset risk, even if an investee or borrower is certainly facing carbon risk. Whether or not there is a transfer of risk depends on the type and duration of the financial relationship and the company’s assets and strategy. This can be frustrating for financial institutions and analysts who are looking for a sector-wide answer to the question, “Should we be concerned?”
For example, an equity investment in a power generator with an asset portfolio made up entirely of coal-fired power plants is riskier than an equity investment in a power generator with a diversified portfolio made up of coal, natural gas, solar and wind energy assets. Both investments have the potential for carbon asset risk, but diversification in the second investment protects the investor.
Myth 4: More climate-related government regulation of the private sector would be unwelcome by investors.
This December, the nations of the world will agree on a new international climate action agreement at the COP 21 summit in Paris. New public policies are likely to cascade from that agreement, with enormous impacts on the private sector. As we approach the summit, governments are already putting forward their proposed climate actions (called intended nationally determined contributions, or INDCs) for the period after 2020, and the Paris outcome is likely to provide significant new momentum for a shift to low-carbon, resilient economies. With these new policies in motion, it will become all the more important to assess and manage carbon asset risk.
By implementing clear regulations and policies, our political leaders can put us on a path to a sustainable future while helping to stabilize financial markets. The financial sector needs negotiators in Paris this December to demonstrate decisive leadership, and policy makers to translate the agreement into meaningful and articulate policies.
This is a pivotal time in the history of our economy, as many sectors and industries look to overhaul their business models and operations. Meanwhile, entirely new industries are on the rise. As the floor shifts beneath the feet of financiers, the ones that proactively and accurately assess and manage the various effects from climate change are most likely to succeed in the decades to come.