In our view the prior decade, which has been the hottest in history, marked peak indifference on climate change. Australia is ground zero for climate change, and the current bushfire crisis has given the world a glimpse into what the coming decade may bring if mitigating steps are not taken.
Without taking a stance on the science of climate change, it is evident that the status quo comes with a giant price tag that cannot be maintained. We are now approaching an inflection point, where the aggregate effects of climate change are beginning to constrain economic growth and welfare, such that the cost of inaction is fast beginning to outweigh the cost of action.
The planet’s finite resources have been exploited beyond their limit, and the impact of climate change via lost homes and livelihoods to natural disasters, agricultural productivity, coastal resources, water security, and air quality is taking its toll. The cascading effects resulting from these supply constraints, like food price spikes, water security concerns, migration and other severe disruptions induced by the increased incidence of extreme weather events will see credible climate policy and increased action in an attempt to mitigate climate related risks. For investors these changes pose a number of questions, opportunities and risks.
The World Economic Summit in Davos begins next week, and ahead of the gathering the World Economic Forum’s Global Risks Report is dominated by the environment. That means for the first time in history the agenda meeting of the world’s elite in the idyllic Swiss mountains will be governed by climate change as the biggest risk the world faces, with extreme weather conditions being the top priority.
Climate Action could be one of the most transformative and disruptive challenges faced by the global economy, and by the same token the long term risks posed by climate change are also the largest faced. Societal, political and shareholder pressure is mounting ferociously for the corporate sector to align their practices with emissions reduction targets and warming thresholds. If governments are to follow through on their pledges to reach net zero emissions by 2050 or before, a wave of emission targeting regulation should be about to sweep through the private sector.
Quantifying the effect of climate change on investments via damage to infrastructure and property, reduced economic output or lost productivity, and also mitigating policy actions is a crucial undertaking.
Physical Risk: An increased incidence of extreme weather events, like floods, tropical cyclones, and extreme temperatures will physically impact business operations. Longer term threats include rising sea levels, lost ecosystems, pollution, natural disasters and higher temperatures making land uninhabitable and/or no longer fit for purpose.
Transition Risk: Inevitable policy shifts aimed at tackling climate change and decarbonising means that emission-intensive companies will become less competitive, and therefore trade a valuation discount. Most companies are poorly equipped for an abrupt change in mitigating policy so transition risks also arise throughout the adaptation process. This can include the potential for increased operational cost, refinancing issues, relocation/supply chain alteration, reduced output and reduced demand for product as consumer preferences change.
As the 3rd decade of the millennium begins and we move past peak climate indifference, it is clear that climate risk is now heavily embedded in both investment risk and opportunity.
Sectors at Most at Risk
In some sectors the physical and transition risk is more apparent than others:
As the foundations for a sustainable finance ecosystem are laid a huge reallocation of capital will be underway. Investors and corporates who do not gear their portfolios towards more sustainable business models risk facing large losses in the coming decades, holding stranded assets, flooded properties or businesses whose operating model is no longer viable due to regulatory burden/environmental impact.
Ultimately, companies who do not meet the requirements of new and improved sustainability and positive impact mandates or regulatory environments, where climate is a top consideration, will trade at a discount. For example, it is not unforeseeable that as the coal phase out obligations of the Paris Agreement in OECD countries by 2030 are implemented some companies and investors will end up holding stranded assets via reserves of un-burnable coal. These companies then become much more risky investments over the next decade.
An example of the mounting pressures sweeping through the corporate sector, last week a group of institutional investors in Barclays, Europe's biggest financier of fossil fuels, filed a resolution calling for it to stop financing firms not aligned with the Paris climate agreement, which aim to limit global warming to 1.5C. The resolution will be voted on at Barclays' annual meeting in May, and would require the bank to stop funding any company that has not aligned itself with the Paris targets.
Sectors most at risk include financials, REITs, Utilities, Resources, Transportation and Agriculture, the graphic below identifies some of the key considerations (physical and transition risks) these companies face in reducing their carbon footprint and adapting to a world where climate change and sustainability becomes a top policy priority.