A Practical Approach To Factoring Climate Risk Into Financial Valuation

By Kathryn Bakos 18 September, 2020

It is not a matter of 'if' but 'when' physical climate risks are taken into account. ICCA's Bakos expands

There is increasing worldwide recognition that physical climate risk translates into economic impact and needs to be factored into investment decision making – the question on investors’ minds is “How”?

In answer to this question, the Intact Centre on Climate Adaptation recently released the report “Factoring Climate Risk into Financial Valuation”, supported by the Global Risk Institute, Scotiabank, Intact Financial and University of Waterloo.  Summarised below are the key report findings, including practical methodologies to factor physical climate risk into financial valuation.

According to the United Nations Intergovernmental Panel on Climate Change, climate change and associated extreme weather risks (e.g., flood, drought, fire, hail, wind, etc.) will continue to increase in frequency, intensity and duration, globally, throughout the 21^st century [1,2].

The cost of “physical climate risk” will continue to have global scale impacts; USD2.98trn from 2010-19…

…and then there is the big insurance gap

Due in part to climate change, the cost of “physical climate risk” (i.e., natural disasters and extreme weather events) will continue to have global scale impacts.  Considering natural disasters in modern history, 2010-2019 has been the costliest decade with total direct economic damages and insured losses tallying USD2.98 trillion globally, USD1.1 trillion higher than previous decades [3]. 

Notably, the insurance protection gap, the portion of economic losses not covered by insurance, was 69% in 2019, leaving governments, businesses and individuals to pay for the majority of damages and disaster recovery efforts [4].

As effectively irreversible climate change and exacerbated extreme weather events continue to have global impact, many companies spanning most (if not all) industry sectors will suffer disruptions to the continuity of their operations due to physical, climate-change induced impacts [5,6,7,8]. When these disruptions are material – for example, if an extreme weather event resulted in flooding that truncated supply chain, which subsequently impacted a company’s long-term cash flow – fiduciary duty would require that this information be disclosed, as it could affect the decision of an investor to buy/hold/sell stock in the company [9,10,11].

The question is subsequently, “how can key physical climate risks be identified and disclosed in a way that is practical and readily understandable by portfolio managers?”

The solution proposed is the development and application of sector-specific “Climate Risk Matrices”. These matrices identify the top 1-2 physical climate risk impacts that portfolio managers should prioritise as most material to affect performance of companies within a given industry sector.

The solution are Climate Risk Matrices – identify top risks & potential measures to reduce impact

These top impacts reflect the expert advice of operations officers or similarly experienced subject matter experts – based on their collective experience, these practitioners are best positioned to identify a short list of material means by which flood, drought, fire, wind, etc., may convey risk to companies within a specific sector. Importantly, the Climate Risk Matrices not only identify top risks, but also identify potential measures to reduce impact, as well as key questions that can be asked to assess how these risks are being managed.

As part of the published report, two Climate Risk Matrices have been created – for Electricity Transmission & Distribution (T&D), and Commercial Real Estate (CRE) sectors within Canada.  An example of the T&D Climate Risk Matrix is presented below – illustrating the user-friendly and interpretable information that a portfolio manager would use to determine if, and how, issuers are mitigating climate change and extreme weather risk satisfactorily. The protocols used to develop both the T&D and CRE Climate Risk Matrices are transferable to any industry sector, within any geographic location.

The matrices also offer value to securities commissions, credit rating agencies & Boards of Directors

Climate Risk Matrices offer utility that is consistent with direction of the Task Force on Climate-Related Financial Disclosures (TCFD) and Canada’s Expert Panel on Sustainable Finance (EPSF). Additionally, although Climate Risk Matrices address the needs of institutional investors, the matrices also offer value to securities commissions (to guide expectations on climate risk relative to disclosure), credit rating agencies (to identify a borrower’s key climate risk liabilities) and Boards of Directors (to set a framework for Board members to ask appropriate climate risk related questions of management).

A further question that is frequently posed is, “can these non-financial measures be translated into impact on share price?” The short answer is, yes. The report also provides guidance to help ensure that issuers profile climate risk data, relative to each industry sector, in a manner that is readily predisposed to five common financial valuation methods:

1. Ratio Analysis
2. Discounted Cash Flow
3. Rules of Thumb Valuation
4. Economic Value Added (EVA®)
5. Option Pricing Models

Additionally, a quantitative case study presents climate risk impacts on share price, illustrating how so-called “non-financial” measures of performance are predisposed to valuation.

It is not a matter of “if” but “when” these risks are appropriately taken into account

From the perspective of portfolio management, there is no doubt that climate change and extreme weather risks can and should factor into business valuation. As the impact of physical climate risks translates to increasingly longer-term adjustments on stock price, the capital markets will pay increasing attention [12]. The irreversibility of climate change effectively guarantees this realisation [13] – i.e., it is not a matter of “if”, but rather “when” these risks are appropriately taken into account.

Time is not a luxury in applying climate risk to portfolio management. The development of industry-specific Climate Risk Matrices offers an immediately executable and practical means to incorporate physical climate risk into portfolio management now, which in turn will drive GLOBAL preparedness to arrest the future impact of irreversible and largely debilitating climate change.

References

^[1] Bush, E. and Lemmen, D.S., editors (2019): Canada’s Changing Climate Report; Government of Canada, Ottawa, 444 pp. https://www.nrcan.gc.ca/sites/www.nrcan.gc.ca/files/energy/Climate-change/pdf/CCCR_FULLREPORT-EN-FINAL.pdf
^[2] IPCC (2018): Summary for Policymakers. In: Global Warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty. World Meteorological Organization, Geneva, Switzerland, 32 pp. https://www.ipcc.ch/sr15/chapter/spm/
^[3] Aon (2019): Weather, Climate & Catastrophe Insight Annual Report, 83 pp. https://www.aon.com/unitedkingdom/insights/Weather-Climate-Catastrophe-Insight-2019-Report.jsp
^[4] Aon (2019): Weather, Climate & Catastrophe Insight Annual Report, 83 pp. https://www.aon.com/unitedkingdom/insights/Weather-Climate-Catastrophe-Insight-2019-Report.jsp
^[5] Krueger, P., Sautner, Z. and L. Starks. 2019. The Importance of Climate Risks for Institutional Investors. ECGI Working Papers in Finance. Working Paper No. 610/2019.
^[6] Roman, K. 2019. Climate Change Threatens Both the Economy and the Financial System, Says Bank of Canada. CBC News.
^[7] Macklem, T., Chisholm, A., Thomassin, K. and B. Zvan. 2019. Final Report of the Expert Panel on Sustainable Finance – Mobilizing Finance for Sustainable Growth.
^[8] TCFD (Task Force on Climate-Related Financial Disclosures). 2019. Task Force on Climate-Related Financial Disclosures: Status Report.
^[9] Bank of Canada. 2019. Researching the Economic Impacts of Climate Change – available at https://www.bankofcanada.ca/2019/11/researching-economic-impacts-climate-change/
^[10] Giuzio, M., Krusec, D., Levels, A., Melo, A.S., Mikkonen, K. and P. Radulova. 2019. Climate Change and Financial Stability. European Central Bank.
^[11] Tooze, A. 2019. Why Central Banks Need to Step Up on Global Warming. Foreign Policy.
^[12] TCFD (Task Force on Climate-Related Financial Disclosures). 2019. Task Force on Climate-Related Financial Disclosures: Status Report.
^[13] ECCC (Environment and Climate Change Canada). 2019. Canada’s Changing Climate Report – Executive Summary.

Further Reading

• The Future Of Finance – HKGFA’s Dr. Ma Jun believes in post-COVID times, investors & bankers should expect more emphasis on environmental disclosure by regulators, which will pave the way for higher quality green finance products
• It Happened – Central Banks And Water Risks – Half a dozen new reports by the NGFS means that CWR has achieved a key milestone in embedding water risks in finance. Debra Tan and Dharisha Mirando expand
• Capital Threats Remain Post COVID – There is no vaccine for climate & water risks, yet some in the financial sector are still burying their heads. CWR’s Dharisho Mirando reminds us how our capital is at risk & steps we can take to reduce them while going green
• Climate Fight: Finance As Asia’s Most Effective Weapon – Green finance is set to take off as regulations promote carbon pricing and better disclosure but Dr Ma and Huang also see gaps that need closing like integrating ESG factors in risk management
• Regulators Have A Role To Play In Tackling The Global Water Crisis – Climate change creates systemic risks to financial systems. With USD316bn of losses from disasters in 2018-19, Ceres’ Robin Miller on urgent actions regulators can take to ensure stability and investors that have made a start on water risks

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