Have Investors Incorporated Climate Risks Into Portfolios?

By Jean-Marc Champagne, Sam Hilton 15 November, 2018

WWF HK's Champagne & Hilton introduce climate change risks to institutional investors

The consequences of climate change are already detectable & investors’ portfolio investments may face high levels of acute physical risk, from typhoons to drought-related fires
It's not just physical risk; govt policy responses to climate change can also expose investors to regulatory risk, reputational risk & even liability/litigation risk, which can all affect portfolio holding valuations
Institutional investors need to integrate climate change issues into their operations & investment processes; ideally initiated from the top for full integration

Climate change presents an existential threat to modern civilisation. However, because its effects manifest over generational timescales, the present generation has limited incentive to address the threat.

In the financial sector, institutional investors are becoming more aware of the risks presented by climate change, and more willing to take action. However, this awareness differs by geography, with relatively lower engagement with the issues in the Asia-Pacific region.

The Climate Primer for Institutional Investors is intended to provide an introduction to the basics of climate change with a focus on Asia-Pacific and the energy sector. It provides an overview of the science of climate change, an articulation of the global policy response, a survey of technological approaches to the problem, and an outline of the various financial entities and resources involved in addressing the issue.

Climate change is a simple story

The science of climate change is complex, but the story is not complicated:

  1. The Earth’s atmosphere naturally traps a certain amount of solar radiation as heat via the greenhouse effect.
  2. Carbon dioxide (CO2) is the primary gas involved in the greenhouse effect, due in part to its extremely long life in the atmosphere. Other gases also play a role.
  3. By burning fossil fuels, humans have significantly increased the amount of carbon dioxide in the atmosphere.
  4. The higher levels of carbon dioxide have trapped more heat, raising average global land and ocean surface temperatures.

The increased temperatures have numerous consequences that are already detectable

The increased temperatures have numerous consequences that are already detectable. These include rising sea levels, changing weather patterns, reduced polar ice coverage and melting glaciers, higher frequency and/or intensity of extreme weather events, loss of crucial ecosystems, and increased oceanic acidity.

Depending on their location, investors’ portfolio investments may face higher levels of acute physical risk

All of these climate-related physical effects have risk implications for investors. Depending on their location, their portfolio investments may face higher levels of acute physical risk – these are mainly event-driven risks from extreme weather events such as typhoons, floods, or drought-related fires and may also affect their own operations. In addition, investors with longer-duration assets may be exposed to chronic physical risk. These unfold over timescales stretching from years to centuries, such as sea level rise or changing weather patterns.

Global policy response – market-based & regulatory approaches

There are two primary policy paths to encouraging emissions reductions: market-based approaches and regulatory approaches. Market-based approaches are generally broader, and involve pricing carbon in some way, while regulatory approaches tend to be more sector-specific. Governments are using both approaches in their efforts to address climate change. This exposes investors to policy and regulatory risk, reputational risk and liability or litigation risk which can affect portfolio holding valuations.

Responding to climate change ultimately takes the form of investments in adaptation and mitigation. This will require investments in human capabilities, communities, systems, and, most importantly, technology. This presents opportunities for investors.

Responding to climate change presents opportunities for investors

Initial efforts to mitigate climate change have focused on the energy sector, which comprises almost 70% of global emissions. Compared to adaptation, mitigation offers a wider range of investment opportunities and vehicles compatible with current investment processes, especially for investors who focus on secondary market instruments such as listed equities.

Asset owners/managers who can provide direct investment or debt finance are less limited in their investment options

Asset owners and managers who are able to provide direct investment or debt finance in particular are less limited in their investment options, as across both the mitigation and adaptation spaces, market rate debt via project or corporate finance is the primary form of project funding.

Climate finance flows originate ultimately from public or private sources. On the public side are governments and various public financial intermediaries, while the private side includes corporates, households, project developers, and private financial intermediaries.

Public finance is a crucial player in addressing climate change, in particular by getting the private sector to focus a portion of its far-larger resource base on the problem. In combination with the appropriate policies and regulatory environment, public finance can help stimulate and direct flows of private capital by demonstrating feasibility, creating markets, fostering innovation, and reducing risk.

“Public finance is a crucial player in addressing climate change…

….in particular by getting the private sector to focus a portion of its far-larger resource base on the problem.”

How the private finance ecosystem can address climate change

The private finance ecosystem can address climate change both directly and indirectly. Banks and project developers are the predominant source of private direct financing of mitigation, with traditional institutional investors playing a smaller role. This is because the financial system tends to focus on more mature sectors with relatively high funding needs. This does not match up well with the comparative newness of the various technologies and business models involved in delivering climate investment, nor with the limited scale of many projects. As a result, indirect investment via equity or debt securities is the primary channel through which most institutional investors will be able to deploy capital to address climate change.

Institutional investors need to integrate climate change issues into their processes…

…ideally, this would be driven from the top

However, this does not mean they are helpless in the face of the problem. Institutional investors need to integrate climate change issues into their operations and investment processes. Ideally, this would be driven from the top – with the board level establishing the asset owner’s climate-related beliefs, policies and targets, and communicating them down the organisation. For asset managers, such integration is partially about client service – asset owners with climate processes will likely have a preference for engaging asset managers with complementary capabilities.

Investors should make use of existing and emerging tools to assess the climate risk their portfolios contain, a task that will become easier as climate-related disclosure improves. From there, they can determine how to mitigate this risk, whether through portfolio decarbonisation, corporate engagement, or other methods.

Although the policy and regulatory environment with respect to climate change is constantly shifting, the direction of travel seems clear. Institutional investors are in the process of coming to grips with the risks involved.

Further Reading

  • Upgraded Water Risk Filter: From Assessment To Response – WWF’s Water Risk Filter has been upgraded, from expanded data sets & climate change projections to new response & valuation sections. Their Ariane Laporte-Bisquit highlights everything new
  • Dell’s Water Stewardship – Dell is not only reducing water use in its supply chain but also managing water as a shared resource at a watershed level through water stewardship. Find out more from their Jason Ho
  • Big Data Accelerates The Expansion Of Green Supply Chains – Check out which brands are leading on green supply chains in China as IPE’s Erin Wong & Helen Ding share results from the 5th CITI report, which also includes a new GHG emissions index
  • Belt & Road Initiative Injects Vitality Into Economies – Professor Asit Biswas & Cecilia Tortajada from the National University of Singapore show how China’s Belt & Road Initiative can benefit developing economies in Asia & Africa by promoting connectivity
  • APAN Climate Adaptation Forum: 3 Takeaways – As climate adaptation conversations becomes mainstream, the focus is now to accelerate actions. China Water Risk’s Feng Hu shares key takeaways from the Asia Pacific Climate Change Adaptation Forum
  • Water Risk Valuation – What Investors Say – See what 70+ investors have to say on different valuation approaches we applied to 10 energy stocks listed across 4 exchanges. Is there consensus? What are they most worried about?
  • 5 Trends For China Green Finance – CWR ‘s Xu sees positive outlooks from the 2018 Green Finance Conference: from disclosure to OBOR
  • Hong Kong Green Finance Association Launch: Key Takeaways – What is the Hong Kong Green Finance Association and how can it aid China’s Belt & Road Initiative? China Water Risk’s Dharisha Mirando shares 3 key takeaways from the launch
  • Oil To Fall As Electric Vehicles Take Off – The growth of electric vehicles in China could displace 1mn barrels/day of crude oil by late 2020s. How will this impact companies with fossil fuel assets? How can Asian investors minimise their exposure? WWF’s Jean-Marc Champagne on their latest report
  • Can APAC Lead In Adaptation Finance? – After attending two key climate conferences, including COP 22, CWR’s Hu shares why adaptation financing in APAC is crucial though it’s lagging and how the private sector can lead this effort
Jean-Marc Champagne
Author: Jean-Marc Champagne
Jean-Marc’s main focus is heading up WWF’s newly launched Bankable Nature Solutions initiative for Asia, which aims to originate and develop scalable bankable projects with conservation impact. He is also managing the Asia-Pacific portion of the origination facility for the €160 million Dutch Fund for Climate and Development. He was instrumental in launching the Climate Impact Asia Fund in January 2020 and is a member of its Investment Advisory Committee. He also advises institutional investors, lenders, and underwriters on the financial and economic risks and opportunities related to climate change and environmental issues. Prior to WWF, he spent 17 years in the financial industry advising institutional investors on equities and equity derivatives. He started his investment banking career in 1997 with Merrill Lynch in New York City and has been based in Hong Kong since 2004, working for BNP Paribas and Jefferies. He graduated from Clarkson University in Potsdam, New York.
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Sam Hilton
Author: Sam Hilton
Sam Hilton is a Senior Research Analyst for Environmental Finance at WWF-Hong Kong. He was previously an equity research analyst at Keefe Bruyette & Woods and FoxPitt, Kelton (acquired by Macquarie) in Hong Kong, where he covered banks, brokers, and exchanges across the Asia-Pacific region.
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