Wipeout – 8 Reasons Why Stress Testing For Chronic Risks Will Strand Assets
By Dharisha Mirando, Debra Tan 25 February, 2021
Hear from CWR's Mirando & Tan why stress tests are inevitable as water risks are rising
Understanding water risks is complicated due to its locational and interlinked nature. Not only do you have to contend with understanding risks related to freshwater which could have impacts due to access/supply, quality, and disruptions through floods and droughts, but you also need to understand if your assets are at risk from coastal threats and how climate change will accelerate all the risks. Oh, and because sectors use/pollute water differently, water risk profiles are also different across sectors.
Plus, don’t forget regulations; they can protect your assets and operations, but it might be painful in the short term. And you need to watch out for places that governments aren’t acting. Many tools exist to assess these risks but they aren’t perfect – see here for a summary of climate risk assessment tools, which was compiled by UNEP FI who also does not believe they fully capture all the impacts. That’s because these risks are complicated: see interlinked water, climate and regulatory risk diagram here.
But so far, we’ve been slow to act when it comes to water risks even though assets based in vulnerable locations could be stranded. Unfortunately, this stranding may actually happen even earlier than expected and lead to a fall in asset prices – here are eight reasons why.
1. Billions of $$$ and millions of people at risk = no choice but to act
US$4.3trn of GDP at risk along 10 rivers in Asia and US$5.7trn of GDP at risk from just 20 APAC cities
Asia is extremely vulnerable to chronic fresh and saltwater threats – mismanagement of freshwater from 10 river basins (which are already feeling climate impacts from accelerated glacier melt, less snow and changing monsoon patterns) could impact US$4.3trn of GDP generated in 16 Asian countries. Plus, just 20 APAC cities from Auckland to Tokyo could see US$5.7trn of GDP affected from coastal threats of rising seas and storm surges. This is equivalents to the GDP of France and the UK as the graphic shows.
2. NGFS is growing and banks are pledging carbon neutrality – they recognise how significant the risks will be without action
There are now 83 members and 13 observers in the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), and it grows every day. This is happening because they recognise that environmental and climate risks could trigger systemic shocks because of the material and interlinked impacts.
Plus, banks have started setting carbon neutrality pledges because of the both the policy risk but also because they realise that without mitigation the physical risks will be too dire. But to make sense, these pledges must centre on lending and investing activities, not operations. Recently JP Morgan and HSBC set carbon neutrality targets for their lending – they both have a long way to go as they are leading lenders to the fossil fuel industry coming in 1st and 12th respectively, so clearly these pledges are a positive shift and show the coming trend.
3. Stress testing has already started
NGFS is growing & stress testing FI portfolios for water risks has already started
With this locational risk now starting to be recognised, central banks are piloting stress tests on financial institutions (FI) against both physical and transition risks. The Bank of France has already started, and we should see the results later this year; the Bank of England will start this year with results published in 2022; HKMA also sent notices to FIs in December; and MAS has published guidelines to ensure FIs integrate governance, risk management and disclosure of environmental risks into their risk management frameworks and carry out stress tests.
These are only a few examples; there are many more, plus we expect to see more coming through this year. These are pilots, so they won’t lead to immediate changes in capital requirements, but it’s not far off.
4. Scenario testing = understand the risks facing FIs from plausible threats = valuation adjustments
The debate rages on about how accurate climate models are – in summary they aren’t great at short term and very specific ideas of the risks. And they are expensive and hard to understand! But they can give you a good idea of the trends.
Hence why scenario planning is the way to go – you can test out how well or badly your portfolio would do against plausible risks – whether it’s 3m of sea level rise by 2100 or 5.65m storm tides. These numbers might look alarmist but unfortunately on our current climate path they are extremely plausible. Our analysis shows worrying results – so we need dramatic adaptation and mitigation action, or assets will be revalued.
5. Insurance won’t be a sure thing
The insurance industry has been depended on to be the final bearer of the risks. But this can’t be relied on forever – for example, New Zealand may run out of coastal insurance from as early as 2030. What happens to the rest of the world when insurers decide that the risks are just too high? Banks will be left with the risks; some areas will become uninvestable; and the insurance industry will need a re-set if it wants to continue to exist.
6. Assets will be revalued
Physical risks … could lead to a sharp fall in asset prices
FIs carrying out scenario-based stress tests will realise that multiple assets, whether in their loan books or investment portfolios, face significant risks. This will lead to valuations of these assets having to be adjusted – as the FSB said in its report last year “physical risks – particularly that prompted by a self-reinforcing acceleration in climate change and its economic effects – could lead to a sharp fall in asset prices and increase in uncertainty”.
If this adjustment has to be carried out for only a few assets it’s ok – but the chances are that portfolios will be skewed to more vulnerable locations due to clustering.
7. We already know how to revalue these assets
We already know how to revalue assets at risk from chronic risks – it’s the same as having different valuations for leasehold vs. freehold assets
Yes, some of these risks will only transpire in the long-term, but valuations are inherently long term as the terminal value makes up the majority of any asset or equity valuation. So, does an asset that may not be able to operate in 50 years command the same valuation as one that would still be standing in 100 years? This is the same as different valuations of a freehold vs. leasehold asset – as this research shows we clearly price these types of assets differently by as much as a 15%-25% discount for a 100-year leasehold asset compared to a freehold one.
So, inevitably multiple assets will be revalued post stress-testing and scenario analysis, and we already know how to do this!
8. Chronic risks are only rising
Increasing demand for water, economic growth and urbanisation will lead to more water stress. Plus, rising temperatures are leading to accelerated sea level rise.
Better management and reducing carbon emissions can reduce the risks but they will never go away. Unfortunately, our current lack of action is only accelerating chronic risks and for many they continue to be too far in the future to fully understand. But the issue is we need to take action now or it will be too late.
|Not just banks, pension funds also at risk
From research carried out by CWR with Manulife Investment Management and AIGCC we know that Asian pension funds have concentrated portfolios in their domestic markets – on average, 64% of the allocation of these is invested in domestic equities and bonds. Unfortunately, Asian indices are also concentrated in sectors that are vulnerable to water risks such as real estate, which could be underwater; finance, which faces clustered portfolio risks that aren’t being managed; and IT and consumer discretionary, which rely on vulnerable trade infrastructure.
This is an Asia wide problem whether it is Hong Kong, Singapore or China. This concentration of assets and investments puts all savings and even government reserves at risk unless these locations are protected
Assets will be stranded and capital requirements will increase
Assets will be stranded due to the physical risks but they will also be stranded when all the risks are considered & incorporated into valuations…
…this could happen before the physical risks transpire
Clearly, systemic shocks from water risks are inevitable unless action is taken to reduce emissions, manage water resources and protect people and assets from the baked in risks. Unless this happens, we will have multiple stranded assets.
So central banks need to start rethinking if current capital requirements are sufficient. The Basel III framework was agreed to ensure micro-prudential and macro-prudential systemic risks in the banking sector were addressed by increasing capital and liquidity requirements. However, it has yet to account for environmental risks. But faced with the results of these scenarios and stress tests, plus stranded assets central banks and financial regulators may have no choice but to change capital requirements.
This isn’t new. We’ve already seen this done with COVID-19 – stress tests showed just how vulnerable banks could be, which led to multiple banks having their dividend payments restricted. Shareholders at banks such as HSBC have felt the brunt of these rulings. However, with 90% of HSBC’s profits coming from Hong Kong, which as Bloomberg cited ranked among the top five cities most at risk from coastal threats in our CWR APACCT 20 Index, and with property development continuing in vulnerable areas, could HSBCs shareholders be facing much higher risks down the road unless its loan book changes or capital requirements are increased?
The regulations, stress tests and capital requirements are inevitable. So if I was a banker or investor I’d try to front run what’s heading my way and get my house in order.
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