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

With billions of $$$ & millions of people at risk it’s not surprising that central banks & regulators are accelerating action to push FIs to stress test & act to protect the financial system from climate risks
Scenario analysis & stress testing will lead to assets being revalued & we already know how to do this – it’s the same way we value leasehold vs. freehold assets
Assets will be stranded due to rising chronic risks, but they will also be stranded when all the risks are considered & incorporated into valuations, which could happen before the physical risks transpire

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 yearphysical 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.

Further Reading

  • Future SLR Projections & Biggest Worries – In this follow up interview, HKU’s Dr. Nicole Khan shares her biggest concerns on how future SLR projections are rising higher & faster than thought & shares the best approach for building realistic scenarios
  • 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 on these game-changing moves by the central banks. The credit evolution has started
  • 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
  • Are Asia’s Savings Exposed To Water & Climate Risks? – Asian asset owners have portfolios skewed towards domestic markets that will bear the brunt of climate change. Find out about these risks and what to do as our Dharisha Mirando shares key takeaways from the new report China Water Risk co-authored with Manulife Asset Management & the Asia Investor Group on Climate Change
  • Thirsty And Underwater: Rising Risks In Greater Bay Area – How will water & climate risks, including rising sea levels & droughts, threaten the already water-stressed Greater Bay Area (GBA)? CWR’s Tan & Mirando explain in their latest CLSA report and highlight companies’ failure in climate risk disclosures
  • No-Sense Climate Strategies: From DSD To HSBC – Hong Kong’s shortsighted & unrealistic climate plans will leave key assets & infrastructure exposed that mean the government, companies, investors and the public are even more exposed. China Water Risk’s Dharisha Mirando & Debra Tan expand

More on Latest

  • 5 Trends for the Year of the Ox – Will the Ox deliver it’s well known strength and stability and turn stubborn “old” cows into raging bulls for a better planet? Find out what the lunar new year has in store for us in our 5 trends
  • A Transformational Framework For Water Risk – DWS’s Francesco Curto, Michael Lewis & Murray Birt share their latest report’s findings on how investors should address water risks with a new transformational framework
  • If China Sets An Eco-target, It Reaches It – Global water gurus Prof Asit Biswas & Dr Cecilia Tortajada layout why they are confident China will meet it’s ‘Beautiful’ 2035 target
  • The Adaptation Principles: 6 Ways to Build Resilience to Climate Change – Adaptation cannot be an afterthought to development as climate change will impact the macroeconomic situation. World Bank’s Dr Stephane Hallegatte, Dr Jun Rentschler & Dr Julie Rozenberg share 6 principles
  • Singapore: Making Business Unusual the Norm – Covid disruption has seen old businesses die and new ones sprout up. CWR’s Dawn McGregor shares how Singapore is innovating its climate threats into building resilience & new ways of making money
Dharisha Mirando
Author: Dharisha Mirando
Dharisha Mirando hails from the finance industry and joined CWR as she believes that climate and water factors are downplayed by the sector despite being significant investment risks. To tackle this, her ambition is to help build consensus, bridge the gap between finance and science, and engage with investors to incorporate these risks into their due diligence and portfolio management. This could in turn lead to innovative Green Finance instruments becoming more prevalent. She has already made strong headway as the lead author of a recently published report with Manulife Asset Management and the Asia Investor Group on Climate change, which highlights the imminent threats to Asian asset owners' portfolios from climate and water risks. Dharisha has also undertaken a number of speaking engagements on these pressing issues at investor and insurance conferences. Prior to joining CWR, Dharisha worked for a long-only public equities fund. She has also worked in the impact investment space in London and Singapore where she provided technical assistance to social enterprises, helped them raise equity investments, and managed a debt portfolio.
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Debra Tan
Author: Debra Tan
Debra heads the CWR team and has steered the CWR brand from idea to a leader in the water risk conversation globally. Reports she has written for and with financial institutions analyzing the impact of water risks on the Power, Mining, Agricultural and Textiles industries have been considered groundbreaking and instrumental in understanding not just China’s but future global water challenges. One of these led the fashion industry to nominate CWR as a finalist for the Global Leadership Awards in Sustainable Apparel; another is helping to build consensus toward water risk valuation. Debra is a prolific speaker on water risk delivering keynotes, participating in panel discussions at water prize seminars, numerous investor & industry conferences as well as G2G and academic forums. Before venturing into “water”, she worked in finance, spending over a decade as a chartered accountant and investment banker specializing in M&A and strategic advisory. Debra left banking to pursue her interest in photography and also ran and organized philanthropic and luxury holidays for a small but global private members travel network She has lived and worked in Beijing, HK, KL, London, New York and Singapore and spends her spare time exploring glaciers in Asia.
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