Climate change: The next global sytemic risk

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This article is part of NordSIP Insights – The Recovery Handbook. Read or Download the entire publication here.

by Wendy Cromwell, CFA, Vice Chair and Director of Sustainable Investment, Wellington Management

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Wendy Cromwell, Vice Chair and Director of Sustainable Investment, Wellington Management

The COVID-19 pandemic has provided a painful reminder of the consequences global systemic risks can have on companies, economies and society. While we are living through history, my colleagues and I also have our eyes firmly on the future.

Looking ahead, I see climate change as another systemic risk which will impact the world sooner and more profoundly than many investors believe. Currently, most are aware of climate change and many are focused on mitigating the transition risks from changes in regulation and policy, including strategies to reduce greenhouse gas emissions. But few are fully aware of the physical climate risks that will occur even within the next decade, regardless of society’s efforts to mitigate transition risks. Nor are they aware of the implications these physical risks are likely to have on capital markets and asset prices.

One of the problems is that, although climate science and finance have many similarities as disciplines — for example, both are deeply analytical — the knowledge gap between the two is surprisingly wide. Investors study capital markets and focus on issues such as macroeconomics and valuations of individual securities, whereas climate scientists understand representative concentration pathways and climate models.

Bridging the knowledge gap

To integrate these two separate disciplines, we launched a groundbreaking research partnership in 2018 with Woodwell Climate Research Center, one of the world’s leading climate science institutes, which was until recently known as Woods Hole Research Center. The partnership was originally formed with the California Public Employees’ Retirement Scheme (CalPERS), and Ontario Teachers’ Pension Plan joined the initiative earlier this year. The partnership’s aim was to gain a deeper, fact-based understanding of physical climate risks which would inform our investment processes and thus improve portfolio outcomes for our clients.

By bringing these two disciplines together, this unique partnership has resulted in some powerful synergies and insights far sooner than we had imagined. For me, one key early lesson was that greenhouse gas emissions have a long half-life: their consequences remain long after they are first emitted. Even if all emissions were to cease today, many of the physical climate risks the world will experience over the next 10 – 15 years would still be unavoidable.

Mapping physical climate risks

One of the key outputs so far from our climate research partnership is a series of maps which show projected climate outcomes compared with our reference period of 1950 – 1980, which are then overlaid with capital markets data. This helps us to visualise and quantify where the effects of climate change will be most severe and to understand which companies and issuers will be more — or less — affected. We can then use this information to invest accordingly to help us meet the objectives of our clients and their beneficiaries. The maps focus on six key climate factors: heat; drought; access to water; flooding; hurricanes; and wildfires. They reveal that the near-term risks are more consequential than we expected.

For example, our research shows that Scandinavia faces a number of climate-related challenges, including a reduction of up to 20% in solar irradiation due to snow melt, which will have potential implications for the region’s energy density, methane emissions and infrastructure. Many warmer climates face even greater challenges. Within Europe, the Iberian Peninsula is likely to experience 10 to 12 additional three-month droughts over the next decade, according to Woodwell. That will have implications for a wide range of businesses. For example, hydroelectric plants on the peninsula are expected to generate far less electricity. As a result, some far-sighted local utility companies have been divesting their hydroelectric assets and shifting towards other renewables, notably solar.

We have also learnt that some regions of the world face a worrying combination of climate risks. For example, Woodwell projects that, from 2020 to 2029, India will see three additional months of dangerous — or extremely dangerous — days of heat compared with the 1950 – 1980 reference period. At the same time, it will face severe water scarcity issues, compounding the problem. Our analysis also indicates that Houston in Texas is likely to experience two additional months of dangerous or extremely dangerous heat days annually over the 2020 – 2029 period compared with our reference period of 1950 – 1980. Unfortunately, Houston also faces increased hurricane and flooding frequency. However, this does not seem to be reflected in the pricing of many local municipal bonds relative to those of towns and cities elsewhere in the US which don’t appear to face similar climate risks.

According to our research, some of the world’s most important agricultural regions will contend with multiple climate risks sooner than previously believed. The economic and investment implications of these types of risks are substantial, but our analysis indicates that markets are not yet repricing them. We believe that, when policymakers, market participants and the public eventually come to understand the cumulative risks of climate change, many assets will be repriced — in some cases, dramatically. We believe it is important for active managers not only to seek to mitigate the adverse effects of such repricing on clients’ portfolios but also to take advantage of any mispriced opportunities where there is the potential to generate long-term outperformance.

Engaging to drive climate preparedness

We also seek to discover whether companies and issuers are informed about the risks they face and how they are addressing them. Unfortunately, it turns out that many haven’t previously been exposed to this type of analysis, and they rarely have a proactive approach. To assess their awareness, we scan publicly available information like transcripts of earnings calls and CDP (Carbon Disclosure Project) reports to see if a company has highlighted a physical risk.

This work has also started to inform our engagements with companies and issuers. We listen and ask questions, share the maps we have developed and help them to think through how the physical risks of climate change may impact their business.
In many engagements, we also share a consultation document we developed with CalPERS. Our “Physical Risks of Climate Change (P-ROCC): a new framework for corporate disclosures” is designed to help companies integrate climate-risk scenarios into their strategic planning. The early response to our climate research and engagement focus has been positive. This has reinforced our belief that further work in this area can prove beneficial for our clients, portfolio companies, partners and industry peers. We are also committed to engaging with the companies and issuers we invest in, helping them to build their resiliency to climate risks and to communicate their approach to climate preparedness.

Putting theory into practice

While the work of our climate partnership is available to all of Wellington’s portfolio managers, some approaches lean on it particularly heavily. One such approach is the Wellington Climate Strategy, which was launched in 2007. This fundamental, bottom-up approach aims to deliver a “double bottom line” of strong investment returns and good sustainability outcomes. It invests in companies focused on providing products or services that seek either to mitigate climate change or to adapt to it. The team sub-divides these companies, which span a broad range of industries globally, into five categories: low-carbon electricity; low-carbon transport; water and resources management; energy efficiency/management; and climate-resilient infrastructure. Security selection is based mainly on in-depth fundamental analysis of each company, and allocations to various sectors and themes are continually reviewed to ensure they are consistent with the team’s top-down views.

Conclusion

The main objective of our work integrating climate-science data and capital markets data is to achieve better long-term investment outcomes for our clients. However, we also believe that, as society adapts to and mitigates the physical effects of climate change, we will be better able to safeguard our environments for future generations. We hope to play a role in that most important outcome as well.

 

For more information please visit www.wellingtonfunds.com/climate-change or contact:
Dennis Kwist +44 20 7126 6107 | [email protected]
Therese Axelsson +44 20 7126 6603 | [email protected]
Diana Nilausen +44 20 7126 6575 | [email protected]

 


 

Important information

Disclaimer: For professional or institutional investors only. The value of your investment may become worth more or less than at the time of the original investment. This material and its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase, shares or other securities. Investing involves risk and an investment may lose value. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in any financial instrument. Any views expressed are those of the author(s), are based on available information and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is provided by Wellington Management International Limited, a firm authorised and regulated by the Financial Conduct Authority in the UK.

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