The Biden administration’s focus on climate change may greatly increase regulatory requirements for climate-risk reporting, and climate-change stress tests could be an important part of these regulatory disclosures. But apart from helping investors meet regulatory requirements, these could bring more transparency about companies’ and their investors’ exposures to climate-change risks and opportunities, accounting for a range of potential outcomes.
Accelerating regulatory demands climate disclosure
The Task Force on Climate-related Financial Disclosures (TCFD), established in 2015 by the Financial Stability Board, jump-started the discussion on climate-related disclosure requirements. The TCFD received strong support for the recommendations for climate-risk disclosures it published in June 2017. The Banque de France, Bank of England and Dutch National Bank took a leadership role shortly afterward, proposing to integrate TCFD-inspired disclosure guidelines into their existing supervisory roles. These efforts eventually formed the basis for the Network for Greening the Financial System (NGFS). Now, the NGFS has more than 80 member institutions. Notably, the US Federal Reserve joined the initiative in December 2020.
It is no coincidence that central banks are focusing on stress testing and scenario analysis as tools to provide transparency about the economic impacts of climate change. First, there is large uncertainty about future pathways for climate change and its economic impact. Second, the economic impact is complex, and there are multiple dimensions such as transition risk — the cost or benefit from a transition to a greener economy — and physical risk — the impact of more, or less, frequently occurring extreme weather events. Finally, there is no real precedent, so we cannot learn much from history. Hence, investors may wish to assess a range of climate-change scenarios and their potential impact.
Stress test of transition and physical risks
We have analysed how companies in the MSCI Europe Index could be impacted by climate change. Our methodology included both transition and physical risks and opportunities. First, we looked at transition risk for two climate-stabilisation goals: the 1.5°C and 3°C temperature-rise scenarios. While MSCI Climate Value-at-Risk metrics can be calculated at a security level, Chart 1 shows the impact to the enterprise value for the “average” company in each Global Industry Classification Standard (GICS) industry group, whereby companies are equally weighted.
Carbon-intensive companies in energy, transportation, utilities and materials were most severely impacted by policy risk — with the average energy company losing 67% in enterprise value under a 1.5°C scenario. This was partially offset by revenue opportunities from a low-carbon transition, or technology opportunity, which could be as high as 41% for the average utilities company. Companies in other industry groups, such as automobiles and components, also possess the potential for a climate upside, as they hold low-carbon technological innovations that could be used to green the economy into the future.
Of course, one should keep in mind that averages hide a wide range of differences between companies. Under a 3°C transition scenario, the risk level was significantly smaller because companies would need to make less effort to reduce emissions, with both policy risk and technology opportunity being less pronounced.
Next, we looked at the impact of physical risk to the enterprise value of the same set of industry groups, for two scenarios: an average and an aggressive scenario. The magnitude of the impact is generally smaller than for transition risk; e.g., the average European energy company loses 18% in the aggressive physical-risk scenario, while it loses 49% in the 1.5°C scenario for transition risk.
However, the physical risk is predominantly on the downside, with little upside, as the exhibit below shows. The impact is more spread out over the industry groups, because the main driver of physical-risk exposure is the location of companies’ facilities.
Still, we see a larger impact on energy companies — as capital-intensive industries are more vulnerable to extreme weather events — and to food & staples retailing companies — because extreme weather could impact food productivity. Although physical risks could be reduced by a transition to a greener economy, extreme weather events may become more frequent and some of this risk might materialise regardless of the climate-change mitigation efforts undertaken.
As regulatory pressures mount, portfolio stress testing sheds new light on the potential impact of climate change on investment outcomes. Our analysis shows how exposed different industry groups are to climate change and the huge potential variation between industry groups. For investors, this may be critical information as they construct and monitor their portfolios.
