Climate change deniers will not go away anytime soon. But the damage is real, and investors should follow the smart money and push for their portfolios to be prepped for the risks that worsening natural disasters and extreme temperatures bring.
SINGAPORE (Apr 22): As awareness about climate change and its ill effects grows, many investors are shunning businesses that have an obviously negative impact on the natural environment. But most have yet to work out whether their money managers are actually helping them manage the risks to their portfolio that come from the actual effects of climate change. “It’s not something I look for in a fund. I just look [at whether] they are investing in anything that causes harm, like mining and fossil fuels,” says Jacob Puthenparambil, co-founder of communications firm Redhill.
“I don’t want them to invest in the fossil fuel industry for sure,” says space engineer Akshay Gulati, co-founder of satellite servicing company Infinite Orbits. But, as he tells The Edge Singapore, he does not have time to look into how his fund manager manages climate risk. “I trust the manager to grow my money, and that is enough of a headache to build that trust.”
Yet, the active management space is under growing pressure to mitigate climate risk in investment portfolios. Institutional investors are demanding that money managers quantify the severity of the environmental risks they are exposed to.
Global reports projecting warmer temperatures and the resulting impact on economic growth have played a hand in getting investors to be on high alert. A study in 2015 by the London-headquartered The Economist Intelligence Unit estimated that private investors stood to lose between US$7.2 trillion and US$13.8 trillion from now to the end of the century if the temperature rises by 5°C or 6°C. This would be in the form of not only physical asset losses but also weaker asset growth and lower returns across all sectors. Sovereign funds, institutional investors and pension funds have also put pressure on companies to disclose more information and show how they can mitigate the risks around their operations or risk losing investors’ support. For instance, Swedish public pension fund AP4 sieved out 150 carbon emitters in the Standard and Poor’s 500 index and promptly diversified its holdings in them.
Meanwhile, regulators around Asia are also turning up the heat. China plans to impose tougher ultra-low emission standards for steel manufacturers this year. Singapore introduced a carbon tax this year. In Indonesia and Malaysia, major palm oil producing countries, new laws to stop deforestation have been introduced.
Consequently, many of these asset owners and managers are coming up with ways to assess climate risks to their investments. That is quite a turnaround for the US$85 trillion ($115 trillion) industry that has a long history of dismissing the threat of global warming in favour of profit growth.
Part of the reason is growing evidence of the financial impact of climate change. In 2005, Hurricane Katrina in the US caused US$62 billion worth of damage. A decade later, as global temperatures swung to extremes, Hurricanes Harvey and Irma are estimated to have caused as much as US$200 billion in destruction, disrupting the global oil and petrochemicals industry. The US economy in the last quarter of 2017 grew at 2.6% y-o-y, slower than the expected 3%.
In Asia, Tropical Storm Nock-ten in 2011 brought on the worst floods in Thailand in half a century. Factories and farmland were underwater for weeks, disrupting food supply and the manufacturing of cars and computers. According to the World Bank, the floods caused an estimated economic damage of US$46 billion.
Unfortunately, such events are likely to become more frequent and more severe: Climate experts warn that rising sea temperatures, as a result of global warming, would only cause tropical cyclones to become stronger and more devastating. And, Asia is particularly vulnerable to the risks from climate change. According to the Asian Development Bank, the region is expected to experience a temperature rise of 6°C by the end of this century. More severe tropical cyclones would affect coastal developments, where most of the urban populations are located, causing damage to ports, factories and disrupting global supply chains.
Michael Lewis, who leads the ESG (environmental, social, governance) thematic research at DWS, the asset management unit of Deutsche Bank, expects the situation in Asia to worsen as the region continues to undergo rapid urbanisation. “Most of [these developments] are in coastal areas. So, you have this sort of [problem] where typhoon, storm surges and floods could damage properties and infrastructures.”
Assessing climate risk
Jennifer Wu, global head of sustainable investing at JP Morgan Asset Management, says that in the last two years, her firm has been having more conversations with clients about climate risks than before. The large investors, who are in for the long term, are keen to understand the financial risks they are exposed to as climate conditions become more erratic and severe.
And the risks are manifold. “First, there are liability risks [such as] victims seeking compensation from those polluting. Second, physical risks arising from damage to physical assets [from] climate change and extreme weather events. [Lastly, transition risk where] highly valued commodities such as fossil fuels might undergo rapid devaluation resulting from, for example, technological or regulatory changes,” explains Frederic Samama, co-head of institutional clients coverage at French asset management firm Amundi.
So far, most investors and investment managers have generally focused on the so-called transition risk associated with the global push towards a low-carbon economy. This involves measuring the carbon emissions that companies are responsible for, or evaluating a specific fund’s exposure to fossil fuel and related businesses. But this strategy fails to consider the physical risks of climate change as manifested in rising sea levels, drought, flooding and storms. The utilities, transport, construction, semiconductor and mining industries are some sectors that could be adversely affected by heatwaves and water stress, for instance.
Recognising that investors’ top concern in the next decade is climate risk, and using the growing body of data that climate scientists and other experts have put out, investment managers are developing methodologies to assess the impact on portfolios. “One thing about climate change is that it is a forward-looking investment thesis — it can be harder to predict,” says JP Morgan’s Wu. “In a way, it is more qualitative. But that is changing, with more data available. For instance, we look at extreme weather patterns, add to physical risks from climate change. For example, in [our] commercial mortgage-backed securities strategies, they are monitoring extreme weather events to see how [these] could impact mortgage-backed portfolios.”
Wu says, while the investment firm has always looked at climate risks, the methodologies are more advanced in some sectors such as utilities, infrastructure and energy. In the investment strategies of other sectors such as semiconductor and automobile, climate risk is a new element arising out of tighter regulations and changing societal pressure for greener practices.
“We look at impacts of 1.5°C and 2°C temperature increases, and current and potential policy responses, and try to assess the risks to companies in the energy, utilities and physical infrastructure space,” says David Smith, Asia-Pacific head of corporate governance at Aberdeen Standard Investments.
Pictet Asset Management has rolled out two climate risk metrics for some of its products that are not available to retail investors. Among other things, it plans to look at how the firm’s investments are exposed to physical risks induced by climate change events such as droughts and floods. But Eric Borremans, Pictet Asset Management’s head of environmental, social and governance, admits that this metric would be difficult to quantify. “This risk is currently more difficult to quantify, owing to uncertainties of climate modelling and lack of data on the location of individual assets and supply chains,” he says.
In 2014, Deutsche Bank’s asset management arm built an ESG dataset that includes transition and carbon risks. In 2017, Deutsche teamed up with California-based research firm Four Twenty Seven to map out how natural disasters, as a result of the changing climate, could impact its investment portfolios. Four Twenty Seven has mapped the physical locations of companies’ facilities, which can help gauge how operations are susceptible to climate hazards such as typhoons and droughts. The data can help asset managers predict how rising sea levels could damage coastal construction as well as oil and gas infrastructure, or how drought and flood can disrupt agricultural activities.
However, all this is still in its infancy. The firm has only just started the process of integrating physical climate risk into its investment process. “We are currently working with a number of data providers to understand their dataset — a dataset that is evolving rapidly,” Lewis says.
Beyond ESG
Asset managers are measuring the impact of climate change on the firm’s investments because, among other reasons, strong ESG disclosure may not be enough to climate-proof a company. According to a Deutsche research last year, the correlation between a company’s ESG disclosure and its financial performance is weaker than other ESG factors such as philanthropic activities and ESG reputation. Unfortunately, investors may think greater disclosure equals a more resilient company, but it may be that companies provide only information that is beneficial to them rather than unbiased ESG details.
As Lewis explains, “Investors in Europe put more emphasis on ESG. And if you look at companies in Europe, they disclose more information on ESG. So, in that sense, you might think these European companies are more advanced and more aware. If you’re an investor and want to have only an A or B score [in] ESG rating [among your investments], what happens is the portfolio just starts moving towards European companies because they have more disclosure, which you think is [safer], but actually it’s not material to performance. And so, what happens is you get a portfolio [that] just tilts towards large European corporates and then delivers you an exposure of euro dollar. It is a currency exposure.”
Take, for instance, the 2011 floods in Thailand, which have cost the global economy about US$46 billion. It affected the gamut of industries, from tourism and agriculture to automobile and hard disk manufacturing. But which companies were most affected by the flooding?
California-headquartered research firm Four Twenty Seven mapped out the rainfall and facilities of global hardware manufacturers in Thailand. It identified three Asian hardware manufacturers that were affected by the floods: Acer, Lenovo Corp, Samsung Electro-Mechanics. It then measured the impact of the floods on these companies’ Thai facilities. The data showed that the companies with the most exposure to the flood zones saw their stock prices fall in the next four months. By mapping out the physical assets of investments and understanding the climate risks of the areas, the firm could help investors gauge the different risk profiles of their investments.
As part of an exercise for a corporate client, Deutsche used data from Trucost — a company that estimates the hidden costs of unsustainable use of natural resources — to map out the physical risks and transition risks of various sectors across Asia. In its report, Indonesian cement companies were found to be the least resilient against climate change, as they are located close to the coast, where they are vulnerable to storm surges. These companies are also high carbon emitters, which makes them subject to tighter regulations against emissions. At the other end of the spectrum, South Korean cosmetic companies ranked among the most resilient when faced with physical and transition risks. This is mostly because of the physical location of their manufacturing bases and the fact that the industry does not consume a lot of resources.
Indeed, some sectors are more vulnerable than others. “Agriculture is a sector that is very vulnerable to climate change,” says JP Morgan’s Wu. “In Asia, unfortunately, those extreme weather events [affected] a lot of the economies directly and more frequently. So, we do see companies having a hard time setting aside time [and capital] to plan for this.”
Reaching out
The demand for a greater focus on climate risks comes at a time when the active managers are facing increased competition from passive indices and robo-advisories. But even as asset managers talk about institutional clients’ growing demand for climate-resilient portfolios, the challenge ahead is to extend the risk assessment capabilities beyond the large investor community to the ranks of retail investors. That could serve as a boost for the fund managers that have seen retail interest in their services steadily dwindle over the past few years. One manager says, while margins across the industry are already tight, they could shrink further, as investors want greater scrutiny of environmental risks.
Lewis of DWS says data on physical climate risk modelling is still very rarely taken into account for investments in the public market today. But its utility will be vital for investment decisions as climate events becomes more unpredictable. He believes climate risk scoring will help investors mitigate some of these risks. “We can start to price emerging market risks more efficiently,” he explains. “We get a much better idea of the types of investments [made] by different companies in different sectors. For instance, if a large corporate is exposed to an Indonesian cement firm, do we relocate it and put it somewhere safer?”
There is no date on any product launch around physical climate risk by Deutsche so far. It previously said it wanted to set up passive investment indices in 2018. Deutsche, which is undergoing merger talks with rival Commerzbank, has said it would stop financing coal projects as part of its commitments under the Paris agreement to mitigate the impact of climate change.
Ultimately, money managers in the retail market will need to develop climate risk assessments and quantify how those methodologies protect investors’ returns. And that would require companies to have an honest look at their own operations.
“We realise that this is an area of concern, but we are unable to quantify the impact this would have on the companies beyond the agricultural sector,” says Peggy Mak, chief investment officer of managed accounts at integrated Asian financial house PhillipCapital. “I believe most corporates do not yet have definite plans [to handle climate change] because, like us, they have no clear idea how the climate risk will evolve and how it will hit them.”
To that end, it may well take investors — large and small — to exert the requisite pressure on both their investments and the people who manage them.
