Climate change and investments: Steps for understanding climate risk

Across all industries, there is a widespread and growing acknowledgment of climate-related risks and opportunities. Regulators expect large organizations to measure, report, and disclose their risks from the changing climate to avoid financial shocks. Investors are demanding that businesses measure their exposure to physical climate risk, which they view as material and significant, and many are beginning to divest from carbon-intensive assets.

 The field of climate finance is complex and difficult to navigate; even with research, benefits managers and advisors are often left with more questions than answers regarding how to serve their clients in this area. The following article suggests steps for understanding climate risk which can serve as a resource for advisors.

With the new US administration’s net-zero commitments and push to measure and assess climate risk, the time is now for investment managers, advisors, and professionals to understand climate risk.

 Learn the Language

 With sustainability moving to center stage in the investment arena, it is important for advisors and professionals to understand various terminology and acronyms used by the sustainability community. Key acronyms include:

• CDP: With the goal of a sustainable economy, the CDP (formerly the Climate Disclosure Project) shapes global environmental reporting through voluntary disclosure by companies, state and local governments, investors, and others to manage their environmental impacts. 
• ESG: Environmental, Social, and Corporate Governance refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business. Analysis of these criteria is thought by some to help to better determine the future financial performance of companies.
• FSB: An international body, the Financial Stability Board (FSB) works to stabilize and strengthen financial systems and global financial markets by assessing vulnerabilities, establishing guidelines, developing best practices, and more.
• RCP: A set of climate scenarios that model future paths based on different assumptions around renewable energy use, efforts to curb carbon emissions, and more, Representative Concentration Pathways (RCPs) range from RCP 2.6 to RCP 8.5 with RCP 8.5 representing the highest concentration of greenhouse gases in the atmosphere in the year 2100 and 2.6 representing the lowest.
• PRI: The Principles of Responsible Investing work to understand the investment implications of ESG factors; to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. Over the last decade, the number of signatories to the Principles for Responsible Investment (PRI) has grown from 100 to more than 3,000.
• SASB: Used to guide the disclosure of financially material sustainability information by companies to their investors, Sustainability Accounting Standards Board (SASB) Standards identify the subset of ESG issues “most relevant to financial performance in each of 77 industries.”

Understand the Task Force for Climate-Related Disclosure

Critical to how virtually all markets will address climate change, the acronym “TCFD” deserves its own sub-section in this article. 

The TCFD was set up by the Financial Stability Board in 2015 to develop and promulgate climate-related financial disclosures. The disclosures are designed to solicit consistent, decision-useful information on the material financial impacts of climate-related risks and opportunities, allowing companies to better inform investors, lenders, insurers, and other stakeholders.

The purpose of the TCFD is to help investors know the risk companies face so their investments are better informed. According to TCFD Chair Michael Bloomberg, the widespread adoption of the TCFD’s recommendations “will ensure that the effects of climate change become routinely considered in business and investment decisions.”

TCFD reporting is voluntary disclosure of climate-related risks and opportunities in an organization’s annual report. The work and recommendations of the Task Force will help firms measure and manage the risks they face from climate change and will help inform investors and prepare financial markets for what is to come.

Know that climate risk is now central to risk management

Climate risk management is becoming embedded in the risk operations of every organization, from insurance to real estate development and beyond. 

Risks are generally categorized into two areas: physical and transition. Physical risks relate to the impact of weather, floods, droughts, and natural disasters on operations, property, and other assets. Transition risks relate to the financial impacts of policies and regulations (such as carbon pricing), emerging technologies, reputational shifts, and litigation.

The impact of these risks on any given company is modeled through “climate scenario analysis.” This work evaluates a variety of hypothetical outcomes by considering alternative plausible future states (scenarios) under a given set of assumptions and constraints. It is often mapped to the RCP scenarios, referenced earlier in this article, developed by scientists to model future warming based on emissions trends.

Climate scenario analysis has begun to be employed by institutional investors and corporations worldwide to understand their exposure to climate risk. Understanding the basics of this work will be key for investment professionals and benefits managers in the coming years.

Stay apprised of regulatory updates

 The regulatory landscape is changing dramatically and fast when it comes to climate risk. For example, it has been reported that President Biden is preparing an Executive Order on “Climate-Related Financial Risk” which mandates federal oversight of all sectors – including institutional investments and pension funds.

 Other regulatory changes to keep an eye on include:

• The SEC is expected to propose new rules on corporate climate risk disclosures in the second half of 2021.
• The Treasury Secretary Janet Yellen proposed new efforts to address climate risks in the financial system that would create a “hub” to review financial stability risks and seek tax policy incentives for addressing climate change.

Building climate change capabilities in risk management

Climate change has the potential to destabilize financial markets unless financial institutions build their capabilities for risk management in this domain. With losses from climate impacts mounting, investment professionals have a responsibility to learn and understand these developments in order to make decisions in the long-term best interests of their beneficiaries. Developing an understanding of climate risk and the TCFD is a good first step on this journey.

Tory Grieves is VP of Analytics for The Climate Service, where she utilizes her technical expertise in both environmental science and business to accelerate climate adaptation and resilience. Backed by an advisory board including four IPCC Nobel Prize-winning scientists, and strategic partners including Aon and IBM, The Climate Service has developed a software as a service product, the Climanomics platform, to support reporting and disclosure aligned with the TCFD framework. Our company’s goal is to help investors, companies, and communities to understand their risks from the changing climate, and the opportunities from a transition to a low-carbon economy. Our mission is to embed climate risk data into every decision on the planet and facilitate the world’s transition to a low-carbon economy.