Institutional Investors Find Alpha In Climate Risk Matrices: Global Survey Finds
by Natalia Moudrak, Kathryn Bakos, Joanna Eyquem, Hugh O’Reilly, Ashby Monk, Soh Young In
December 2020
This report that presents results of a global institutional investor survey focused on understanding the methods to assess physical climate risk, the extent of formal training on physical climate risk received by the Boards of Directors, C-Suite officers and portfolio managers, and the utility of Climate Risk Matrices to aid portfolio managers in investment decisions.
PRESS RELEASE
December 9, 2020
New Climate Risk Matrices are welcomed as a way to identify financial exposure to physical risks from climate change, such as the growing threats of flooding and wildfires.
Lead by the Intact Centre on Climate Adaptation (University of Waterloo), Global Risk Institute and Stanford Global Projects Center (Stanford University), a global survey of institutional investors managing $2-trillion (U.S.) identified a need for concise and interpretable information regarding risks portfolios face from physical climate change. In response, many of these investors are looking to a new risk-assessment tool, the Climate Risk Matrix (CRM).
The CRM, developed by the Intact Centre, is a tool that institutional investors can use to identify material physical risks that investee companies face from climate-related extreme weather events.
Globally, the Task Force on Climate-Related Financial Disclosure (TCFD), central banks and financial regulators warn that climate change threatens the stability of financial markets, and they advise that mandatory disclosure of climate-related risks is on the horizon. They are calling for a global, standardized method to assess such risks.
As highlighted by Sonia Baxendale, President and CEO of the Global Risk Institute, “Climate change is a risk, not only to our environment but to the long-term stability of our economy and global financial system. Investors need to understand the physical and transition risks that climate poses to their portfolio companies.”
In response, the CRM presents one or two of the most material physical risks from extreme weather specific to an industry sector, and how those risks can be minimized, in a simple template applicable to any company within the sector. For instance, an electricity Transmission and Distribution (T&D) company in Canada may have thousands of kilometres of power lines that are vulnerable to ice loading and collapse. The CRM offers practical means for a portfolio manager interested in investing in a T&D company to identify this risk, and to consider whether mitigation measures, such as tree trimming and boosting current to melt ice, have been implemented to avoid outages and lost revenue.
The survey of 13 major institutional investors from North America, Australia and Europe took place in October 2019 and is detailed in the report “Institutional Investors find Alpha in Climate Risk Matrices: global survey finds.“ It found:
- Physical climate risk: a majority of investors, 54 per cent, viewed physical risks from climate change as a “very high” or “somewhat high” material issue.
- Financial valuation: 62 per cent of investors surveyed have not yet translated physical climate-change impacts into financial valuation of assets.
- Climate risk training: boards of directors and C-suite executives generally lack formal training regarding climate-related risks. For example, 46 per cent of surveyed investors indicated that either “none” of their board members had received training on climate risk, or they were not sure about the extent of climate risk training received by board members.
- Climate risk reporting: there is a lack of accessible, “decision-friendly” reporting by individual issuers regarding their physical climate risks.
- Climate Risk Matrix: a majority of institutional investors surveyed — 85 per cent — say the “Climate Risk Matrix” is an excellent approach with which to begin analyzing physical climate risks facing the assets they manage.
“A suite of CRMs, developed for a range of industry sectors, would immediately help institutional investors manage their portfolios in a manner consistent with direction described by TCFD,” says Dr. Blair Feltmate, Head of the Intact Centre.
Material, physical losses from extreme weather — including loss of life and property and disruptions to economic activity — have cost $1.3-trillion (U.S.) in the past 10 years, according to the International Monetary Fund. Some losses have hit financial markets heavily.
Moreover, as suggested by Natalia Moudrak, co-author of the report, “Climate change is effectively irreversible. This punctuates the need for capital markets to incorporate physical climate risk into investment decision-making. CRMs offer a pragmatic solution to do so TODAY.”
The Intact Centre is an applied research centre at the University of Waterloo. For additional information, visit: www.intactcentreclimateadaptation.ca
BACKGROUNDER
Recent developments in the financial world suggest that the “Climate Risk Matrix” tool could play a key role in fulfilling a global demand for full disclosure of physical climate risks, consistent with TCFD.
Central banks and global financial regulators warn that climate change is a significant threat to financial stability — one that markets and investors have not adequately assessed.
Central banks are calling for a standardized global framework for measuring and disclosing issuers’ climate-related risks. They signal that disclosure (which is currently voluntary) may soon be mandatory (as will be the case by 2025 in the United Kingdom).
Banks and regulators point to a compelling need for market players to reveal their climate-related risks:
- Some extreme weather events can hurt markets significantly, the IMF says, such as the 2011 flooding in Thailand, which caused losses equivalent to 10 per cent of the country’s GDP, and a 30-per-cent drop in the stock market over 40 days.
- Stock markets and assets may be overvalued, the IMF suggests, as they are not pricing in the risks from climate change. Risk may be underestimated because investors may not be adequately factoring them into their valuations of companies and other issuers. For instance, an IMF review of equity valuations around the world (for 2019) found they “did not reflect any … commonly discussed global warming scenarios” or associated hazards or physical risk. This lack of information about financial vulnerability to climate change “could be a significant source of market risk looking forward.
- In early November, the U.S. Federal Reserve said for the first time that climate change is “a systemic financial risk” and a key risk to U.S. financial stability. Chairman Jerome Powell said the central bank has a responsibility to protect U.S. markets from this risk.
- The international Task Force on Climate-related Financial Disclosures (TCFD) has developed a global risk-disclosure code, but says that too few companies — just one in 15 — are voluntarily disclosing their financial vulnerability to climate change.
- The IMF, Bank of England and Britain’s Financial Reporting Council (FRC) say a global standard for disclosing climate-related risks could help to preserve financial stability. The TCFD’s voluntary code is “an interim step” toward a global standard that should result in disclosures with detailed, company-specific information, the FRC said.
- In late November 2020, Canada’s eight largest pension funds, managing $1.6-trillion in assets, jointly called on corporations to use a standardized method for reporting their environmental, social and governance (ESG) data. Investors want “a consistent, transparent means of measuring ESG impacts and risks,” said Neil Cunningham, CEO of PSP Investments, which manages the pensions of federal government employees and the RCMP. Companies that understand their risks and disclose them fully tend to outperform others, he said. For pension funds, “the ability to identify those outperformers will increase our returns, and then benefit our beneficiaries. This is just smart investing.”
- A major focus of next year’s United Nations Climate Change Conference (COP26) will be devising global standards for valuing issuers and portfolios in relation to climate change — with the goal of protecting investors and the economy, said Mark Carney, UN Special Envoy on Climate Action and Finance. The former governor of the Bank of Canada said governments and regulators must also make climate-related disclosure mandatory.
- The Bank of Canada and the Office of the Superintendent of Financial Institutions (OSFI) will study different climate-change scenarios to gain a better understanding of the risks to the financial system as the world transitions to a low-carbon economy. A pilot project announced in November 2020 will involve a small group of banks and insurers, and aims to building the Canadian financial sector’s capacity for analyzing and disclosing climate-related risks. “Climate change is a major challenge for the economy, and it is accelerating,” said Bank of Canada Governor Tiff Macklem. “We need to accelerate our work to understand the implications for the economy and the financial system.”
- On Nov. 9, the U.K. became the first country to declare that the disclosure of climate-related financial risks will be made mandatory by 2025. It will require industry reporting to align with the TCFD’s global disclosure code.
Contact Details:
Dr. Blair Feltmate
Head, Intact Centre on Climate Adaptation
University of Waterloo
226-339-3506 | bfeltmate@uwaterloo.ca
Hugh O’Reilly
Executive in Residence
Global Risk Institute
horeilly@globalriskinstitute.org
Natalia Moudrak
Director, Climate Resilience
Intact Centre on Climate Adaptation
University of Waterloo
226-220-4982 | nmoudrak@uwaterloo.ca
Soh Young In
Research Director of Sustainable Finance
Global Projects Center
Stanford University
si2131@stanford.edu