How do we create a climate resilience investment framework for physical climate risk?
Mahesh Roy, IIGCC Investor Practices Programme Director
Managing the impact of physical climate risk is fast becoming an essential part of an investor’s fiduciary duties, to protect their clients’ and beneficiaries’ assets and the world in which they are valued.
Ethics aside, there is clear proof that climate disasters affect portfolios and the assets within them; be it through immediate, operational, supply- or value-chain disruption.
Rising sea levels, extreme weather fluctuations and events such as the devastating flooding in Pakistan serve as stark examples of the intensifying consequences of climate change.
As well as the tragic loss of more than 1,400 lives, economists estimate Pakistan’s direct crop damage to be in the region of $2.3bn, forcing the world’s fifth-largest cotton producer to rely on agricultural commodity imports and aid.
READ: Working towards a Climate Resilience Investment Framework
In response to this increasing risk, IIGCC seeks to create a conversation around the design of a climate resilience investment framework (CRIF).
Instead of going fast and trailblazing this framework alone with our investor members, IIGCC recognises it must go far; through interlink with other sector efforts in insurance and banking, as well as working with real economy actors and governments at every level.
Building on the widely-used net zero investment framework, the discussion recognises an investor’s first responsibility – their fiduciary duty – alongside the mission of contributing to a net zero and resilient future as outlined in the Paris Agreement.
To be comprehensive and address discrete assets, investment portfolios and broader systemic risk, we must work together to build the right components of a practical and robust framework.
Ability to respond
Recently, responsible investing efforts have focused on climate change mitigation, widely referred to as ‘net zero’, with financed emissions reduction targets to 2030 and beyond.
But mitigation forms only one part of an investor’s response to climate change. How they anticipate and respond to physical climate risk, as well as directing capital to the opportunities in adapting to it, are fast-becoming as important.
Climate resilience refers to the strategies, actions, and partnerships through which an entity absorbs or responds to climate-related hazard impacts on its operations and/or value chain, both now and in the future.
By their nature, these actions create shared benefits for the communities and natural ecosystems where that entity operates.
Resilience maintains ongoing operations and associated supply chains in the face of climate disasters, whereas adaptation is the reaction to specific events.
Many investors are already alert to this issue, with 50 firms representing $10 trillion in assets sharing their expectations that companies should be identifying and responding to physical risks.
By integrating physical climate risk into financial decisions, increasing engagement, allocating to assets that are resilient and demonstrating or are building adaptive capacity, more funds will flow to adaptation and resilience initiatives.
While some nations and regions face more acute challenges than others, none are immune to physical climate risks and therefore investors must integrate this into their overall risk management practices. By doing so they can help build the climate resilience of both individual assets and hence their portfolios.
They can also channel investment towards adaptation solutions, for instance investing in sovereign or sub-sovereign resilience bonds, that provide both investment returns and contribute to resilient economies that can benefit their other assets at a systems level. This in turn contributes to climate resilient societies.
Identifying physical climate risk
Physical climate risks are understood to affect investment portfolios through multiple transmissions channels.
For example, assets directly or indirectly impacted by climate hazards such as floods or heat stress may cause a risk to investors through a change in asset valuation; the ability of the asset to pay back loans or provide dividends.
Physical climate risks may also exacerbate several risks to which investors are exposed, including liquidity risk, reputational risk, and credit risk.
Most investors have noticed the impact of such risks at an asset level – water scarcity affecting big-name beverage brands being one recent example – but at a portfolio level whole sectors and regions can be affected, leading to concentration risk.
In 2018, low water levels in the Rhine affected the financial performance of German chemicals companies with production facilities along the river. Relying on its flows to operate, BASF SE was forced to lower its capacity utilisation, which reduced earnings by around €250 million.
At the same time, Covestro AG reported an EDBITDA reduction of around €50 million due to higher logistics and feedstock costs, and volume losses of around 1% from those same low levels.
It seems likely that to be comprehensive, investors will need to pursue climate resilience – understanding adaptive capacity at asset and market levels, with increasing consideration for addressing systemic risk at large.
Levers of change
There are then several tools available for investors to begin addressing these risks in line with their fiduciary duties. Those outlined in the discussion paper are:
- Portfolio and/or fund construction
- Asset allocation or alignment
- Investment in adaptation solutions
- Policy advocacy
- Meeting regulatory requirements
Through our work we envisage these factors will be set, measured, and reported using the same structure as the net zero investment framework. The key components of this are governance and strategy; targets and objectives; strategic asset allocation; asset class alignment; policy advocacy and market engagement.
It is vital that any resilience and adaptation commitment supplements existing mitigation efforts. Those who commit must already have begun those efforts via an established net zero initiative, as successful mitigation efforts will reduce the severity of physical climate risk.
This new framework poses a more complex challenge than traditional mitigation efforts. 2030 and 2050 net zero goals are quantitative, relatively clear, and pathway-reliant: climate resilience goals are more process-based and context-specific.
This means that the new framework must be iterative, complemented by new guidance over time as the field develops. As such, our working group will continually test and release new components of the framework, with input from broader actors in finance, the real economy and governments.
Prioritisation then, will be key.
IIGCC suggests that the framework follows a multi-criteria decision based on needs such as the ‘importance of risk’ factor, the size and importance of asset class at both asset and systems level, and the potential for practical application in the short term.
One thing is certain – a broad set of actors must work together to create a framework that supports assets and capital markets in the face of physical climate risk.
Work with us in building the climate resilience investment framework today.