Ignoring climate risk is more costly than grappling with it

A trio of recent deals tells us something important about capital markets: that 2020 may be the year when climate-risk analysis of portfolios moves out of a niche into the mainstream. Investors and boards have begun to realise that it can be more costly to ignore these issues than to try to grapple with them. Last September MSCI, the global index company, bought Carbon Delta, a boutique focusing on climate risk analysis. A few months earlier Moody’s acquired Four Twenty Seven, a similar boutique. 

Last year ended with S&P making a move for sustainable index player RobecoSAM. Several factors are driving the trend. First, a flurry of central banks are introducing climate stress tests for banks and insurers, following the lead of Mark Carney, Bank of England governor. The insights these tests provide could be used by boards and investors to change practices in asset allocation and risk management. The scenarios and tools that are developed are likely to spread into the investment world too. Tests designed by Australian policymakers, in fact, will explicitly cover pension funds, not just banks and insurers. The second driver: better metrics. Until now, investors, lenders and insurers have lacked a clear view of how companies may fare as the environment changes, regulations evolve, new technologies emerge and customer behaviour shifts. Without high-quality, comparable data, financial markets struggle to price climate-related risks and opportunities effectively. 

However, the Task Force on Climate-related Financial Disclosures (TCFD) has made progress in shaping a standard for voluntary disclosures by businesses, and well over 900 public- and private-sector organisations have signed up to support it. The quality of the data is steadily improving. Better metrics will be critical because simply excluding entire sectors, such as energy, is unlikely to work at scale. The transition to a lower-carbon economy will require large-scale reallocations of capital and investments in infrastructure — perhaps as much as $100tn globally, over the next decade. Blanket exclusions are like holding a short on the ingenuity of companies to transform themselves and invest in new opportunities.

This, in turn, is fostering a third shift: investor activism. Companies have made great strides in voluntary reporting, but there are stragglers and numerous inconsistencies. Sir Chris Hohn, the hedge fund manager, has urged all companies to publish their climate-related disclosures on a TCFD basis, and I agree with him. Investors’ voices will be critical in this effort, to ensure data is useful enough to inform decisions. Already, some investors are starting to believe that there could be large valuation dispersions between the leaders and the laggards. It is striking that large numbers of hedge funds are now looking into the investment opportunities and risks, complementing longer-term asset owners. 

While some of the physical effects of climate change may take years to materialise, putting them beyond the horizon of a typical investment mandate, we could see much earlier shifts in regulation, taxation, competitive position, brand impairment, financing costs or litigation. We can already start to see the early signs of repricing in the energy and auto sectors. We have yet to see the full implications of the Australian wildfires. There are plenty of caveats, of course. The models are still rudimentary. A priority for policymakers and investors will be to separate signals from noise. Central bankers may take baby steps in the first stress tests as they learn on the job. Moreover, they will not wish to inadvertently create “stranded assets” through too harsh a process (although this may be the longer-term impact.)  

Another risk is if different policymakers create a cacophony of differing standards, data taxonomies and scenarios — let alone different environmental policies — which will be tough for boards and investors to interpret. This risk will be high on the agenda at Davos later this month, and also for Mr Carney, in his new role as UN special envoy for climate action and finance. Lastly, and critically, this process will work only if investors reprice the cost of capital for different firms. This could be tricky, as negative interest rates and “QE Infinity” policies have had side effects, distorting asset prices, impairing banking systems and challenging insurers. Transmission mechanisms may now be less effective. 

Still, markets have a habit of moving well ahead of consensus expectations. The bottom line is this: investors and financial institutions want to get smarter in managing climate-related risks and opportunities. If they do, then those bets by MSCI and co on evaluating the impact of climate risk on investment portfolios are likely to pay off too.