Commentary

The Adaptation Agenda: Preparing Investors for a 1.5°C+ World

Institutional investors are focusing on understanding, measuring and managing climate risks in their portfolios, but the toolbox for physical risks is still coming together, says Florian Gallo, Senior Research Lead, Physical Climate Risk, at the London Stock Exchange Group.

In the wake of COP26, and with the 27th edition in sight, the latest IPCC assessment reports [1,2] starkly highlight the risks we are facing if we fail to curb greenhouse gases emissions.

With global surface temperatures already 1.1°C higher than in the pre-industrial era, the physical effects of climate change have already started to materialize. ([1], [3], [4]). Natural disasters have always occurred, but climate change is making them more frequent and more intense. In 2020 alone, global losses from natural disasters were estimated at US$210 billion, with over US$10 billion in losses each from wildfires in California, floods in China, and cyclone Amphan in India [5]. Chronic and interlocking long-term effects – such as water scarcity, decreasing yields might be less spectacular but even more crippling.

Failing to mitigate climate change would be catastrophic, putting billions of people at risk and inflicting estimated damages and losses at over US$20 trillion annually by the end of the century [6].

Rapid decarbonisation and achieving the 1.5°C objective of the Paris Agreement would of course significantly limit these impacts. But even in this best-case scenario, physical climate risks[1] will continue to increase for decades to come. The harsh reality is that societies and investors will need to adapt to living – and investing – on a hotter planet.

 

Diagram 1 – Projected impact of rising temperatures on GDP in 2050, following three climate scenarios. Even the most optimistic scenario (RCP2.6, corresponding to a Paris-aligned world) leads to substantial impacts for many countries, especially in Latin America, Africa and Southeast Asia. Almost all countries might be faced with negative impacts, some as early as 2030 [7].

Understanding physical risks for sound financial decision-making

Institutional investors have been increasingly focused on understanding, measuring and managing transition risks in their portfolios but the toolbox to come to grips with physical risks is in many ways still being put together.

The reality is that today, the uptake of our expanding scientific understanding of physical climate risks into investment decisions and financial risk management remains limited. For many institutional investors, physical risks remain ‘terra incognita’.

This gap is dangerous, both to portfolio returns and society at large and urgently needs to be closed. As the UN Environmental Programme (UNEP) summarises in their Adaptation Gap Report [8], “adapting to climate change makes economic sense” – with the Global Commission on Adaptation estimating a return of US$7.1 trillion in avoided costs and other benefits, for a US$1.8 trillion investment in adaptation measures [9].

Overcoming this challenge requires raising awareness about how escalating physical climate risks are changing risk/return profiles across sectors and asset classes. It also requires overcoming resistance among mainstream investors to integrate yet another large, complex, sustainability-linked information set into their already increasingly crowded investment process.

There are significant technical challenges in making expanding physical risk data decision-useful for financial actors. Physical risk datasets are structured in decades, expected precipitation patterns, cyclone pathways, longitudes, and latitudes. Connecting them with the world of security identifiers and valuation ratios is a challenging task. Some parts of the financial industry – like re-insurers and soft commodity investors – are further ahead than others, but there is a long, complex road ahead.

We believe four enablers are central to better integrating physical climate risk into the investment process:

First, we need more physical risks expertise in the financial industry. Finance practitioners need to reinforce their understanding of physical risks methodologies, while climate experts are expected to provide usable climate information for financial risk management. It is encouraging that large financial institutions have begun to develop in-house physical risks expertise and are increasingly focused on acquiring or partnering with the growing number of physical risks focused start-ups.

Second, we need to build better asset level data. This means systematically compiling the underlying physical and geographical profile of investable financial assets. In the same way that investors in a company have the board members and their CVs at their fingertips, they need an inventory of their physical assets –warehouses, datacentres, factories – to evaluate physical risks effectively.

This is often the ‘missing link’ that prevents physical risk data to meaningfully enter the investment process. The bad news is that this is a monumental task for the industry, the good news is that it aligns well with other trends in the industry such as the growing focus on asset level finance and expanding use of satellite data.

Third, while a growing number of solutions exist to capture physical risk in qualitative terms, a better quantification is needed to systematically estimate the financial impacts and adaptation costs at the asset or counterparties level (so-called ‘damage functions’). Such quantification process is itself data hungry and time-consuming and requires significant interdisciplinary expertise across finance, data science, and climate and earth sciences.

Finally, we will need to agree common language and data standards. These are critical to enable the rapid scaling of the use of physical risk information in investment processes and avoiding the industry getting bogged down in proprietary methodological black boxes.

Collaboration required between finance, data and climate science

Triggering these four enablers requires collaboration between finance, data and climate science. Large-scale initiatives are contributing to this collaboration effort between academia, financial institutions, and private data providers. For example, the Open Source-Climate initiative seeks to establish a collaborative community building a data and software platform to boost global capital flows into climate change mitigation and resilience. Creating and improving data is of vital importance, but enabling users to access, understand and use the data is even more crucial to embedding climate into financial risk management.

At LSEG, we have begun this journey and are investing in physical risk and geospatial capabilities. This means bringing expertise in-house but also collaborating with academia, start-ups and third-party suppliers.

Accelerating the low carbon transition to mitigate climate change must remain a priority, as physical climate risk increases exponentially with global warming. But at the same time humanity needs to adapt to living in 1.5°C+ world. For the finance sector this means creating better tools and insights to anticipate shifting physical risk profiles and mobilising capital to invest in adaptation and resilience.

This article was co-authored by Jaakko Kooroshy, Global Head of Sustainable Investment Research at FTSE Russell, an LSEG business.

References:

[1] IPCC, 2022: Climate Change 2022: Impacts, Adaptation, and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [H.-O. Pörtner, D.C. Roberts, M. Tignor, E.S. Poloczanska, K. Mintenbeck, A. Alegría, M. Craig, S. Langsdorf, S. Löschke, V. Möller, A. Okem, B. Rama (eds.)]. Cambridge University Press. In Press.

[2] IPCC, 2022: Climate Change 2022: Mitigation of Climate Change. Contribution of Working Group III to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [P.R. Shukla, J. Skea, R. Slade, A. Al Khourdajie, R. van Diemen, D. McCollum, M. Pathak, S. Some, P. Vyas, R. Fradera, M. Belkacemi, A. Hasija, G. Lisboa, S. Luz, J. Malley, (eds.)]. Cambridge University Press, Cambridge, UK and New York, NY, USA.

[3] see the reports from the World Weather Attribution initiative, for example

[4] SwissRe, 2022. https://www.swissre.com/media/press-release/nr-20211214-sigma-full-year-2021-preliminary-natcat-loss-estimates.html#:~:text=Extreme%20weather%20events%20in%202021,Re%20Institute%27s%20preliminary%20sigma%20estimates. Last accessed on April 11th, 2022.

[5] MunichRe, 2021. The natural disaster figures for 2020. (https://www.munichre.com/en/company/media-relations/media-information-and-corporate-news/media-information/2021/2020-natural-disasters-balance.html. Last accessed on April 11th, 2022.

[6] Kompas, T., Pham, V. H., & Che, T. N., 2018. The effects of climate change on GDP by country and the global economic gains from complying with the Paris Climate Accord. Earth’s Future,6, 1153–1173

[7] Gallo, F., Lancesseur, N., & Moussavi, J., 2022. Anticipating the climate change risks for sovereign bonds Part 3: Insights on the physical risks. FTSE Russell Index Insights.

[8] United Nations Environment Programme, (2021). Adaptation Gap Report 2020. Nairobi.

[9] Global Commission on Adaptation (GCA) (2019). Adapt Now: A Global Call for Leadership on Climate Resilience. Rotterdam and Washington, D.C.: Global Center on Adaptation and World Resources Institute.

 

[1] Climate risks can be categorised in two types: transition risks are inherent to the transition of the economy towards a low-carbon model (e.g., behavioural, regulatory, political changes) whereas physical risks are linked to the physical impacts of climate change on livelihoods, activities and assets (e.g., increased droughts leading to water scarcity, increased damages due to more frequent cyclones).

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