Climate Chaos – It’s getting physical

Investment

“Climate change is affecting us now, particularly the poorest and most vulnerable, and will only become worse. It is imperative that the finance sector identifies market vulnerabilities and manages climate risks as we adapt to a warmer world.”

Eric Usher, Head of UNEP FI

Physical risks, which were once perceived as distant concerns, are now becoming more tangible as we witness the present impacts of climate change in 2023. This month, global average temperatures have reached unparalleled levels, and it is expected that this record will soon be broken again as we continue to experience extraordinary weather. [i]

Physical risks arise as a result of a changing climate and relate to natural disasters such as storms, floods, droughts and wildfires (sudden risks) as well as slow changes in weather patterns (slow onset risks).

The UK is not immune. Scotland’s devastating wildfires recently ravaged a vast area of the Highlands.[ii] It is said to have been one of UK’s largest ever wildfires,[iii] destroying years of work to restore native woodland (in line with government ambitions to restore millions of hectares of woodland)[iv] and negatively impacting on local species.[v] The trend of increasing wildfires is expected to continue, with rising temperatures drying out forests, acting as kindling for wildfires.

Beyond the UK, there have been a swathe of global disasters, from flash floods in China, Chile, Ecuador and DRC, to cyclones in India, Bangladesh and Myanmar.[vi] By 2030, under current trends, we might face ~560 natural disasters a year, costing ~$330 billion,[vii] and impacting millions of people.

Source: United Nations Disaster Risk Reduction, based on EM-DAT database on international disasters

Physical risks are impacting investor portfolios today

The investment industry has been slow to integrate assessments of physical risks exposure, barring few select asset managers and asset owners leading the way. Today, we focus on two key challenges facing the investment industry.

Physical risks are being underestimated

Investor modelling of climate-related physical risks are likely under-representing the economic cost to portfolios. With complex climate models necessarily simplified for investor deployment, the focus is on linear relationships between temperatures and economic outcomes, which largely ignore climate tipping points (and within the Isio climate model, we scale up physical risks in response). The below box sets out the issue in more detail.

What are the climate experts saying about climate tipping points?

Climate tipping points are irreversible changes in the climate system. For example, permanent ice sheets melting, releasing carbon/methane into the atmosphere and increasing global average temperatures beyond a level at which permanent ice sheets can naturally occur. Typically, climate tipping points are at risk of occurring where global average temperatures rise by ~2⁰C above pre-industrial levels, but there is also a low level of risk below this threshold. Under a 4⁰C scenario, equivalent to widespread global failure to respond to the climate emergency, pivotal climate studies by Nordhaus and Weitzman cite an economic cost of ~4% to ~9% a year by the end of the century (measured in annual GDP losses). Neither of these studies account for climate tipping points, and by incorporating these changes the economic cost would rise to ~50%, according to Dietz and Stern. There will also be social tipping points, with mass migration as areas of the Earth become uninhabitable, for example, which we will address in a future blog.

Ultimately, physical risks will be felt both via portfolio assets and liabilities. Resulting in asset return drags, alongside increases in the cost of insurance, many assets may also become uninsurable. There will be investment opportunities, including in adaptation infrastructure (e.g. to protect against flooding and sea level rise). From the liability perspective, mortality will also become increasingly hard to predict, both in terms of distribution across time and space, but is likely to increase in general with rising physical risks.

Climate-related adaption is the process of adjusting to actual or expected changes in the climate system. With natural or man-made solutions used to moderate or avoid harm from physical changes. As well as increase exposure to opportunities from a changing climate.

Investors need pinpoint accuracy, but climate systems are not granular

Physical risks will not be evenly distributed across regions, and climate change will disproportionately threaten some of the poorest economies and people.[viii] With investor preparedness being key, we need an understanding of the geographic distribution of physical risks. Obtaining portfolio pinpoint accuracy of physical risks is however at odds with climate models that capture regional/global phenomena.

Some leading climate scientists are trying to translate global phenomena to local outcomes. For example, the Woodwell Climate Research Center has developed an understanding on the types of physical risks and where these could be felt most, which asset managers and owners are deploying. This includes sector-specific analysis (e.g. localised water availability impacting on agricultural productivity can be used to understand how individual investee companies’ bottom lines might be affected.[ix]

How investors can tackle physical risks today

There is an investor opportunity, with $2.5 trillion a year needed to adapt to a changing climate, out to 2050.[x] To date, spending on physical resiliency has been dwarfed by decarbonisation spending, with just 19% of green, social, and sustainable bonds earmarking proceeds to climate resilience.[xi] With ambiguity surrounding resilience investing, the Climate Bonds and United Nations Disaster Risk Reduction have proposed a taxonomy on resilience investing,[xii] which is an important place to start. But there are other areas where investors can start today, including:

Climate-related physical resilience measures the ability to cope with and recover from changing weather patterns and increasing natural disasters. The focus is on managing or avoiding physical risk exposures from climate change.

Understanding portfolio risks, including climate modelling to understand impacts on asset classes (scaling physical risks to account for climate tipping points), or granular physical data to identify company or real asset laggards
Assessing investment managers on physical risk management processes, and identify potential areas of improvement
Engaging to raise the profile of physical risk resilience, including engagements with investment managers and investee companies, as well as collaborative initiatives[xiii]
Disclosing and improving the approach over time, as the data and science continue to evolve

With widespread physical resiliency needed, there is growing investor momentum. Any response to physical risks will necessarily be commensurate with the scale of your portfolio assets and associated timeframes. Regardless, our collective response to physical risks will need to ramp up, from today.