This article is sponsored by Bloomberg.
The risks posed by climate change become more concerning each year, and investors are looking to understand the impacts of climate risks both on a portfolio and overall sector level. Edo Schets, head of climate products on the sustainable finance solutions team at Bloomberg, and Zane Van Dusen, Bloomberg’s global head of risk and investment analytics products, discuss the challenges investors face when it comes to assessing and accounting for climate-related risks.
How concerned are investors about the impact of climate change?
Zane Van Dusen: We are seeing that firms are increasingly concerned about the potential impact of climate change on their investments. Earlier this year, we surveyed a group of clients and market participants about this topic and found that about 85 percent are already assessing climate risk in some form or are in the process of developing a climate risk framework – which is different from years past. Interestingly, a lot of traditional risk management professionals are involved in the conversation rather than just people in more ESG-specific roles. Climate risk is moving into the mainstream as people recognise the financial impact.
While we found that ‘regulations and disclosure’ was the largest driver for this development, only 25 percent of respondents indicated it was their primary driver. There was a broad range of reasons for firms to start focusing on climate risk, including internal risk management, performance, and reputation risk, indicating that this is generally not a ‘check the box’ exercise for most firms.
The only general consensus was that the mandate to assess the impact of climate change on investments and manage that risk is coming from the top within these organisations. This is good news because it means firms are taking climate risk seriously. The bad news is they’re taking it seriously because it is a real risk.
Edo Schets: We call it climate risk, but it’s two different things. On the one hand, it is the physical effects we’re already seeing with wildfires, droughts and floods. Those impacts are already being felt and climate change will make them more frequent and severe. These are known as physical risks. To prevent these events from getting much worse, reducing greenhouse gas emissions is key.
This is where the other aspect of climate risk comes into play, transitioning to a low carbon economy. For example, maybe you’re forced by policies to reduce your emissions and you weren’t prepared for the associated costs. Our energy research arm, BloombergNEF, shows that the rise of new energy technologies will benefit some companies but can create losses for others, especially those that are heavily exposed to fossil fuels. Investors are faced with the challenge of supporting companies to adapt to these changes, while also hedging their risks. Overall, we’re seeing that climate risk is something that investors are certainly thinking about.
Is the focus mostly on evaluating risks, or on identifying opportunities?
“Climate risk is moving into the mainstream as people recognise the financial impact”
Zane Van Dusen
ZVD: The initial focus appears to be on evaluating risks since there’s consensus that climate change could adversely impact investments in the future. However, there’s a lot of uncertainty around how significant impacts may be and when they will happen. Firms should focus on stress testing, multi-scenario analysis and considering tail risk, rather than trying to check a box for regulatory purposes or trying to forecast the impacts with false precision. At the same time, firms are beginning to realise they could be missing out on potential opportunities if they exclusively focus on the risks.
ES: The regulatory attention on climate risks enhances the focus on risk, but there are major opportunities for investors who can identify new technologies that will become commonplace. It’s likely that the transition will affect companies within peer groups unevenly. Companies whose business models are adaptable to new technologies and regulations will face smaller transition risks and larger opportunities than companies that are more rigidly tied to carbon-intensive production.
What are investors’ main challenges in assessing climate risk – and how can these be overcome?
ZVD: Data continues to be the biggest challenge. Investors need to analyse a large web of interconnected data sets like greenhouse gas emissions, geolocation, supply chain info, weather data and forward-looking climate scenarios. These are relatively complex data sets to start with, but they also need to be merged together to produce intuitive and actionable metrics, which is an extremely complex task. And even with the right metrics in place, many firms don’t know what to do with them. For example, even if I know how physical risk could affect a company, how much should I invest in mitigating that risk?
A cohesive data strategy is key to overcoming the challenges associated with managing climate risks. Bloomberg helps clients get access to complex data sets in a consistent and easy-to-use form so they can integrate that data into their own analysis. However, even with the best data, gaps still exist, as companies are not fully reporting ESG metrics, such as carbon emissions. We also focus on helping clients fill those gaps by using innovative models to produce accurate company-specific estimates for GHG emissions and similar metrics where coverage is critical.
We also recognise that not every client can or wants to build their own model for climate risk; therefore, we are developing our own climate risk models and metrics. Similar to our traditional risk products, we are taking a data-driven approach that combines the latest market data with the latest scientific research to produce ready-to-use climate risk metrics that also reflect the level of uncertainty in this relatively new domain.
How will government strategies on climate change impact investors over the next two to five years?
ES: Whether we are looking at transition risk or physical risk, government regulations are a huge factor to consider. For the physical risks, how bad things will get depends on the actions we take today. On the transition risk side, if we are going to act, especially with policies put in place that put a price on carbon emissions, there will be costs.
The next two to five years are going to be crucial if we want to limit the rise in global temperatures to below two degrees. According to the Paris Agreement, global emissions need to be halved by 2030, so this is the decisive decade. Although the role of governments is huge, emissions have to ultimately be reduced by the real economy. The key is for the public and private sectors to come together to help reduce transition risks, through coordinated action.