This discussion was co-ordinated in collaboration with Climate X
Climate change is making its impacts felt across all sectors of the world’s economy. But as investors and corporates turn their attention to adaptation and resilience, the nature of the impacts and the investor exposure varies substantially across asset classes. A private equity firm needs to consider adaptation through a very different lens to their counterparts in private debt, while public market investors have a whole range of other considerations to take into account.
Although data on asset exposure to climate risks has improved in recent years, important gaps still remain. And the challenge of making sense of all the data that is available still poses a considerable test for even the best-resourced investment managers.
Meanwhile, the ESG backlash has caused further complications, particularly in the US, as investors seek to respond to climate risks while avoiding being caught up in contentious political discussions.
In partnership with Climate X, Responsible Investor brought together leading figures from several different asset classes in New York to discuss the challenge of adaptation. Michael Bowen, reporter at affiliate title New Private Markets, chaired the proceedings.
The panel
Head of sustainability,
Oak Hill Advisors
Jeff Cohen
Head of impact,
Sonen Capital
Amanda Feldman
Managing director,
StepStone Group
Bhavika Vyas
Director of sales, Americas,
Climate X
Alexandre Crépault
Managing director,
JPMorgan Asset Management
Nishesh Kumar
Head of sustainability,
BC Partners
Colin Etnire
Head of sustainability, Americas,
Schroders
Marina Severinovsky
The financial impacts of climate risks
Which asset classes are experiencing the financial impacts of physical climate risk most acutely?
Marina Severinovsky: Clearly, there are regions and sectors that are more exposed than others. For example, we carried out some research with Cornell’s Global Labor Institute regarding the need to protect workers from extreme heat. In that analysis, we found that without addressing worker safety, a number of countries in the fashion supply chain risk were missing out on $65 billion in export earnings and a million new jobs. These are the types of nuances that are important when considering the financial impact of climate risk.
“If we know there is a climate risk, but we can’t discern the scale or the time frame, then it’s undefined”
Bhavika Vyas,
StepStone Group
I would add that in addition to physical damage, you need to consider issues relating to loss of service, supply chain disruption, labour productivity losses, product recall and redesign, trade disruption and even inflation when thinking about the financial impacts of climate risk. All these things can elevate volatility in listed assets, which represent most of our AUM, together with higher borrowing costs for companies that are at risk. Having said all that, climate risk also heralds investment opportunities, of course – particularly relating to adaptation.
How can you measure physical climate risk in a private credit portfolio, in particular?
Jeff Cohen: The simple answer is, it’s not easy. That is partly because private credit investors have limited access to information, particularly in certain sponsor-backed deals and depending on the credit investor’s role in the financing. A private credit investor’s ability to connect with company management may also be limited. It’s debatable whether detailed climate information for all the different sites across a company and its suppliers is going to be at the top of your priority list relative to other information that you want to request at the time of issuance.
As far as how financially material physical climate risk may be, it depends on the time frame in which that risk is likely to mature. For us, the emphasis is on understanding acute risk because our investment horizon is not as long as it may be for private equity investors. It can be hard to get a full picture, but that is certainly something we consider in our underwriting in conjunction with all other risks.
Is access to information more readily available for other areas of the investment universe?
Nishesh Kumar: In the context of public markets investing, the short answer is no, we don’t have the information we require, and not for want of trying. Mitigation is one thing. There are metrics in place around Scope 1, 2 and 3 emissions. But if you are looking at a public company, with many different assets, it can be very challenging to determine what should be reported from an adaptation perspective. Should it be dollars spent, or miles of cable taken underground, or percentage of vegetation removed? There are just so many different potential metrics depending on the asset and its situation, that things can quickly get very complex.
I would add that, even armed with all this information, experiences with Hurricanes Katrina and Rita, for example, have taught us that a lot of this is just sheer dumb luck. You might own the one asset left standing after an extreme weather event or you could own the asset over the street that is wiped out. In some cases, even where assets have been left standing, those that run those operations haven’t been able to make it into their offices. In other words, even if you do all your homework, there can be curveballs.
Marina Severinovsky: There has been a significant increase in the physical risk data that has become available in recent years, but there are still challenges, certainly. Our private markets business, Schroders Capital, has spent the past 18 months looking at geospatial modelling for real assets, but we still haven’t found the perfect fit. There are companies out there that are doing modelling for buildings, but there don’t seem to be specific damage curve models for different infrastructure asset types. We need to be able to add asset-specific features in order to quantify risks for specific asset types and also be able to test any mitigation action that could potentially be taken to lower those risks.
On the public markets side, we use MSCI climate Value-at-Risk tools, but here again we find that data to be insufficient. So, I do think we need to see higher-quality, asset-specific location data that can be verified and published by the companies themselves, and then integrated into forward-looking climate scenario modelling.
A lot of the reporting on climate scenarios that we have seen focuses on time horizons out to 2050. We need to understand what the implications of specific climate events might be in a more immediate context, which is why we are actually trying to narrow models down to specific asset locations and shorter time periods.
Amanda Feldman: We find that data is relatively easy to access across all asset classes, so long as we ask the right questions upfront. We encourage fund managers to share the information they think is material to their investment strategy, while also following up on other information that is important to us. It is vital to set expectations at the outset.
Colin Etnire: As a buyout firm, we have a different level of access to information when compared to Jeff on the credit side, or when compared to a public markets investor, for example. I think buyout firms are uniquely privileged when it comes to the level of access and level of control that they have over the asset.
“A lot of this is just sheer dumb luck – even if you do all your homework, there can be curveballs”
Nishesh Kumar,
JPMorgan
Furthermore, over the almost 10 years that I have been doing this, the cost of getting decision-useful data around climate risk has come down substantially. That decision-useful piece is important. Studies of a whole industry or a whole country’s exposure are not that useful to us as managers, owners and operators of specific companies. We need to know precisely where in a valley a factory is located and how exposed that location is to flood risk, for example. That information now exists and is accessible.
I would, however, echo Jeff in saying that we place a greater emphasis on acute risk than chronic risk. Physical climate risk is particularly important for businesses that have a handful of crucial assets, such as factory sites. If one of three factories is affected by flooding, that can have a huge financial impact, whereas if you have 1,600 sites, the impact of one or two being flooded won’t be nearly as significant.
How do you discern the relevant time horizon for an acute climate event and how do you factor that into underwriting?
Bhavika Vyas: If we know there is a climate risk, but we can’t discern the scale or the time frame, then it’s undefined. Some investments we have to take off the table entirely. But there are others that fall within a time frame where there is something we can actually do to address those risks. There are decisions we can make in the management of the asset or in portfolio construction that mean we can still put together a workable investment case.
Colin Etnire: We have a three- to five-year holding period in theory, which is a small window when it comes to the likelihood of acute climate risks.
But what about future buyers? Is the exit itself not compromised by not assessing physical climate risk on a longer-term basis?
Colin Etnire: We have a five-year target holding period but usually underwrite to 10 because we are thinking about the next owner. Potentially, we could lengthen that to 15 years, but if flood risk is deemed to be a once-in-a-100-year event, for example, we are still talking about a very short time horizon.
Engaging with data
What could be done to improve access to physical climate risk data?
Amanda Feldman: The question that we all face every day is how we bridge what we want to know with what we need to know. That encompasses both the quantitative and the qualitative, because we do sometimes need to use some judgment to derive conclusions from the information we receive. It can sometimes feel as though you are swimming in seas of data. Figuring out what to do with all that information is the big challenge.
Jeff Cohen: I am a big fan of open-source tools. They can provide companies with a sense of a property’s exposure to physical risk and what resilience measures can be put in place, as well as the ROI or the payback period attached to those measures. We take these tools and share them extensively. We aim to encourage action by helping companies pay closer attention to physical climate risk.
To what extent are companies happy to engage on physical climate risk reporting once an investment has been made?
“It can sometimes feel as though you are swimming in seas of data. Figuring out what to do with all that information is the big challenge”
Amanda Feldman,
Sonen Capital
Bhavika Vyas: I think your ability to influence as an investor depends very much on the asset class. A lot of real estate managers, for example, are already on this journey and are carrying out scenario analyses of their own. Venture capital managers, by contrast, have very limited physical footprints.
Nishesh Kumar: We find that companies are willing to address reporting around acute climate risk, but when you are talking about chronic risks, it is much harder to get them to respond. We have seen that with what has happened in California, for example, as well as the Gulf Coast storms.
Reporting is still very much in a narrative form. It is difficult to access hard data. Gulf Coast refiners, for example, will tell you what steps they took after those storms, and they will tell you how the impacts of recent storms have improved as a result. But in terms of having decision-useful data out there in the public domain, they are still struggling with what metrics to use and how that information should be conveyed.
I do appreciate that it’s not that easy for companies that have hundreds of different assets. Putting granular information on every asset into the public domain is a huge undertaking. There are questions around what information should be published and how the market is likely to digest that information. It is not an easy problem to solve.
Navigating the backlash against ESG
Have you seen a shift in what investors are looking for through this period of ESG backlash?
Bhavika Vyas: We manage several bespoke separate accounts and we actually see a great deal of consistency in what those clients are looking for when it comes to climate. There are clients that don’t want to do grey to green if there is too much grey, for example, so those are things that we have to be mindful of in our commingled pools. We are seeing quite a bit to do though, and our investment decisions are commercial first.
Marina Severinovsky: I think there is more openness to the concept of grey-to-green transition investing today. Investors are recognising this is where it’s possible to have the greatest impact. Of course, there is still some scepticism, but in general I think people are now more willing to entertain this narrative.
How are investors viewing investment opportunities, in general, in light of climate risk?
Marina Severinovsky: Investors think about climate risk through a number of different lenses. First, there is the issue of stranded assets and the need to reduce exposure to things that might devalue in the future. A lot of our investments are very long term, so this is really important.
“We can talk about climate-related investment opportunities almost entirely without mentioning climate change”
Marina Severinovsky,
Schroders
Then there is the need to be an early mover in identifying a company’s capabilities around physical climate risk, in order to pick winners and protect downside risks, as well as the opportunity to engage with companies and to support them in their adaptation and resilience endeavours. The influence you have tends to be higher when you are talking about emerging markets or moving further down the cap scale. We have really strong relationships with our small-cap companies, for example, and with companies in our emerging equities business.
These are topics that our investors can be focused on, looking for businesses that do everything from early warning systems, to water resource management and resilient building materials. These all constitute investment opportunities.
Finally, I would highlight insurance as a climate-related investment opportunity. Our impact investment arm, BlueOrchard, has a distinctive private equity adaptation-focused climate insurance strategy, investing in insurance companies and distributors, together with enabling technology and financial intermediaries. The first two fundraises with that strategy involved catastrophe insurance and crop insurance. For the third fundraising, we are going to be looking at health insurance as well. This is about extending insurance to places where it hasn’t previously existed, to create more resilience.
What’s interesting is that we can talk about this investment opportunity almost entirely without mentioning climate change. You can focus on the fact that these are fast-growing companies meeting a very real market demand. Right now, I believe we are the only private equity fund focusing on this sort of insurance resilience concept and it definitely feels like an area of opportunity that we can feel good about.
Amanda Feldman: We think about the Just Transition investment opportunity from an asset allocation standpoint in terms of how we can reduce carbon emissions while meeting the demands for access to food, shelter and energy required by a growing population.
The second objective involves grey to green – the opportunity to support transition solutions and decarbonise high-emission sectors. That is not for every allocator, but more and more are moving in that direction. Again, we see opportunities across sectors, including agriculture, food, the built environment and transportation.
The third area of opportunity involves climate change adaptation and resilience for all, and in particular for vulnerable communities. This is about making sure those most affected by climate change are given the tools to become more resilient. Those are the three ways in which we categorise the overall opportunity set. For some investors, all three are interesting. For others, there is more of a focus on one than the others.
Colin Etnire: The problem with those grey-to-green transition opportunities is that there is so much capital chasing them. As a buyout firm without a specific transition mandate, we are unlikely to compete with transition funds for an impact-orientated asset.
“The problem with grey-to-green transition opportunities is that there is so much capital chasing them”
Colin Etnire,
BC Partners
Having said that, we do see opportunities to create value by repositioning assets towards transition. For example, we own a waste management business in North America. We have pursued a whole range of initiatives there from recycling to gas capture and natural gas conversion. All of a sudden, that becomes a much more interesting proposition for investors than a company that just picks up your trash. The cost of capital goes down when you pivot your assets.
Bhavika Vyas: We are increasingly favouring B2B models over B2C models, moving away from meat substitutes and sustainable fabrics, for example, and focusing more on things like sustainable plastics.
Nishesh Kumar: I would agree that there are some very interesting ideas being developed in the B2B space. Data centres, for example, consume a huge amount of water, but there are really good businesses that are coming up with proprietary technologies for cooling to minimise water consumption. These companies are strengthening their clients’ assets by providing these solutions and have long runways to success.
Jeff Cohen: For listed companies, Bloomberg has capabilities where it captures if companies identify whether they believe they face physical climate risks, and highlight if they are taking steps to address the risk. There are companies that identify if they are facing risks but do not disclose that they are addressing these risks. That scenario is an opportunity for engagement.
There is no guarantee that those companies will choose to engage. The quality of the engagement, if successful in prompting a discussion, depends on the person you manage to talk to – and what department they are in and their level of climate expertise.
From analysis to action on adaptation
What are your experiences, in general, when it comes to companies’ willingness to engage on adaptation?
Nishesh Kumar: One of the points that differentiates adaptation from mitigation is the nature of engagement. With mitigation, there can be challenges in convincing a company that they need to decrease their carbon footprint. There may be a concern that the costs involved will put them at a competitive disadvantage.
With adaptation, companies do tend to appreciate the benefit of resilient assets, but the challenge is that you are talking about one-in-30 or one-in-100-year storms, rather than evaluating projects based on reasonably certain cashflow projections over the next 10 years. How does a CEO or CFO sanction a project on that basis? Do they invest now and amortise over the next 10 or 15 years? These businesses are facing a whole range of calls on capital and adaptation doesn’t always fit readily into existing frameworks for capital allocation.
One area where companies are being proactive around adaptation, however, involves supply chains. We have all seen what is going on in the cocoa business, for example. That is being impacted by multiple different factors and prices have risen dramatically as a result.
Companies are responding by doing a lot of supply chain analysis to discern if they are overly exposed to particular regions and to consider whether they should be diversifying. Some are even investing in lab-grown chocolate. I think engagements on adaptation are generally more interesting when they relate to challenges that are chronic in nature.
Overall, I would say that adaptation-related engagements are increasing, even as mitigation-related engagements potentially decline because of all the uncertainty that exists around that area right now. There are still challenges, however. Access to data remains difficult. We are probably at the same stage with adaptation now that we were with mitigation 10-15 years ago. There is still more to be done around metrics, KPIs and stewardship, and quite honestly I think that is going to be an even bigger challenge than Scope 3 emissions.
Is this where insurance has a role to play?
Colin Etnire: I definitely think insurance has a role to play here. If insurance companies lower premiums in response to adaptation measures, then that is a neat way to derive an immediate financial benefit from adaptation investment. Insurance is the ideal translator of climate risk into individual cases.
Alexandre Crépault: Insurance companies tend to keep their cards very close to their chests when it comes to the data they hold. I believe greater collaboration could be hugely beneficial. Adaptation credits offered to finance resilience-building projects or result-based pricing structures that reward adaptation efforts are a good starting point. They could represent an opportunity for asset managers and insurers to further collaborate and share knowledge.
