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Integrating climate risk

By Matt Orsagh*   
  • Asia
  • Global
Asset managers who understand the climate issue will be best positioned to serve their clients

Climate change threatens to remake the world, transforming our economies and our financial markets. Governments and policymakers are likely to play the biggest role in combating climate change, with trillions of dollars of spending on green infrastructure projects and subsidies for green transportation and energy. But the financial world will play a significant role in supporting the move to a lower carbon future by redirecting capital and financing toward such opportunities.

Banks are already shying away from power and infrastructure projects with large carbon footprints, and the global asset management industry is looking to catch up with investor demand for climate-friendly portfolios. According to data from Morningstar, environmental, social and governance (ESG) funds saw US$51.1 billion of net new inflows last year. This is in the challenging context of a marketplace where clear, timely and comparable climate data is often hard to come by.

The physical risks of climate change include extreme weather patterns which could increase drought and food and water scarcity in parts of the world, which will in turn change where and how we live. Some regions of the world which are now heavily populated are projected to become tough habitats for humans if we do not adequately address climate change.

These physical risks will lead to widespread change, such as mass migration of populations, the kind of food we cultivate, and the energy we produce and consume on a large scale. It makes intuitive sense when we hear that fossil fuel companies are looking to diversify into clean energy, or that real estate developers are moving away from coastal areas, or having to fortify their design plans to deal with more extreme weather events.

However, no industry will be untouched. Bankers around the world have already come under pressure to cease or phase out financing for fossil fuel production. Technology companies are huge consumers of energy and are having to plan for cleaner power use and finding water often needed to cool their server farms.

Physical risks are the most immediate, but investors need to understand transition risks as well. Much has been written about the expected large-scale transition to electric cars in the coming decade. But the speed of such transitions matters immensely as investors who bet on these changes early may be left with little to show for their foresight.

Action needed

The finance industry, and more specifically, asset management, has a role to play in combating climate change.

First and foremost, financial professionals need the tools necessary to meaningfully incorporate climate analysis into the investment process. That starts with putting a price on carbon.

Today, about 20%-25% of the world’s carbon emissions are in markets that are under some kind of carbon pricing scheme. Participation in carbon markets needs to increase and carbon prices may rise over time to more accurately reflect the externality of greenhouse gas emissions.

This leads us to another aspect of climate change analysis that needs improving: the data. Investors need quality, comparable and timely data on climate-related metrics to adequately analyse the physical and transition risks – and the opportunities – presented by climate change. Engagement by large global institutional investors, as well as emerging standards such as the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-Related Financial Disclosures (TCFD), have led to more and better disclosure by issuers.

Recent efforts by the IFRS Foundation to push for the creation of international standards on sustainability reporting will aid the transition to better, more frequent and more comparable climate data. It is up to investors to engage with policymakers, standard setters and issuers in their demands for the climate data they need.

Our recommendations

A recent CFA Institute report** on climate change lays out the steps which investors, issuers and policymakers can take to better integrate climate change analyses into the investment process. These are:

  • Price on carbon: We call upon policymakers to ensure that regulatory frameworks for carbon markets are designed to deliver transparency, liquidity, ease of access for global market participants, and similar standards across jurisdictions.
  • Include carbon price expectations in analyst reports: CFA Institute recommends that investment professionals account for carbon prices and their expectations thereof in climate risk analysis.
  • Increased transparency and disclosure on climate metrics: We recognise the coalescing of the investment industry around the SASB and TCFD standards for climate-related disclosures. These are the most relevant and succinct standards that address the materiality of climate-related risks.
  • Engagement with companies on physical and transition risks: We suggest that investors should engage with issuers to ensure that climate data, scenario analysis and related disclosures are sufficiently thorough to support robust climate risk analysis in the investment process.
  • Education: Investors need to continue educating themselves about climate change to provide related analyses that clients require.
  • Policymaker involvement: The investment industry needs to continue to work with policymakers to ensure that investors have the tools they need to meaningfully incorporate climate-related risks and opportunities into the investment process.

There is opportunity to expand inclusion of climate risk in financial analysis in the Asia Pacific region.

Our climate change report is underpinned by a survey which found that 67% of investment practitioner respondents said they or their organisations currently do not currently incorporate climate risk into their analysis. The reasons cited include lack of measurement tools, lack of regulatory requirements, lack of client demand, and climate risk not being a priority for their investments.

Furthermore, there appears to be a disconnect between the lack of climate analysis and what the C-suite believes is important. Some 89% of global C-level executives in the Asia Pacific investment industry responding to our survey said climate change is an ‘important’ or ‘somewhat important’ issue.

End-investors in the region also have the least focus on climate risk among peers in the Americas and Europe, Middle East and Africa regions, with two-thirds of respondents stating that their clients are not asking for more information and analysis on climate change.

Climate change is already bringing changes to our societies and the financial markets that serve them. These changes will keep coming, and they are likely to accelerate as more markets adopt carbon pricing schemes, more regulators integrate climate action into policy, and more investors look to integrate climate action into their portfolios.

The asset management industry has a large role to play in each of these changes. Asset managers who understand the issue of climate change and its ramifications will be best positioned to serve their clients in the future.

*Matt Orsagh is senior director, capital markets policy, at CFA Institute.

**Climate Change Analysis in the Investment Process