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February 2024
AAM Magazine
February 2024
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Navigating climate risk

  • Asia
  • Global
Investors should focus on managing the risk and getting compensated for it

Material environmental factors such as climate change are pre-financial indicators that can affect a company’s future financial viability and clients’ long-term risk-adjusted investment returns. When managed well, they can position a company for success and when mismanaged, they can result in significant risks. 

Northern Trust Asset Management answers some key questions on how to incorporate climate risk assessment into the investment process. 

What does climate risk mean to investors? 

From an investor’s perspective, climate changes pose a great threat, which could negatively impact economic growth, inflation and investment returns. We differentiate between two types of climate risk: physical risk and transition risk.

Physical risk is the risk of damage to land, buildings or infrastructure because of droughts, storms and flooding. Transition risk is the risk to businesses or assets because of policy, legal and market changes as the world seeks to transition to a lower-carbon economy.

Rising transition risk dominates in the decade ahead as a worsening carbon emissions trajectory becomes the focal point of regulatory response. 

From 2030 to 2050, transition risk and physical risk may rise almost in unison, with transition risk rising in tandem with the emission trajectory and physical risk growing as the world surpasses 1.5 degrees Celsius of warming.

How should investors mitigate climate risk in their portfolios?

We don’t think in terms of eliminating or even mitigating climate risk. We believe investors should focus on managing the risk and getting compensated for it. 

To do so, investors can identify the companies which are vulnerable to climate change, and those that will be the winners of tomorrow. 

The winners will likely be companies that prove resilient in their management of climate risks while also providing solutions to reduce the damage from climate change. 

What is the primary risk that companies face?

Primarily, we’re talking about the risks around companies transitioning to a lower carbon world. This transition means the global economy will likely need to be rewired, with help from government policies and regulations. 

Companies must navigate these changes along with the growing physical risks, including changing weather patterns, forest fires and flooding. 

We think companies which manage climate risks well more likely position themselves for success. Mismanagement of climate change likely will increase risk for the companies and their stakeholders.

Where should investors start?

Investors can take practical steps to incorporate climate risk assessment into the investment process. This includes research, financial modelling (to value securities), risk management and investment stewardship.

With regards to investment research, there’s a real intersection between climate science and research. Investors must seek to become more informed, aware and educated around climate science. 

This doesn’t only include academic partnerships. Investors can accomplish it through engagement with investment industry initiatives such as the Principles for Responsible Investment and Climate Action 100+, or think tanks such as the Carbon Disclosure Project and Carbon Tracker.

With financial modelling, a strong understanding of climate science can help investors identify exposures to climate-related risks in their portfolios. They can identify which industries in their portfolios are the most vulnerable and develop models to translate climate risk into financial impact. 

Good data is key to managing the evolving risks. There is a growing plethora of data providers available. We use several of them, with a focus on data most connected to financial impact on companies. 

With the data, investors can identify the relevant metrics to measure, monitor and manage portfolio risks related to climate change.

This information, through an investment lens, allows investors to really turn on their stewardship toolbox. By prioritising the most important risks related to climate change, investors can engage with companies and use their shareholder voting power to advocate for continual improvement of companies’ decarbonisation strategies.

Mitigating long-term climate risk 

Getting ahead of the climate risk curve does not necessarily mean mapping out every global warming scenario and analysing every possible climate risk. 

Using climate criteria while evaluating investments is an important way to mitigate long-term climate risk that cannot yet be quantified and analysed. It will actively tilt investors away from companies with business models that are more exposed to the negative impacts of climate change while pointing them towards those that are more likely to benefit from the new environment.