Can climate risk affect performance?

Eric VAN LA BECK, Head of SRI - OFI AM
Head of SRI

What exactly is climate risk?

It’s the idea that climate phenomena could lead to an erosion of asset values in a portfolio and undermine the profitability of certain investments.

In 2015, during a speech on the “tragedy of the horizon”, Mark Carney, Governor of the Bank of England, was one of the first to alert economic agents to climate risk exposure, which he classified into the now universally recognised categories of physical risks, transition risks, and reputational or legal risks.

Physical risks (linked directly to climate change)

“Physical risks” are the financial impacts of climate change faced by the insurance sector, in particular.

  • Climate change-related claims are costing insurers more and more. Extreme weather phenomena, including droughts, higher sea levels, and storms, are worsening in extent and in frequency. This is leading to more claims and higher insurance payouts.
  • Valuations of assets held by insurers are at risk. Climate events can cause some companies to lose value and, hence, impact insurer portfolios. This is what happened in Thailand, when flooding disrupted auto production chains worldwide, including an interruption in gearbox deliveries. Another example occurred in Germany, where extreme drought hit the Rhine river, forcing one company to halt production of raw materials, which could not be transported by river. Damages were estimated at 100 million euros.

The physical impact is real. A rise in sea level would expose coastal zones, where more than 50% of the planet’s inhabitants live, and would affect the value of production facilities located around harbours.

For all the aforementioned reasons, financial research is being forced to reflect companies’ increased exposure to physical risks.

Transition risks (resulting from societies’ reaction to these risks)

Transition risks are the financial impacts on economic agents of implementing a low-carbon business model.

The quantity of carbon contained in global fossil fuel reserves is far higher than the estimated ceiling on emissions that would be necessary to comply with the 2°C objective. It will therefore be impossible to burn those reserves, as the planet would be unable to bear the consequences. A large portion of them will therefore have to stay below ground, and those non-exploited reserves will lead to a collapse in the value of many energy sector companies.
Governments will very certainly act to halt production of fossil fuels through climate laws and regulations and, given the heavy weightings of oil and energy companies in the major European and global indices, the value of investments could take a big hit.

Legal risks

Legal risks result mainly from negligence in dealing with climate risks.

One example of this risk is Pacific Gas & Electric (PG&E), a Californian utility found guilty of causing forest fires because of its defective electrical grid and other cases of negligence. Crushed by the weight of litigation, PG&E had no other choice but to declare bankruptcy.

Climate risk in investment management

Almost 30 years ago, the system of carbon credits (i.e., a unit equal to the emission of one tonne of CO2) was developed under the Kyoto Protocol to require signatory companies to limit their greenhouse gas emissions. The system would have worked well if it had been implemented worldwide, as originally planned, but only Europe joined it.

The carbon credits system puts a price on air and requires those that pollute it to pay that price.

The way it works is that each company is granted a certain number of carbon credits equal to the quantity of CO2 that it is entitled to emit. If a company that has reduced its emission ends up with surplus credits, it can sell them to a company that has exceeded its quota and wants to acquire additional CO2 emissions rights.

Currently, the CO2 price (about 40 euros per tonne) requires polluters to acquire carbon credits to continue operating. Financial analysis can reflect that cost by projecting various scenarios of the CO2 price, along with trends in a company’s energy mix and the environmental quality of its products to indicate whether a company’s valuation is too high when factoring in CO2 prices. If so, the stock may be taken out of the investment portfolio or no longer be considered a stock worth buying.

Climate risk, an opportunity for companies

In responsible investment, investment managers and analysts can adjust their models to lower or raise the financing costs of companies that fail to take the measures necessary for addressing climate-related issues.
Climate risk can thus offer an opportunity for companies that wish to transition into production methods that have a lower climate impact. The Danish oil company Ørsted is a perfect illustration. Originally a maker of fossil fuels (coal and oil), it undertook a radical transformation of its business model and is now the world’s offshore wind power leader.

Yes, climate risk can affect performance!

Currently available data are not as precise as desired but regulatory developments are expected to make companies disclose more transparently what they do that is good – and less good – for climate.

One challenge of European regulation that is being roll out deals with having financial actors take climate risks into account in their investment decisions.

This content was originally published in French on the Boursorama website as part of the program "Ça vaut le coup !"