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Climate Risk = Financial Risk

Updated: Apr 26



As we celebrate Earth Day 2024 and many corporations use this day to signal their green bonafides, I am struck by how few people understand that climate risk is indeed financial risk. Companies protesting against disclosure, or failing to take stock of their emissions and the risk in their value chains, are providing an inherent disservice to investors and stakeholders by hiding the costs of these risks. Investors are also guilty of not forcing more transparency which would ensure that these costs are baked into asset values. On this day to celebrate our planet, I would like to believe that corporations and investors are not doing this with the intent to hide or deceive, but rather, because of a lack of tools and knowledge. 


As a long-time finance executive and a more recent climate change specialist, I am surprised by how few people recognize that climate risk = financial risk.  In the lead-up to the SEC regulations announced last month requiring public companies to disclose their climate risk, there were a lot of protests and lobbying efforts by companies to avoid this requirement or to water it down (which eventually succeeded). But why? One of the arguments given was that the SEC shouldn't mandate a climate-specific approach because CFOs already are required to report on material risks in their financial disclosures; therefore, they would report on it if they felt it was material.  However, as the Task Force on Climate Related Financial Disclosures reported for 2022, only 35% of US companies report on emissions metrics and even fewer disclose other recommended climate risks in their financial filings.  This would indicate that US CFOs don't think or aren't aware that climate risk poses a material enough financial risk. I beg to differ.

 

Broadly speaking there are 2 kinds of risks associated with climate: physical risk and transition risk.

  1. Physical risks are the damages to property, assets, business operations, and supply chains that companies face as a result of increased catastrophic weather events (hurricanes, flooding, drought, wildfires etc..) caused by rising temperatures.  Don’t think this is material? The 2022 floods wiped out 2.2% of Pakistan's GDP, a severe drought at the Panama Canal has impaired a waterway that handles $270B a year in global trade, and America suffered 28 natural disasters that did more than $1Bn of damage last year breaking the previous record of 22 in 2020. Think that these risks are priced in? Not a chance. Normally insurance companies serve as the canary in the coalmine for systemic risks but in this case, the signal is getting distorted.  Despite major insurers abandoning California and Florida altogether and insurance premiums for those who remain skyrocketing, the true cost of insurance is still subsidized by state and federal-backed entities to shield homeowners. In Florida's case, a state-owned insurer of last resort that is now the largest in the state (Citizens Property Insurance Corp) has an exposure exceeding $400B which is greater than the state's public debt - all on properties that are deemed uninsurable by private insurance, mind you! Does that sound sustainable? Not a chance. For more on the potential climate costs not baked into real estate assets (hint, 12 zeroes) see the cover article from a recent issue of the Economist.

  2. The other kind of climate-associated risk is transition risk. This is the cost to businesses and investors of the sustainability transition whether it be changing consumer preferences, revamping supply chains, compliance-mandated retrofits, or the associated legal costs for lack of compliance. This includes many huge business operations: everything from reduced plastic production as a result of global treaties to eliminate plastic, to stranded oil and gas assets that will not be monetized because of fossil fuel reduction targets, to building retrofit costs to reduce GHG emissions, to loss of revenues for large agribusinesses that can't export into markets that prohibit any products with supply chains that are involved with deforestation. Think these risks are priced in? Not a chance.  Companies are not calling out risks to future earnings as a result of compliance-mandated costs or potential revenue degradation from markets their products won't be compliant in anymore and investors are not charging a risk premium for emission-heavy industries. A prime example - as European lenders back away from lending to oil, gas, and coal companies, US regional banks are eagerly swooping in. 

 

Essentially, investors and other stakeholders are blind to these risks because no one is reporting them. As a result asset values are inherently overpriced because they do not account for these costs so when the enormity of that risk sinks in we could see massive changes and volatility in financial markets. Don’t take my word for it - the Basel Committee on Banking Supervision has said climate change has the potential to affect “the safety and soundness of banks and the stability of the broader banking system."

 

At EcoAdvisors and EcoInvestors we help you to understand how to assess the risks of climate change to your business from a disclosure standpoint, for current and forthcoming regulations, as well as help you develop long-term sustainability transition planning so you can turn these risks into opportunities. For Corporate clients, this means having a well-thought-out and documented sustainability transition plan with a transparent measurement and reporting process for stakeholders to follow. For investors, we offer additional climate risk assessment for your portfolio, pathways to achieve your net zero portfolio goals, and advice to your portfolio companies on decarbonization strategies.

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