13. CLIMATE ACTION

How Investors Are Sizing Up Climate Change’s Risks—and Opportunities – Harvard Business School Working Knowledge

Impact team
Edited by Impact team

How Investors Are Sizing Up Climate Change’s Risks—and Opportunities  Harvard Business School Working Knowledge

Until a few years ago, climate change’s potential impact seemed abstract for many investors. Now, as sea levels rise, hurricanes intensify, and droughts threaten food supplies, many investors are confronting its financial realities.

But it’s not a simple calculation. These and other physical effects of climate change—as well as many, varied government policies trying to mitigate its effects—are also inspiring technological innovations that will give rise to new products, services, and business models in the coming years. How can investors effectively price these risks and opportunities?

On March 4, Harvard Business School gathered senior executives, risk experts, and leading investment professionals from some of the world’s largest asset managers to share how they’re approaching these complex questions. The conference, titled “Risks, Opportunities, and Investment in the Era of Climate Change,” explored climate change’s profound early effects on portfolio returns and highlighted the growing need for investors to understand how to measure and price climate risk.

“We have seen a real shift, with so much more recognition from chief risk officers and chief investment officers that [climate change] is a massive megatrend,” said Audrey Choi (MBA 2004), Morgan Stanley’s chief sustainability officer and chief marketing officer, during a panel discussion. “It’s a fundamental material risk to earnings and portfolios.”

This increased awareness has elevated climate change from a niche imperative to a matter of value.

“Climate is extremely important to understanding the long-term value prospects of individual companies,” said guest speaker Ronald P. O’Hanley (MBA 1986), CEO of State Street, which oversees nearly $32 trillion in assets as one of the world’s largest custodian banks. “It’s not about values. It’s about value and how you’re creating value, how you are showing that the companies in which you’re investing are creating value.”

However, many barriers still prevent asset managers from accurately assessing and pricing climate risk, including a dearth of reporting standards and data. Many governments around the world have begun assigning prices to carbon dioxide emissions, but it’s unclear if they can agree on a common global standard.

Without industrywide measures, firms have been taking their own steps to evaluate the risks and potential opportunities that climate change is creating, including:

Embracing new climate risk terms

Investment firms are evaluating climate risk primarily along two distinct dimensions. They’re considering “physical risks,” such as the business and economic impact of warmer temperatures, more frequent and extreme weather events, and rising sea levels. Physical risks reflect “the potential for losses as climate-related changes disrupt business operations, destroy capital and interrupt economic activity,” according to Kevin Stiroh, executive vice president of the Federal Reserve Bank of New York and a guest speaker.

Investors are also looking at the “transition risks” associated with shifting to a lower-carbon economy. New and more stringent regulations and practices will likely spur that transition, though it’s unclear how, when, and to what extent these changes will materialize. Stiroh noted that this transition risk includes technological innovations and changes in consumer sentiment, both of which affect the value of assets and liabilities.

Physical and transition risks will likely introduce new strategic risks as new industries move to the fore as others fade, Stiroh said. Such a complex scenario will force firms to develop new models and tools.

“Traditional backward-looking models based on historical trends will no longer be reliable,” Stiroh said. “We’ll need to develop a more forward-looking approach that’s grounded in scenario-based analysis.”

Finding tools to measure and analyze physical risk

Partnering with climate scientists. The investment management firm Wellington Management has partnered with climate scientists at the Woods Hole Research Center (WHRC) to understand how and where climate change may impact capital markets.

“This was our first indication that we were on to something, that the capital markets had not paid attention to this yet.”

Wellington Vice Chair Wendy Cromwell explained during a panel discussion how her firm uses a heat index developed in conjunction with the WHRC to consider geographic location in its risk analysis. Comparing two municipal bonds, one from the US Midwest and one from the US South, Cromwell demonstrated the analytical impact of overlaying the heat index forecast on these two locations.

The bonds have nearly identical credit ratings and yields, even though the Southern location is projected to experience more extreme heat and humidity by the time the bond matures, suggesting greater economic vulnerability of this region.

“This was our first indication that we were on to something, that the capital markets had not paid attention to this yet,” Cromwell said.

Heeding the warning of rising insurance costs. Despite the lack of widespread data about companies’ climate risks, rising insurance costs offer a valuable bellwether, said Luca Albertini, CEO of Leadenhall Capital Partners, during a panel discussion. If the cost to insure a construction project, say, on a coastline is exorbitant, that should give any investor pause.

“If your policy is too expensive, that’s the insurance industry telling you, ‘Sorry, you shouldn’t be there,’” said Albertini, whose firm specializes in insurance-linked securities. Climate risk factors that make a property or project costly to insure will likely worsen with time, eroding future returns.

“We’re going to slam on the brakes because we’re going to recognize the risk.”

Bracing for a sudden transition

Preparing to “slam on the brakes.” Many investors expect policymakers to react to climate change gradually, imposing cap-and-trade systems or carbon taxes that gradually become more stringent, for example. But Bob Litterman, a founding partner of Kepos Capital, said during a panel discussion that policymakers will likely need to take more drastic measures to address the gravity of the situation.

“We’re going to slam on the brakes because we’re going to recognize the risk,” he said. “We’re going to recognize what we did wrong and that we’re dealing with an uncertain situation. And so, when we start to price it, we’re going to err on the high side. So that leads to transition risk—the risk that we’re going to have a phase change in the economy when we price the risk.”

Litterman, who spent years leading risk management efforts at Goldman Sachs, says that this economic shift will lead to dramatic changes in valuations and other aspects of society. For that reason, investors should understand the risk their companies face if governments rapidly adopt more stringent climate policies.

Applying the “universal owner” model. The world’s largest assets owners have taken note of the scale of this exposure. Large pension funds invest so broadly—through index funds, private equity, or other securities—that they become “universal owners” of all companies.

“We have to pay attention to what’s happening to the market, not only what’s happening to the portfolio we own,” said Hiro Mizuno, then chief investment officer of Japan’s $1.6 trillion Government Pension Investment Fund, one of the largest pension funds in the world.

As a universal owner, diversifying is not enough when it comes to managing climate risk. “We have been told how to diversify portfolios that hedge the risk of the capital markets,” said Mizuno, a guest speaker. “But we never knew how to prepare our portfolios for this kind of huge systemic risk.”

Recognizing innovative opportunities amid the risk

“It’s unrealistic to say that coal corporations are going to transition to become solar installers,” O’Hanley said at the start of the day. “So, we need to be thinking about the disruption.” At the same time, he noted, “there will be brand new opportunities coming out of this.”

The conference culminated in a session about some of the innovative technologies that are emerging to address climate change, with presentations from the leaders of Indigo Agriculture, Form Energy, Carbon Cure, and Carbon Engineering. 

These companies are pioneering ways to reduce carbon dioxide emissions by removing it from the atmosphere so that it can be sequestered or used it in agricultural soil, building materials, or fuels. As incumbent companies and industries embrace these technologies through adoption or acquisition, more new opportunities will emerge.

Continuing the climate risk conversation

Professors Ramana Nanda, co-director of the HBS Private Capital ProjectMichael Toffel, faculty chair of the HBS Business and Environment Initiative (BEI), and George Serafeim, who leads the HBS Impact Weighted Accounts Project, co-chaired the conference. Organized by the BEI and HBS Alumni Relations, it was one of the first large HBS alumni discussions about how climate change is impacting the economy.

“How to value these effects and how to allocate portfolios based on climate risk are going to be important,” said Nanda, the Sarofim-Rock Professor of Business Administration, at the start of the conference.

As the economic fallout of COVID-19 pandemic unfolds, some risk-management parallels between climate change and the coronavirus crisis were becoming clear. As Litterman said, “If you have enough time, you can solve just about anything. It’s when you run out of time that a risk problem becomes a catastrophe. And, in both of these contexts, we’ve probably gone way longer than we should have to address them.”

Visit the HBS Business and Environment Initiative website to watch videos from the conference.

About the Author

Danielle Kost is a senior editor at Harvard Business School Working Knowledge.

[Image: iStockphoto]

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Source: hbswk.hbs.edu

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