The United Nations identifies climate change as the “single biggest threat” to sustainable development. An average of 24 million people are displaced by devastating weather events each year, a figure predicted to increase nearly sixfold by 2050 without significant climate action. Children are leaving their classrooms to demand greater urgency in addressing our current climate crisis.
The effects of climate change are likely alarming to the average investor. But for financial advisors stewarding the wealth of generations, they’re flashing bright red. One trillion dollars of corporate assets are at risk due to climate-related impacts, many of which are expected to affect financial performance within the next five years—if they haven’t already.
How can wealth advisors address these vulnerabilities for their clients? There are many ways to integrate climate risks and impacts into portfolios. At Ethic, we break climate-related risks into two main categories: physical risks, which are associated with assets vulnerable to climate change, and transition risks, which relate to the economics of transitioning to a low-carbon economy. We identify these categories as follows.
Physical risks are risks to tangible assets such as factories or farmland due to a changing climate. Increased severity of extreme weather events, rising sea levels and resource scarcity create risks that threaten company operations in vulnerable regions.
Water scarcity is an example of a physical risk that’s especially important in an industry like agriculture. As droughts limit fresh water availability, companies that depend on fresh water to operate agricultural businesses face financial risk due to low crop yields. Companies with facilities in coastal regions are subject to physical risk from extreme weather; for example, Hurricane Sandy caused close to $19 billion in damages and lost output in New York City alone.
Transition risks are risks associated with changing economic incentives that threaten current business models, like changes in the pricing of carbon from regulation or new technologies. Carbon regulation is an example of transition risk: As governments increasingly restrict carbon output and enforce energy-efficiency standards to comply with national and international targets, companies that depend on fossil-fuel reserves, and companies with poor environmental governance, expose themselves to devalued assets and potential fines. Volkswagen AG, for example, lost nearly a quarter of its value in a single day after admitting it cheated on air emissions tests, going on to pay billions in fines for its misconduct.
The declining cost of renewable energy technologies poses a transition risk to traditional energy companies. As technology develops, renewable energy technologies are becoming cost competitive with legacy energy companies; 75% of coal power plants in the U.S. generate energy that is more expensive than renewable sources. Companies that rely on nonrenewable sources of energy are at risk of getting priced out of the market.
Climate risks are a major threat to the global economy and the wellbeing of clients’ assets. So how can advisors shield clients from the downfalls of these physical and transition risks? It starts with evaluating the ways that companies in a portfolio are exposed to climate risks. Do they have high reliance on water sources? Are their factories in coastal or drought-prone regions? Are companies investing in a renewable-energy future by spending on development of clean technologies? Do they have a history of reducing carbon emissions?
Identifying climate risks and how to measure them is essential to portfolio management. Advisors have a key role to play in shepherding assets through changing climate conditions, which starts with paying close attention to businesses’ risk exposures.