Nothing about our current way of life is viable at a certain temperature above pre-industrial levels, and financial services and asset managers are in no way immune.
As Patrick Arber, group head of government engagement – sustainability at Aviva, recently commented at a City Week conference, “[Aviva is] not going to survive on a 3C or 4C planet.”
There is a 50/50 chance of breaching a 1.5C temperature rise this century, but this is not sufficiently factored into investments, according to Silvie Kreibiehl, sustainable finance expert and lead author of the latest Intergovernmental Panel on Climate Change (IPCC) report.
She recently told ESG Clarity: “Physical risks are completely underestimated by corporates, but also by the financial industry.”
But some responsible investors are starting to calculate and price exposure to the physical risks of a hotter Earth. However, getting hold of the data to do so is no easy task, and will require more regulation, engagement and transparency.
Regulating data
Senior vice-president for sustainable investing at Impax Asset Management, Julie Gorte, says its clients had not yet requested physical risk data, but were always grateful once it had been provided and explained. However, she adds increased incidence of extreme weather events that impact the value of assets could lead to higher demand for transparency on physical risk.
For its part, Impax is striving to get as complete a picture as it can. The team previously wrote to the Securities and Exchange Commission (SEC) in the US asking it to require more disclosure from companies on climate risk. The SEC recently published a draft rule including this and disclosure of Scope 1, 2 and 3 emissions.
In the UK, one of the places an investor should start to be able to access information on physical risk is in a listed company’s annual Taskforce on Climate-Related Financial Disclosures (TCFD) report.
However, in practice, these tend to focus on transition risk linked to climate policy scenarios, regulation and markets, and their potential impact on asset price – these being simpler to calculate than physical risk.
TCFD recommendations include looking at the extent to which the “organisation has assessed the physical impact to its portfolio … and to what extent … physical risks [have] been incorporated in investment screening and future business strategy.”
It also recommends asking: “To what extent has the impact on prices and availability in the whole value chain been considered, including knock-on effects from suppliers, shippers, infrastructure and access to customers?”
TCFD is moving towards both companies and financial institutions disclosing metrics for assets or business activities vulnerable to physical risks.
Guidance published in October last year gave example metrics such as the proportion of assets exposed to climate-related hazards and the amount of revenue associated with water sourced and used in regions of high-water stress.
From last month, the largest UK-registered companies and financial institutions fell under the scope of mandatory TCFD reporting requirements.
However, a December 2021 policy statement from the Financial Conduct Authority acknowledged some finance groups had expressed concern that end investors would be confused by climate-related metrics on products and portfolios.
Bottom-up approach
Pablo Berrutti, senior investment specialist at Stewart Investors, acknowledges there is an increasing amount of data available for assessing different climate scenarios, but it is still not good enough. For this reason, his team prefers “to undertake bottom-up analysis to understand the ways companies are managing these challenges”.
Berrutti gives the example of data about a factory’s risk of flooding depending on whether it is at the top of the bottom of a hill: “As an initial scan or risk screen this is very valuable. However, those scenarios cannot tell you whether the back-up generator the factory relies on is vulnerable to flooding because it is, for instance, situated in the building’s basement.”
He adds that related infrastructure, such as the transportation means by which goods are shipped, is the most difficult to assess. “For any company with a diverse asset base and complex supply chains, this is a very challenging problem to manage,” says Berrutti.
Ketan Patel, fund manager of EdenTree Responsible and Sustainable UK Equity Fund, and ESG Clarity Committee member, considers where all the operations of a company are based and even the rising cost of insurance in some locations with heightened physical risk.
“Often, we go and see companies in situ around the world and you get a sense of where their operations are and how they think about [this] risk. If they haven’t thought about physical risk then that’s a big warning sign,” he says.
According to Patel, answers from companies about locations and risks require a high level of granularity, but this can be tricky when the companies may not have huge resources available to invest in supplying those responses.
Supply chain disruptions
The complexities multiply when you seek physical risk data for very large companies. PwC partner and UK chair, sustainability and climate change, Jon Williams, argues when you consider the challenge of getting the relevant data from a large multinational company you soon need to seek alternatives to first-hand data collection.
“Think about Unilever, about the thousands of products it has and all the ingredients that go into those products and where those ingredients come from,” he says.
“You’re really getting into understanding the supply chains of the company. The head of procurement at a company like Unilever probably has a reasonable handle on where their material risks are. They’ve now got to say: ‘How does climate change affect those risks?’”
Williams adds one of his customers has 19,000 equities in their funds and says it is unrealistic to go through the process described in the example above for that number of holdings.
Instead, he says, when PwC works with asset managers, it will use input output modelling to approximate where those risks are likely to be most significant and notes a data provider called Jupiter Intelligence that PwC works with on this.
WHEB Asset Management partner and head of research Seb Beloe echoes Patel’s mention of the culture shift towards physical risk as he describes the way companies are having to look at their supply chains now.
“Material risk from weather-related disruptions to supply chains is forcing businesses to re-evaluate how they organise their supply chains.
“A lot of businesses are now focusing on ‘just in case’ rather than ‘just in time’, which might seem an inefficient way of running your supply chain. Having multiple suppliers in diverse locations adds cost.
“But it’s a much more resilient way of managing your supply chain and people are recognising that you really have to take on that cost. It ensures you are able to operate in this new environment we are in.”
How are fund managers assessing physical risk in portfolios?
Fund managers are putting pressure on their holdings for this physical risk data so they can test the resilience of their wider portfolios – and are grappling with the most efficient way of doing so.
There is far from a consistent approach to this with some relying on modelling, some using their own data collection methods and others using a hybrid.
Impax Asset Management, has recruited a climate scientist to build a proprietary model to assess the physical risk exposure to climate-related hazards of each company, and thereby each portfolio.
Cost, relevance and accuracy all play their part in fund managers’ decisions on how to calculate this risk in the assets they hold.
And there is plenty of variety on the market when it comes to third-party services, from the scientific datasets available to the platforms that tailor this data for their clients using models and scenarios, according to Samantha Burgess, deputy director of the Copernicus Climate Change Service (C3S).
One such piece of software available is Aware for Investments, a climate risk screening tool that provides the user with a risk report and gives recommendations for further action.
Another tool is the Trucost Physical Risk database from S&P Global Sustainable. This does not provide recommendations for further action, but gives a picture of portfolios’ and holdings’ level of exposure to risks such as hurricanes, floods and heatwaves.
Burgess says there is “quite a need” for standardisation across scenario-based risk approaches and she urges asset managers to make evidence-based assessments of assets using the “best available data”.
Data limitations
Gorte says one of the big barriers investors such as the Impax team faces when it comes to getting the whole picture on physical risk is not data on the very precise locations of operations down the supply chain, which is a challenge, but what companies are doing to mitigate physical risk.
A high-profile case in point is tech giant Alphabet, which failed to respond to Impax’s engagement on the issue.
“We just filed a shareholder proposal at Alphabet and asked it to report on what it’s doing about physical risk. The company didn’t want to talk to us.
“This is going to be on its proxy ballot in June at its AGM. But its headquarters are basically at sea level and if your headquarters flood and you’re not anticipating it, and you don’t have a business continuity plan, you could be vulnerable to a major business interruption.”
Burgess agrees calculating physical risk is not a lost cause, but she encourages transparency on its limitations.
“[For] some climate indicators such as temperature, the scientific evidence [for future change] is very clear. For other climate indicators, such as rainfall, future trends in some locations are less clear.
“In general, asset managers need to differentiate between cases where it is possible to make a quantitative risk assessment and cases when the uncertainty is so large that it is difficult to estimate probabilities. In the latter case, they may need different resilience management strategies,” she says.
The quality and accuracy of data available on physical risk continues to advance and no doubt the investment industry will be in a better place to access and make use of the information than many other industries.
But with everything liable to be impacted by climate-related hazards, there is a long way to go before we have a transparent picture of how physical risk translates to investment risk.
This article first appeared on our sister publication ESG Clarity
