Financial risks of climate change
AUTHOR: JAMES BEVAN, CHIEF INVESTMENT OFFICER AT THE CCLA
Planning ahead for costs and revenues or profits and losses requires assumptions to be set on the what will happen to economies, the environment and markets. Climate change can affect all three.
Climate change is having direct implications for economies, the environment and investment markets. These implications have significant financial ramifications, including variations in weather and the increased incidence of extreme weather events, rising sea levels and reduced availability of clean water where it’s most wanted, the risk for the viability of agriculture and human settlements, and declining biodiversity. These are all examples of externalities – unpriced costs, particularly those borne by entities other than the direct suppliers and consumers, but such externalities do have real financial consequences – it’s just that markets don’t price extra-financial costs and benefits, and don’t apportion them to the drivers of the externalities.
Climate change can also have indirect implications, arising from addressing the causes of climate change and their remediation. Underpinning the challenge of climate change is the premise that its pace and extent are largely the results of human activities, and particularly hydro-carbon energy extraction and usage, and so-called de-carbonisation of the global economy is a key requirement if we are to address the challenge of climate change.
Energy accounts for roughly 8% of global economic activity so converting from carbon-based energy to sustainable and climate-friendly energy systems is itself a significant task, and the steps taken to drive this change will likely include legislation and regulation on both energy production and usage, and taxation and other adjustments to the cost of supply and demand for carbon-based energy and alternatives. We may also see litigation and actions by consumers in effect voting with their wallets.
In practice, we should expect climate change to be addressed by a complex cocktail of global policy initiatives, many of which will have financial consequences and carry financial risks relative to ‘business as usual’.
For financial markets, climate change and its remediation affect both the fundamental underpinnings of assets and economies, and the capitalisation of costs and benefits. If climate change is not addressed, we should expect asset values and net revenue streams to be adversely affected, especially for entities where underlying activities are dis-beneficiaries of climate change, such as insurance companies, agricultural and soft commodity producers, and property companies. In addition, as uncertainties rise and the risk of systemic failures increase, so we should expect the price that investors are prepared to pay to participate in future growth will fall back and there will be growing demand for higher payments to compensate for the additional perceived and actual risk across the board.
If climate change challenges are progressively addressed, so we should expect markets and market participants to be increasingly discriminating in how they want to do business, with whom that business is conducted, and the price of doing business, evidenced in profits streams, rental flows, and cash flows. Failure to address climate change risk will compromise the value and there is the risk of failure at both systemic and individual entity levels. But whilst there’s a required focus on downside risks, we can also observe that for those that are on the front foot, there’s a significant opportunity to create value and support the shift to a sustainable future.
This document is issued for information purposes only. The market review, analysis, and any projections contained in this document are the opinion of the author only and should not be relied upon to form the basis of any investment decisions. CCLA Investment Management Limited (Registered in England No. 2183088) and CCLA Fund Managers Limited (Registered in England No. 8735639), whose registered address is: Senator House, 85 Queen Victoria Street, London EC4V 4ET, are authorised and regulated by the Financial Conduct Authority.