What is climate risk, and how does it affect your investments?
Learn more about how climate change can impact your investment portfolio.
By Asiyah Choudry
January 30, 2023
As the Earth’s temperature increases, spurring extreme weather events like wildfires and drought, climate change poses an increasing threat to the financial system. The Swiss Re Institute estimates that by 2050 10% of global economic value will be lost to climate change. Investors should understand the importance of climate risk in their financial decision-making so they can build a more climate-resilient portfolio.
What is climate risk?
Climate risk refers to the adverse effects that may arise from climate change. There are two categories of climate risk: physical risks and transition risks. Physical risks refer to the physical impact of changing weather patterns. As global temperatures increase, so do extreme weather events like wildfires, hurricanes, and droughts. Physical risks can be event-driven (acute) or the result of a long-term change in climate (chronic).
Transition risks encompass the regulatory, legal, reputational, and technological challenges associated with the low-carbon transition. The shift toward net zero will require businesses to adapt their operating models to align with a low-carbon world. As renewable energy costs fall, the fossil fuel sector risks being displaced. With growing consumer awareness of environmental issues, businesses that actively harm the environment are being scrutinized. For instance, ExxonMobil is facing scrutiny for predicting global warming internally but downplaying the issue publicly. Additionally, climate litigation is being pursued as an avenue for climate action. Businesses that fail to adapt to a changing world risk being litigated.
Physical and transition risks translate to financial losses. Physical risks can lead to direct financial losses through damage to crops, buildings, infrastructure, and natural capital. In the US, economic damages from extreme weather events exceed $100 billion annually.
Similarly, regulatory and technological changes can affect corporate balance sheets. Asset stranding occurs when an asset is devalued before the end of its productive life. If governments mandate the use of low-carbon energy, functional fossil fuel infrastructure may be devalued.
One study estimates that this equates to a greater than $1 trillion loss in future profits and will cause stock valuations to suffer. According to the study, private investors with exposure to the fossil fuel sector, whether through pension funds or other investments, are susceptible to significant financial losses due to the risk of asset stranding.
Regulators have recognized the importance of providing investors with climate disclosures so they can be aware of financially material climate risks. Last year, the Securities and Exchange Commission proposed rule changes that would make it mandatory for companies to disclose climate-related data, including Scope 1 and Scope 2 emissions (and in some cases, Scope 3 emissions).
Investing in climate mitigation and adaptation
Decarbonizing the economy will require significant expenditure to develop new, sustainable technologies. The Climate Policy Initiative estimates that climate finance must reach $4.35 trillion/year (a 590% increase) by 2030 to meet global climate targets. In 2021, climate finance flows were between $850-940 billion - less than one-fourth of the level of finance required to reach net zero emissions. It’s evident that we need to direct financial flows toward climate solutions at a much larger scale if we want to address climate change.
Over the past decade, the number of climate tech companies seeking to address climate change has increased by 400%. There’s a growing demand for solutions to environmental problems as the realities of climate change become more apparent. There’s also an economic incentive for businesses to address climate change. The potential benefit of investing in climate-related opportunities ($2.1 trillion) is seven times higher than the cost of investment ($311 billion). Companies that pursue decarbonization reduce their exposure to the reputational, legal, and technological risks associated with the low-carbon transition.
There is a growing opportunity for investors to redirect their capital toward companies that are taking climate change seriously. Financial products like green bonds enable investors to support sustainable projects while getting a return. If you’re looking to use your capital to create a positive environmental impact, check out our fund recommendations.
The importance of building a climate-resilient portfolio
By evaluating the climate risks in your portfolio, you can make sure that your investments are less susceptible to climate change.
Here are three tips for reducing climate risk in your portfolio:
#1: Switch to a sustainable retirement fund
A recent ruling by the Department of Labor makes it easier for employers to consider climate risk when selecting their retirement offerings. It’s worth investigating whether your employer offers a sustainable option.
#2: Diversify across low-carbon sectors
Sectors that are less likely to be affected by climate risk include renewable energy, clean technology, sustainable transportation, and alternative agriculture. By diversifying, you are reducing the risk associated with exposure to any single sector.
#3: Invest in climate innovators
By investing in companies that are developing new climate-friendly technologies (for example, carbon capture and sequestration or geothermal heat pumps), you could benefit from future growth.
Overall, climate risk is an important consideration when building your investment portfolio. By redirecting our capital toward companies that are propelling us toward a low-carbon future and away from companies that are harming the environment, we have the opportunity to drive change. If you’re looking for more ways to green your portfolio, check out our top tips for making an impact with your money.
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