By Sharon E Fay, Co-Head of Equities and Chief Responsibility Officer at AllianceBernstein
Just like the global financial system, the global climate is an enormously complex, interactive system that challenges investors to translate sweeping changes into ground-level impacts on individual issuers. The COVID-19 pandemic has highlighted these similarities as well as the potential impacts of a changing climate and the imperative of a coordinated global response from society, governments, investors and businesses.
The pandemic has shed light on the challenges of addressing these phenomena, but it has also provided a greater incentive for these stakeholders to accelerate our understanding of, and strategy for, addressing climate change. We can’t let the perfect be the enemy of the good.
The global climate—and response—is anything but simple
For example, the gradual heating of the Earth and rising sea levels have been reasonably well-behaved—but that may not last long. Take the melting of the polar ice caps. It’s well understood that it pushes up sea levels, but it also has knock on effects that exacerbate the process. Think about the bright, reflective ice that gives way to darker ground, which absorbs much more of the sun’s radiation. As temperatures rise even faster, this increase accelerates the cycle — and the impact on the Earth.
As we’ve seen with the pandemic, biological and human systems won’t respond linearly, either. With climate change, wheat fields may flourish with a warmer climate, but only to a point. As the sun’s intensity builds, stalks will begin to falter—and so will crop yields. A hotter climate can also sap human productivity, whether it’s workers struggling in stifling factories or failing to turn up to work at all.
We’ve seen similar productivity outcomes from the pandemic, though driven by policy decisions to curb the spread, not natural factors. Policy responses to climate change — as we’ve seen with the pandemic — can be reactionary and hard to pin down in advance.
Industry obstacles to integrating climate risk
Given the uncertainty and unpredictability of climate effects, it shouldn’t be a big surprise that the investment-management industry needs to make strides in modelling climate change. But investors are a loss-averse crowd, especially when market payoffs aren’t symmetrical. Risk-management tools are largely backward-looking, so they’re largely ineffective at dimensioning climate-change risks.
Portfolio managers also battle internal biases. There’s no historical analogue to modelling climate impact on investment portfolios — unlike monetary-policy regimes, inflation cycles and market corrections. Climate change is a first for everyone, with near-infinite paths. Analysts grapple with skewed outcome distributions, and simple risk models may simply herd investors into the same positions.
The widespread disruption to industries and economies from COVID-19 could be a preview to the type of disruption we might face from the physical impacts of climate change
The pandemic, however, has given investors some empirical precedents to help bound our analysis of the potential outcomes of a physical shock to the financial system, as opposed to the financial shocks we’ve traditionally seen in our lifetimes. We’re just beginning to think through these new parameters, but the pandemic has moved many of the previous “unknown unknowns” of climate-change impacts and their interrelationships with various systems into the realm of experience.
For example, we’ve often hypothesized about the ramifications of decision makers depressing economic growth in order to combat the physical impacts of climate change. The pandemic, with its enforced social distancing and economic shutdowns, has provided a very immediate perspective on how to frame such a scenario.
The long timeframe for analysing climate change, however, throws investors a curve, given that their evaluation and decision timeframe is much shorter. This scenario creates a looming risk. At least initially, financial recognition of climate change will lag physical climate changes (Display), and even social pressure to take action. But, just as we’ve seen with the pandemic, once markets recognize building social pressure to act, investors will adjust very quickly and price it in with a vengeance.
Of course, a small percentage of people don’t accept that climate-change risk is real, that human activities impact it and that it requires action. But for investors, that debate is largely irrelevant. It takes a very long time for societies, governments and other entities to respond to even the possibility of climate change. Given the severe harm from failing to adapt — as we’ve seen with the various forms and degrees of pandemic responses — waiting for complete certainty and agreement on all facets of climate change is simply not an option. The rest of the world isn’t waiting, so we have to understand what all of that may mean.
As the recognition of the potential impact of massive COVID-19-related economic shutdowns became broadly recognized, stock prices plummeted. Markets have regained ground as initial signs of progress have emerged, but the ultimate financial impact is still unclear. What we do know is that the widespread disruption to industries and economies from COVID-19 could be a preview to the type of disruption we might face from the physical impacts of climate change. These could be in the form of more frequent severe weather, natural disasters and other cascading events such as rising temperatures and sea-levels.
Canals and power suppliers: Complex issuer-level impact
Getting a head start on integrating climate change in investing requires evaluating inputs that don’t move uniformly. Local climates vary widely, correlations evolve and climate events can cascade. Human society has arranged itself on the assumption of a stable climate, so the tentacles of climate change will be far-reaching.
The Panama Canal, which is rapidly losing market share, is a case in point. Today, the canal handles 3.5% of global trade, down from 5% a few years ago — climate change is the culprit. The canal needs large volumes of freshwater to adjust its levels, and man-made Gatún Lake has facilitated the process for years. But drought has reduced the lake’s volume, forcing the canal to charge higher rates to ration traffic.
That situation puts the canal’s financial viability in question, threatening a revenue stream that is 8% to 10% of Panama’s sovereign revenue. As customers consider alternate routes, the canal suffers. And alternate routes don’t necessarily hurt companies’ supply chains. Formerly iced-over polar routes provide seasonal passages that can be as much as 30% faster than the canal — and cheaper.
Investors must not only understand these wide-ranging impacts but translate them into viable inputs to individual issuer analysis and decisions. The complexity of this task is highlighted by Con Edison, a regional utility.
The Panama Canal is suffering as shipping transitions to new alternatives as a result of physical change; Con Ed’s challenge is different. It can’t necessarily reinvent itself, so it must fortify against physical risks. A recently completed three-year impact study looked at risk factors to Con Ed, including extreme heat, storm surges, inland flooding and violent weather.
The report, produced in conjunction with faculty from Columbia University’s Earth Institute, will guide Con Ed’s strategy to improve its reliability and resilience. The report estimates that Con Ed will need between $1.8 billion and $5.2 billion in targeted investment may be needed by 2050.
Given their impact on climate change and exposure to it, the utility and energy sectors are perhaps most familiar with the call to invest for resiliency. However, issuers with balance sheets still reeling from simultaneous demand and supply shocks may find a difficult balance between allocating capital for pandemic recovery and longer-term resiliency. After all, the corporate response to a pandemic comprises mostly borrowed capital, as companies also need capital to adapt to climate change at the same time. The focus on spending for recovery could detract from the need to spend on resiliency, putting some companies in worse shape.
Analysts and portfolio managers face many of these same issues as we try and understand how individual issuers will cope with such a challenging time.
But where to start?
Focus on big-picture asset-value drivers first
Assessing macro trends that are major influencers of asset prices can be a good starting point. As climate change tightens its grip, the world’s population will expand more slowly, and productivity will fall, leading to lower gross domestic product (GDP) (Display). Poorer countries are the most vulnerable: most are in equatorial regions where physical change is greatest and the impact most severe. These nations also struggle to fund the needed adaptations.
Lower GDP creates headwinds for corporate profitability, though partially offset by rebuilding activity from more frequent natural disasters. Inflation pressures are likely to rise as productivity declines and carbon cost rises. There are parallels between the battle to address climate change and major conflicts, which tend to drive up inflation as economies retool. Generally slower economic growth, on the other hand, could reduce some inflation pressure.
Then there’s the question of central bank policy. Will their mandates expand or evolve to offset rising inflation after a lengthy period of subdued price changes? How effective will their playbooks be?
Some issuers’ assets will be stranded or impaired by climate change. For example, as decarbonisation demand escalates, fossil-fuel reserves are more likely to remain in the ground untapped. This amount could be as much as 30% of oil reserves, 50% of gas reserves and 80% of coal reserves. Saudi Arabia’s threats to unleash oil supply — even as prices plummeted — has much to do with gaining market share. But could the un-collaborative tone also be influenced by the thought of massive amounts of stranded reserves?
Capital-spending patterns will evolve, too, as more capital is allocated to protecting against and adapting to climate change. It’s estimated that it will take $1 trillion to decarbonize the US economy alone — that’s between 1% and 1.5% of US GDP. Capital spending typically runs from 17% to 21% of US GDP, so decarbonisation spending will help preserve economic production but may also crowd out more productive spending.
This process will result in winners and losers. Fossil-fuel producers, as mentioned, will struggle with impaired and stranded assets. Companies that develop new technologies and services that facilitate adaptation and mitigation, including strengthening the defences of physical assets against climate change, will benefit. However, companies that take the opportunity to rebuild better from the pandemic, with a focus on resiliency against a wider range of risks and scenarios including climate change, are more likely to thrive in the long-term.
If analysts develop a better understanding of the region- and industry-specific impacts of climate change as transmitted through these macro variables, they can paint a more nuanced picture of the patterns of climate change’s impact — and how that translates to individual issuers.
Issuer analysis: Physical and transitional risks
Moving from big-picture factors to issuer-specific considerations, it helps to distinguish between physical and transitional risks. In the physical dimension, higher seas can endanger physical plants and facilities, and may restrict or close transportation routes for supply and human capital. Severe storms and disasters can damage or destroy firms’ physical assets and those of providers in their supply chains.
Similarly, the pandemic’s impact on supply chains have been particularly acute — decades of focusing on the efficiency of procurement strategies and execution have left many issuers vulnerable. The relentless focus on efficiency has, for some vital sectors, created its own costs: a lack of redundancy and capacity. Firms and investors have spent a lot of time taking slack out of the system; in turn, the system has become more and more brittle.
Physical risks are more straightforward: examine the geographic reach of an issuer’s business, and its customers, asset locations and supply chain. But connecting all the threads can be tedious, since climate impacts are the most local and specific. A firm may have the bulk of its plants in central Europe, but its supply chain and customers could stretch as far as Moscow, Shanghai, Miami or Mumbai.
Transition risks — risks from the evolution toward a carbon-free economy — are harder for issuers to cope with than are physical risks and can be just as unpredictable. Regulations change, including fossil-fuel taxes and cap-and-trade policies designed to drive up carbon cost. Technology evolves, including new power sources and manufacturing efficiencies, which alters the playing field. And if governments don’t act decisively enough to protect the environment, lawyers will likely find a way to do it through liability and litigation.
Tracing climate risks and opportunities to financial statements
It isn’t easy to dimension the potential impact of physical and transitional risks and opportunities on individual issuers, but a common framework to map them to financial statements (Display) can help.
Let’s start with physical risks. A hurricane might damage assets, boosting capital costs as management invests in costly repairs or replacement. It could also increase operating costs—for example, storm damage to vendors’ facilities that disrupts supply chains. Lower productivity, a knock-on physical risk from rising temperatures, makes in-house and outsourced capabilities pricier. Severe weather damage to brick-and-mortar facilities can reallocate revenue among competitors, depending on local impacts.
Tracing transitional risks to financial statements requires some detective work, too. Investors can make inroads by analysing issuers’ carbon footprints and the cost of carbon. This process involves looking at scope-one direct emissions from company-owned or controlled sources. It also includes scope-two indirect emissions from purchased energy sources, and scope three: all other emissions, upstream and downstream, in an issuer’s value chain. Most issuers report scopes one and two; very few report scope three.
The income statement is an important focal point for understanding a company’s emissions. Where on the statement are they? How could changing carbon prices affect them? Are there different elasticities or substitutions for different emission types? In other words, how much of carbon costs can be passed on and to what effect, substituted away and at what cost, or just absorbed by the issuer?
Several examples illustrate the wide range of effects on issuers’ financials.
For instance, changing consumer preferences can alter product demand. Animal proteins have a high carbon footprint, and meat-packing companies’ undeclared emissions are multiples higher than are their declared emissions. If consumers turn their backs on high-carbon food sources, and as carbon costs rise, revenue can suffer. Demand can also shift within animal proteins: from high-carbon beef to lower-carbon chicken, for example.
On the positive side of the revenue picture, relative winners from climate adaption and mitigation will include issuers producing more efficient technologies, whether it’s electric vehicles, biofuels, improved HVAC systems, smart grids or wind power.
As for the cost side of the income equation, the producers of animal proteins we mentioned could face rising costs from grain, the most critical input for raising livestock. As climate change advances, declines in crop yields will become more common, raising operating costs that issuers may or may not be able to pass through to end clients.
The big picture: If a tool can help, use it
Just because estimating climate-change impact and calibrating inputs to issuer-specific analysis is hard isn’t a reason for the investment community to throw up its hands. If anything, the repercussions of the COVID-19 pandemic demand that we accelerate our efforts—not put them on the back burner. It exposes some of the weakest links in value chains, the global economic system and the fundamental assumptions underlying both.
As investors, the pandemic has us thinking more broadly about risk from non-traditional sources. We’ve now seen many things that were previously considered low-risk but actually weren’t. The pandemic won’t cure climate change, but as businesses become aware of new and substantial risks, they may respond to risks that attack the system by creating more resiliency — or even by redefining themselves.
In other words, people and systems aren’t necessarily more vulnerable, but they’re more aware of their vulnerability. It’s possible to engineer the risks from the last crisis out of the system, and it’s not clear where the next crisis will come from, but investors may demand more resiliency as they become more sensitive to these independent, out-of-the-box risks.
The pandemic has also emphasized the unique opportunity for issuers—and investors—to rebuild better. A focus on developing resilient infrastructure, reshaping the modus operandi for employees and industries in a variety of sectors are supported by historically low interest rates, a nearly global need to decrease unemployment and a similar scale of behavioural shifts.
We can’t let the perfect become the enemy of the good. Any tool or analytical technique will endure a version 1.0, 2.0, 3.0 and beyond. For early versions, simply determining the direction of change in risk factors may make an impact, particularly versus passive investing. So, why not roll out these tools as soon as they can help?
Science also needs to take a larger role in such a process, and in the decisions facing governments, businesses and societies. AB’s collaboration with Columbia University’s Earth Institute focuses on better understanding how climate science can inform investment analysis. The Earth Institute’s interdisciplinary approach to climate has proved invaluable, as we establish dialogues between our investors and Columbia’s public-health experts and faculty. These conversations are helping us think through the meaning of the new normal for various sectors, industries and other stakeholders.
There will be no single, eternal answer for climate-change risks and opportunities for a company or industry. Human and physical systems will respond in ways we can’t predict, influencing both the climate and investment landscape. However, prevention is better, and more feasible, than a cure. We all need to keep learning and improving — and driving toward better outcomes.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
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