HOW INVESTORS ARE UNDERPRICING CLIMATE RISKS / THE FINANCIAL TIMES BIG READ

How investors are underpricing climate risks

The costs of inaction on global warming are potentially vast and often not sufficiently factored in to asset values

Vanessa Houlder and Nathalie Thomas 

Deadly wildfires such as those in Hawaii, as well as floods and droughts made worse by climate change, could shake up investing behaviour © AFP/Getty Images

The world is reeling from record-breaking heatwaves, wildfires and rainfall. 

Devastating floods have ravaged northern China. 

Wildfires have ripped through Canada, southern Europe and, in recent days, the Hawaiian island of Maui.

The human toll from these disasters, which experts say are becoming more common and more intense due to human-induced climate change, can be counted first of all in the thousands of lives lost.

But it can also be measured in the economic value destroyed, and potentially created, as governments shift policies to contain or mitigate the climate crisis. 

In a world that is rapidly becoming more vulnerable to extreme weather events, outdated assumptions about asset values also need recalibrating.

The big danger is of a “climate Minsky moment”, the term for a sudden correction in asset values as investors simultaneously realise those values are unsustainable.

So far, businesses and investors have paid less attention to the physical effects of climate change and more to the costs and risks of decarbonising, as the world tries to limit the rise in average global temperatures. 

The former is discussed half as frequently as the latter in US corporate disclosures, according to the Brookings think-tank.

Equities have not priced in climate change risks, research by the IMF and others has repeatedly shown. 

The perceived remoteness of risks such as sea level rises is one explanation. 

Another is the formidable difficulty of mapping interactions between the economy and greenhouse gas emissions. 

Nobel Prize winner William Nordhaus, who began modelling climate change as far back as 1975, describes this as the thorniest problem of all. 

Assessing abatement costs is “simple stuff” by comparison, he says. 

Vast computing power is trying to solve the conundrum. 

The data group Cambridge Econometrics and Ortec Finance recently crunched numbers for Singapore’s GIC. 

The sovereign wealth fund’s long-term investment horizon — and the city-state’s vulnerability to flooding — make it unusually mindful of climate risks. 

It wanted to know how a portfolio composed of 60 per cent global equities and 40 per cent bonds would fare under varying climate policies.

Locals fight a wildfire on the island of Rhodes. The evacuation of thousands of visitors from Greek islands this summer was a stark reminder of how extreme heat threatens the tourism industry © Petros Giannakouris/AP

In a “net zero” scenario involving ambitious decarbonisation, cumulative returns over 40 years were 10 per cent lower than a baseline that assumed no climate change. 

The most pessimistic outcome was a “failed transition” that put the world on course for a rise of more than 4C from pre-industrial levels by 2100. 

Cumulative returns were then nearly 40 per cent lower than the baseline, though some feel the outcome could be much worse than that given the unknowable levels of disruption that such a rise might trigger.

Investors “may be surprised by the underperformance” of the hypothetical portfolio, says GIC. 

The message is clear: investors ignore long-term climate risks at their peril.

Grains of truth

Agriculture is among the most vulnerable sectors. 

Morgan Stanley estimated in a report last year that at least 44 per cent of wheat, 43 per cent of rice, 32 per cent of maize and 17 per cent of soyabean production comes from at-risk areas. 

Climate change-induced disasters could put at least $314bn of annual production in jeopardy.

Companies that produce detailed analysis of climate risks are increasingly alert to the potential for sharp increases in commodity prices. 

Unilever estimates that extreme weather events could increase palm oil prices by 12-18 per cent by 2050, depending on the extent to which rising temperatures can be limited, and other food and commodities ingredients by 14-21 per cent.

The impact would be unevenly spread. 

Some cold countries might become more productive. 

The cultivation of certain crops has already migrated northwards, to cooler climates. 

Warmer temperatures helped Russia to become the world’s top wheat exporter last decade. 

Prior to the Ukraine war, scientists named it and Canada as new global agricultural frontiers. 

Climate change has enabled vineyards in regions such as the UK and Denmark.

Food insecurity is exacerbated by water shortages. 

Agriculture accounts for about 70 per cent of freshwater consumption globally, although in regions such as Asia it can be higher. 

Already 2bn people lack access to clean, safe drinking water. 

By 2030, demand for freshwater is forecast to exceed supply by 40 per cent.

Areas that once took water for granted are coming to terms with shortages. 

“For us in Europe, water scarcity was something that affected others and now it’s hitting us,” says Vincent Caillaud, chief executive of water technologies at Veolia, the French water group.

Industry is also reliant on dwindling water resources. 

Moody’s estimates that as much as half of the chemical sector’s global assets are exposed to water stress. 

German industry’s use of the Rhine for cooling and transport has been repeatedly jeopardised by droughts. 

Low water levels in 2018 cut profits at chemical giant BASF by €250mn.

Liquid assets

Too much water can cause as much havoc as too little. 

Around a fifth of computer and electronics factories in Asia are in flood-prone areas, according to Moody’s. 

ON Semiconductors shut one production site hit by disastrous 2011 Thailand floods because of “excessive” reconstruction costs.

Preventive action lowers risks. 

The world’s largest contract chipmaker, TSMC, has raised the foundations of newly built fabrication plants in Taiwan by two metres.

Of all the climate risks, flooding is most straightforward to analyse. 

But that does not mean it is priced in. 

Recently published research suggested that US residential properties exposed to flood risk are overvalued by between $121bn and $237bn. 

In some counties bordering the Gulf and Atlantic coasts, properties are likely to be overvalued by more than 10 per cent on average, their owners falsely comforted by out-of-date federal flood maps and government-subsidised insurance. 

Wildfires are another source of mounting anxiety. 

They were recently highlighted by Dave Burt, one of the “Big Short” investors who correctly anticipated chaos in the US subprime mortgage market in the 2000s. 

In evidence to a Senate committee, he said insurance premiums for wildfire protection were just $1.5bn in 2021; damages were six times bigger. 

A move by insurers to close that gap could result in a drop of up to $495bn in property values, he said. 

The aftermath of Hurricane Ian after it hit the west coast of Florida last September. Research suggests that US homes exposed to flood risk are overvalued by up to $237bn © US Coast Guard/Cover Images/Reuters

Once cyclones and chronic risks such as drought, heat and sea-level rises are factored in, San Francisco emerges as one of the areas most economically exposed, according to a Moody’s assessment. 

Idaho’s state capital, Boise, and Nashville, Tennessee are among the safest. 

Such forecasts provide an insight into likely migration patterns within the US in the second half of this century. 

The consequences for the Bay Area’s sky-high real estate values and its tax base will be significant. 

Globally, the movement of people away from hard-hit areas is likely to be on a far bigger scale. 

More than 20mn people a year on average have been displaced by extreme weather-related events since 2008. 

By 2050, as many as 1.2bn could be uprooted by climate change, according to the Institute for Economics and Peace think-tank.

Sovereign bonds are already registering the financial consequences of these trends. 

Nations facing a greater projected change in physical risks pay higher spreads for long-term debt financing, according to the IMF. 

It suggests that bond investors have more incentive to price in climate risks because a creditor country’s physical infrastructure assets are more likely to be directly affected.

A simulation of the effect of climate change on sovereign credit ratings for 109 countries suggested that climate-induced sovereign downgrades could happen as early as 2030, according to new research by economists from UEA and Cambridge university. 

China and India are among those facing the biggest reductions in creditworthiness.

Water clock

Damage will be mitigated by defences. Dykes have successfully protected the Netherlands, much of which is below sea level. 

Spending $50bn a year on flood defences for coastal cities could reduce expected losses of $1tn to some $60bn in 2050, researchers calculate. 

The wealthier the region, the better the chance of adequate defences. 

S&P recently upgraded Miami bonds to AA on this basis, even though the city expects the sea level to rise by up to 21 inches (53cm) by 2070.

Climate-savvy investors and entrepreneurs are spotting opportunities as industries and countries look to adapt. 

Innovations to mitigate the impact of future water shortages are an important theme. 

Gradient, a Boston-based business that has designed novel ways to treat industrial wastewater, became the first water tech start-up to achieve a $1bn valuation this year.

Desalination — the removal of salt from sea and other saline water — at present covers just 1 per cent of global freshwater demand. 

The market is expected to grow by nearly 9 per cent annually between 2022 and 2027, according to consultancy Technovia. Industries such as mining are exploring its use.

So too are countries such as the UK, France and Italy that have not yet used desalination on a significant scale. 

“Water scarcity and the [climate] situation that has crystallised over the last couple of years are pushing the deployment of these technologies,” says José Díaz-Caneja, chief executive of Spanish conglomerate Acciona’s water business. 

But costs remain relatively high, and efficiency is low. 

One cubic metre of desalinated water can cost between 40 cents and $1 compared with 10-25 cents for the same measure of normal tap water. 

Its use for irrigation is limited as much agricultural land is far from coastal areas where desalination plants are located.

Ear for the long haul

Crop science is also attracting greater political and investor attention. 

Previously sceptical European countries are warming to gene-edited varieties engineered to withstand extreme temperatures and drought. 

Examples include a short corn requiring less water, which Germany’s Bayer hopes to introduce to markets such as the US this decade. 

Brussels has proposed loosening restrictions on some gene-edited crops. 

A change in EU rules is likely to lead to more research, according to Geoff Graham, vice-president of seed product development at Corteva.

Service industries will be forced to adapt. 

The evacuation of thousands of visitors from Greek islands ravaged by wildfires this summer was a stark reminder of how extreme heat threatens the tourism industry. 

For some tropical destinations such as the Maldives, rising global temperatures pose an existential threat. 

For southern Europe, intolerable summer temperatures will force writedowns of hotels and resorts in countries including Spain, Italy, Cyprus, Portugal, France and Greece. 

Heavy rainfall begins in Udaipur, India. More than 20mn people a year on average have been displaced by extreme weather events since 2008 © Avishek Das/SOPA/Sipa USA/Reuters

Southern destinations will try to minimise losses by marketing spring and autumn holidays, but the European Commission is surely underestimating impacts when it asserts that a massive 4C rise in global temperatures would reduce tourism demand in the Greek islands by just 9 per cent. 

Demand in cooler destinations such as the west of Wales could increase by as much as 16 per cent, the commission adds. 

Hoteliers and tour operators will expand cruise lines, which can flex itineraries around weather conditions, along with hotel capacity in northern Europe. 

The head of tour operator Tui suggested this month that destinations such as Belgium would become more popular.

Flawed forecasts

Skilful adaptation would soften the blow from climate change. 

It is rarely accounted for in climate models but is one reason to hope that the most bearish financial forecasts are too pessimistic.

Yet many models also omit factors that could make the outcomes far worse than predicted. 

Many assume that climate change does not slow gross domestic product growth. 

They do not take account of mass migration. 

Climate tipping points, such as thawing permafrost or an ocean circulation collapse, are rarely included. 

More fundamentally, the past is an unreliable guide to the future. 

Modellers typically use a quadratic function to plot the relationship between damages and temperatures. 

Some 2 per cent of output would be lost at 3C of warming, while 8 per cent of output would be lost at 6C of warming, according to Nordhaus’s 2016 model. 

There is great uncertainty about the potential effects of such large rises, but even so the credibility of those predictions looks weak.

It makes more sense to conduct a reverse stress test, argues a new report from the UK’s Institute and Faculty of Actuaries. 

This involves working backwards from an as-yet undefined temperature at which the world’s economy would plausibly cease to function. 

Using this logic, the report’s authors suggest that half the world’s GDP could be destroyed as early as 2070.

There is a cavernous gap between such cataclysmic forecasts and the modest impacts anticipated by pension funds and listed companies in their climate risk reporting. 

Consider, for example, the risk assessments regularly carried out for Shropshire county council, a local authority in the UK. As recently as 2020, it reported that its annualised portfolio returns would be hit by just 0.1 per cent over 30 years even as the world hurtled towards 4C of warming.

Discomfort blankets

There is growing unease that existing climate models may be providing a false sense of security. 

The UK Pensions Regulator recently raised concerns over scenario impacts that “seem relatively benign and appears to be at odds with established science”. 

Last November the Financial Stability Board warned that the scenarios used to assess risks to the financial system may understate climate vulnerability. 

An abrupt correction of asset values is possible once markets recalibrate the likely impacts of climate change, says the Carbon Tracker think-tank founder Mark Campanale. 

University College London professor Steve Keen also predicts such a “Minsky moment” and warns it will be “unpleasant, abrupt and wealth-destroying”.

There are powerful arguments why financial institutions should pay closer attention to the physical risks of climate change. 

Doing so might reduce the chance of sudden shocks and reinforce the case for mitigation. 

Moreover, it would improve the allocation of resources, deter building in flood zones and incentivise spending on climate-resilient infrastructure.

Focusing on the physical effects of poorly mitigated climate change might seem defeatist. 

But time is fast running out to decarbonise the economy. 

Investors have begun to price in the decarbonisation challenge. 

They need to start counting the considerable costs of inaction, too.