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Thursday, January 4, 2018

Climate risk: going mainstream

The governor of the Bank of England and ExxonMobil shareholders are just some of those changing the narrative on climate risk, says Dylan Tanner
Once climate change becomes a defining issue for financial stability, it may already be too late
by Dylan Tanner, The Actuary, September 7, 2017
In June this year, the Financial Stability Board’s (FSB’s)Task Force on Climate-related Financial Disclosures (TCFD) published its recommendations on how the corporate sector should disclose climate risk to investors. The FSB apparently regards climate change as a systemic financial risk, as articulated in a speech by the governor of the Bank of England, Mark Carney, in 2015. Meanwhile, at ExxonMobil’s annual general meeting in May this year, a majority of shareholders demanded that the oil and gas giant discloses its thinking on climate risk more clearly.
Data, analysis and advice on climate risk to portfolios have been around and available to investors for at least 20 years. By the late 1990s, the UN Environment Program (UNEP) Financial Initiative was messaging regularly on the risk of climate-change-induced weather events to the insurance sector and hence the wider markets.
In 2000, the investor-enabled Climate Disclosure Project (CDP) began collecting and aggregating carbon emissions information from thousands of companies around the globe. Financial data sets such as MSCI, Thomson Reuters Eikon and Bloomberg create and sell climate-related metrics on companies as part of their environment, social and governance (ESG) offering.
These observations beg two questions. Is climate risk now going mainstream in portfolio assessment? If so, what has changed? 
The answer to the first question is almost certainly yes, given the mainstream remit of the FSB and the universal nature of ExxonMobil’s shareholder base. The answer to the second is more complex. A key reason that climate risk analysis has not been widely accepted by financial analysts until now is that the messengers have largely come from the climate change and sustainability communities. The UNEP’s remit is to solve environmental issues, not advise on financial risk. Data sets such as CDP and the ESG metrics are regarded as originating in the sustainability agenda, and are used by investors mostly to satisfy sustainable investment commitments rather than inform mainstream risk strategy.
A more significant reason is captured by Carney in his 2015 ‘Tragedy of the Horizons’ speech, where he notes the disconnect between time horizons for current financial risk assessment and manifestation of the effects of climate change.

Predictions come to pass

Two decades have passed since the CDP and UNEP initiatives began, and some of the early indicators of these risks are now appearing. One of these relates to the fossil-fuel production sector, where groups such as the Carbon Tracker Initiative have predicted that a variety of climate-induced pressures could threaten the value of the reserves of oil, gas and coal on balance sheets. In November 2016, Shell shocked the market by estimating that oil demand could peak in as little as 5 years, “driven by efficiency and substitution,” according to then chief financial officer Simon Henry.
A 2016 report from think tank InfluenceMap showed the disparity between the predictions of global electric vehicle (EV) proliferation by the oil companies and those of the automakers and regulators. Toyota predicts 100% EVs and hybrids by 2050 in its sales. France pledges to ban petroleum-powered cars by 2040, and India has a goal of selling only EVs by 2030. Yet, the report notes, ExxonMobil forecasts that EVs will account for “less than 10% of new-car sales globally in 2040.” For a company that probably derives more than 30% of its revenues from petroleum-related transport, this disconnect is a concern. Shareholders are correct to demand further disclosure on the climate risk scenarios it is working with.
Other sectors on investors’ radar when it comes to climate risk and its disclosure include utilities. Reputational, financial and regulatory pressure on the use of coal for power generation is growing, while incentives for the scale-up of renewables is similarly accelerating. Bloomberg New Energy Finance estimates new power generation capacity will be mostly solar and wind by 2040, leaving gas, and especially coal generation and related value chains, as niche businesses. The power sector is one with long-term horizons and multi-decade plant life cycles, so understanding management strategy on future scenarios is essential for investors.

Funds flex their muscle

Pension funds are an important part of the global financial system, with the top 6,000 funds holding around $26trn (£20trn) of capital market assets. They have the ability to create market trends, and account for a significant portion of revenue generated by the financial sector as a whole. 
One of the largest such funds is Norway’s Government Pension Fund Global, with close to $1trn in assets. It adopted criteria in late 2015, allowing it to “exclude companies whose conduct to an unacceptable degree entails greenhouse gas emissions.” In June this year, the smaller but still substantial AP7 pension fund of Sweden announced it was divesting from ExxonMobil and five other companies for violation of the Paris climate agreement. Many other such funds may follow this trend. Such divestment and exclusion actions may be the last resort in an engagement chain, or intended as a signal on acceptable corporate governance. In the case of the Norwegian fund, its managers have a direct remit from the country’s parliament to consider global climate change risk in its management.

Change in data needs

While climate risk is now mainstream, the data needs of the investment community have shifted. For one thing, they are now highly sector-specific. Certain industries, such as energy and power generation and energy-intensive sectors like cement, are the focus, and investors want to understand management thinking on climate issues. To this end, the FSB recommendations stress disclosure by companies on the “resilience of an organisation’s strategy under climate-related scenarios, including a 2 °C or lower scenario” and the regulatory, market, technology and other changes these will bring.
Crucially, the FSB also extends its recommendations to the financial sector, and urges asset owners to test the resilience of the portfolio under the same scenarios. This approach necessitates a focus on forward-looking corporate behavioural metrics and analysis, as well as the carbon emissions accounting approach. For example, investors need to understand the capital asset allocation strategy of an electricity utility, and how this relates to regulatory trends. Likewise, they need to understand whether an oil/gas company’s business model is based on expecting to continue to be able to suppress climate-motivated regulations, and likely scenarios should the political climate shift suddenly.

Mainstream methods apply

Disclosures in line with the TCFD’s recommendations do not feed into any legally binding financial disclosure processes, such as those of the U.S. Securities And Exchange Commission. As a result, achieving universal participation – especially by the most at-risk companies –remains a challenge. 
The TCFD and other disclosure systems aside, mainstream analysis of corporations by investors involves reliance on other sources of information, such as discussions with senior management and third-party investigations.
In the climate risk context, this process will spur the financial research and data sectors to acquire expertise, and perhaps to form unusual alliances with climate specialists in the NGO, academic and technology sectors, to better understand the nuances of portfolio, sector and company risk.

Dylan Tanner is executive director at InfluenceMap

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