Your Net-Zero Strategy

Categorizing climate-related financial risk

clock 5 minute read

The financial risks associated with climate change could come from a transition to a net-zero economy or from extreme weather caused by global temperature rise. Investors want to know that companies are considering such risks as part of their long-term strategies.

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Transition and physical risk

Transition risk relates to risk that arises from the transition to a net-zero economy. It includes:

  1. Policy and regulatory risks that either attempt to limit actions that contribute to the adverse effects of climate change or that to encourage adaptation to climate change
  2. Market risk, such as shifts in supply and demand for certain commodities, products or services
  3. Reputational risk, which ties to changing perception among customers or communities regarding a company’s contribution to (or detraction from) the transition to an economy that removes as much greenhouse gas from the atmosphere as it puts in

Physical risk relates to the risk of changes in Earth’s long-term climate or extreme weather events. Such risks may include longer-term shifts in climate patterns, such as sea level rise, submerged coastal cities, extreme heat waves or drought. Physical risk also may result from extreme weather that spurs cyclones, hurricanes or floods.

How climate risk becomes financial risk

The transition and physical risks of climate change can impact businesses, households and the macroeconomy in a variety of ways. Those impacts, whether measured in damage to property, loss of income, changes in productivity or other effects, can increase risk to financial markets and the economy. The Network for Greening the Financial .System has mapped the possible transmission of such risks in connection with scenarios for exploring the impacts of climate change and climate policy.

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Climate Change Is a Source of Financial Risk. How uncertainty about the magnitude, scope and timing of the economic damages from climate change translates into financial risk, according to a senior policy adviser at the Federal Reserve Bank of San Francisco.

Framing stranded assets in an age of disruption. A look by the Stockholm Environment Institute at which assets are at risk of becoming economically unusable due to the sustainability transition and broader disruption risks.

How climate change may ‘flood’ global equities. Approximately 7% of global facilities operated by MSCI ACWI Index constituents as of Jan. 20, 2020 were threatened by coastal flooding risk; nearly two-thirds (62%) of companies had at least one facility in a flood-prone area. Without significant investment in coastal protection and adaptation, over half of covered global assets at risk could become untenable by midcentury.

Understanding extreme weather events. World Weather Attribution seeks to analyze extreme weather events as they happen, as part of an international effort to analyze and communicate the influence of climate change on storms, rainfall, heat waves, cold spells and droughts.

Financing a Net Zero Economy: The Consequences of Physical Climate Risk for Banks. Annual value-at-risk from physical impacts of climate change on the syndicated loan portfolios of major U.S. banks could approach 10 percent, according to this report from the environmental group Ceres, which finds that two-thirds of banks’ physical risk comes from supply chain disruptions, lower productivity and other indirect economic impacts of a warming climate.

How investors are thinking about climate risk

When it comes to modeling and managing climate risk, the insurance industry may have some lessons to offer. Matthew Lightwood, director of risk solutions at the manager of insurance company assets Conning, and Andy Sparks, MSCI’s head of portfolio management research, join MSCI’s Perspectives podcast to discuss practical approaches for evaluating the financial effects of climate change in a carbon-conscious world.

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