Brewing storm: Are investors discounting climate risks and opportunities?

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Our key points

• Climate change is an asymmetric, systemic and largely unaddressed risk for investors.
• Climate-related asset repricing may cause widespread dispersion of security values.
• In our view, investors do not need to believe in climate change to recognise that addressing the risks and opportunities in their portfolios is good capital stewardship.
• Companies focused on climate change mitigation and adaptation  are an evolving investment opportunity set.

Investors often focus on long-lasting trends, but many seem to be ignoring one of today's most important ones: climate change.

The scientific community is broadly agreed that climate risk is likely to increase over time. In our view, climate risks are on the rise and include not just adverse weather but pressures from regulation, technology and even capital markets. As a result, asset owners should consider an approach that seeks to identify companies focused on mitigating and adapting to climate change.

Dire consequences of warming

Global temperatures have been rising for decades and show no sign of mean reversion (Figure 1). In fact, their rate of increase appears to be accelerating. In our opinion, investors who underestimate or ignore climate risks may do so at their – and their clients' – financial peril.

The shifting of urban population centres to low-lying coastal regions is exacerbating the economic and physical risk of climate change. One study found that population density for low-lying coastal zones is five times higher than the global average and is expected to quadruple by 2030¹. Greater population density increases the potential extent of damage from storms or rising sea levels. By 2070, coastal flooding in large port cities including Shanghai and Mumbai could put at risk up to US$35 trn in property and infrastructure².

These trends have increased the cost of natural disasters. Between 1995 and 2015, 90% of disasters were linked to climate change, and they cost US$250 billion to US$500 bn annually³.

Climate risk focus implies inevitable asset repricing

In our view, asset prices are far from reflecting the long-term systemic risk from global climate change. However, there is growing urgency to act, and many governments and financial reporting bodies recognise the need to develop ways for the corporate sector to account for climate-related risks. As disclosure and reporting (such as the recent guidelines from the Task Force on Climate-Related Financial Disclosures) make climate risk more apparent, large portions of investors' portfolios could be in greater jeopardy, particularly if climate awareness results in a secular rerating of assets. Specifically, if climate risk premiums rise, equities of companies bearing greater-than-appreciated climate risk could come to be seen as less valuable. The opposite would hold true for carbon-advantaged companies.

An even more worrisome aspect of climate change for asset owners is climate liability. Carbon-reduction laws and regulations are proliferating. By early 2017, more than 1,200 climate laws and policies were in place across 164 countries, up from around 60 in 1997⁴, and we expect greater regulation and stricter enforcement globally over the next decade. For many companies, doing too little is likely to be not just financially imprudent but legally risky. Asset owners, particularly those with long investment horizons, should recognise this creeping portfolio risk and the associated asymmetric return distribution.

Opportunities centre on mitigation and adaptation

Investors can take several steps to prepare their portfolios for the effects of climate change and potentially take advantage of opportunities stemming from asset mispricing. One may be to add a dedicated strategy that is informed by the latest climate science, tracks an evolving opportunity set and invests in companies focused on climate change mitigation and adaptation.

Climate change mitigation involves efforts to decarbonise our energy mix via renewable power sources, electrified transportation, resource efficiency and pollution control. Climate change adaptation, which accepts that some damage may be irreversible, entails upgrading or replacing at-risk physical capital with sustainable infrastructure.

A dedicated climate strategy informed by science and the changing regulatory landscape can potentially offer institutional investors with multi-decade horizons the following benefits:

• A fundamental asset-liability match vis-à-vis climate risk
• A way to manage risks beyond near-term, localised or purely weather-related
• Liquid, scalable climate resilience
• Higher inflation sensitivity and lower reinvestment risk relative to many private climate solutions
• An effective hedge if policy, legislation or consumer choice accelerate carbon-free or other climate-focused initiatives (including divestment)

Why we think climate leadership should come from the P&C insurance industry

Property and casualty (P&C) insurers have liabilities that are often measured in decades. They therefore have a vested economic interest in managing climate risk effectively and are likely to lead the repricing of climate risk.

Insurance in general and the P&C industry in particular have historically provided valuable benefits to society. By pooling and managing risk, insurance enables companies and individuals to innovate, thus supporting economic growth. The insurance industry also effectively prices and reprices risks over time, helping to ensure the efficient allocation of capital.

Today, the industry attempts to manage climate risks by focusing on four main approaches. We think each is inadequate to address the systemic, long-term threat from climate change.

• Risk transfer through weather derivatives or catastrophe bonds is a short-term solution that tends to ignore longer-term risks. Pricing is based on historical data, which is likely to prove unreliable if climate change continues to accelerate.
• Risk avoidance may mitigate risks for the insurer, but sends inadequate pricing signals to the marketplace, perpetuating the mispricing of climate risk. Avoidance normally implies dependence on a government agency which may be ill equipped to underwrite risk.
• Raising premiums has two potential drawbacks: it may limit underwriting opportunities; and premiums are still mostly based on backward-looking models that do not reflect future weather and climate risks. Both imply that current premiums may be too low.
• Private infrastructure investing can help to underwrite the creation of necessary climate-resilient assets, but this approach can be difficult to scale and can present liquidity, reinvestment and inflation-hedging risks.

In addition, insurance companies face a correlation risk: they must ensure that their assets (investments) do not lose value at the same time as any increase in their liabilities (the claims they have underwritten) – a challenging proposition if climate risk re-pricing occurs across assets and sectors

Unless an insurer's liabilities on physical property perfectly price in climate change, those obligations can become more onerous over time. And, if an insurer's investment portfolio is heavily exposed to assets bearing climate risk, it may face a classic asset-liability mismatch.

An equity investment approach can help insurers manage climate risk

We believe the insurance industry should provide leadership on climate-risk repricing. No amount of insurance can make a bad risk good. So we think insurers, faced with accelerating climate change, should consider more expansive, multi-decade approaches to managing climate risk. In our view, a public equity investment strategy that offers exposure to companies engaged in climate risk mitigation and adaptation can complement existing hedging strategies.

A more sustainable approach may be for insurers to decouple investment risk from the rising climate-related liability risks they face. Should carbon trading or taxation be more widely used, that may put upward pressure on claims and other liabilities, making a liquid equity-based approach potentially additive to a broader investment portfolio. Those costs are not currently captured in most insurers' asset bases, which are still dominated by fixed income investments. Some portfolio allocators are beginning to recommend equity- based approaches for insurance clients. These may include: asset re-allocation, including divestment and ESG awareness; hedges using low-carbon indexes or derivative overlays; and engagement on policy and physical-risk disclosures.

Learn more about Wellington Management's views on the investment implications of climate change: What should we do about climate change? by Spencer Glendon 

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