Physical Climate Risk in Equity Portfolios – White Paper

At COP23 Four Twenty Seven and Deutsche Asset Management jointly released a white paper featuring a new approach to climate risk management in equity portfolios. Measuring Physical Climate Risk in Equity Portfolios showcases Four Twenty Seven’s Equity Risk Scoring methodology, which identifies hotspots in investment portfolios by assessing the geographic exposure of publicly-traded companies to climate change. Our methodology tackles physical risk head on by identifying the locations of corporate production and retail sites around the world and their vulnerability to climate change hazards, such as sea level rise, droughts, floods and tropical storms, which pose an immediate threat to investment portfolios.

Deutsche Asset Management is leveraging Four Twenty Seven’s Equity Risk Scores to satisfy institutional investors’ growing desire for more climate resilient portfolios and design new investment strategies. “This report is a major step forward to addressing a serious and growing risk that investors face. To keep advancing our efforts, we believe the investment industry needs to champion the disclosure of once-in-a-lifetime climate risks by companies so we can assess these risks even more accurately going forward,” said Nicolas Moreau, Head of Deutsche Asset Management.

Methodology

Four Twenty Seven’s equity scoring methodology includes Operations Risk, Supply Chain Risk and Market Risk:

  • Operations Risk involves screening thousands of facilities for their exposure to climate risks.
  • Supply Chain Risk assesses both the climate risk in countries that produce a company’s materials and the sensitivity of a company’s industry to climate-related resources such as water and land.
  • Market Risk captures how a company’s consumers may change their behavior due to climate variability.

Since different industries will respond to climate hazards differently, the analysis includes both geographic location and business sensitivity. For Operations Risk, Four Twenty Seven screens each corporate site for its exposure and sensitivity to a set of climate hazards that include extreme precipitation, sea level rise, hurricanes, heat stress, water stress and wildfires. To calculate Supply Chain Risk and  Market Risk, Four Twenty Seven uses companies’ financial data, such as revenues and production. The image below shows an example of extreme precipitation risk for 68,000 corporate sites belonging to France’s benchmark index CAC40 (France’s 40 largest public companies).

Findings

This comprehensive, data-driven scoring effort culminates in a composite physical risk score that allows for comparison and benchmarking of equities and indices.  This integrated measure provides a point of entry to understand and address climate risk, engage with corporations and identify risk mitigation strategies.

The white paper includes a relative ranking of CAC40 companies, as shown below.

Climate Risk in Asia

Asia is particularly vulnerable to climate change. Five out of six people in Asia live in climate hotspots. The Asian Development Bank warned that, without mitigation action, Asia will experience temperature rise of six degrees centigrade by the end of the century. Of extreme concern is the region’s vulnerability to sea level rise. For example, China leads the world in terms of coastal risk, with 145 million people and economic assets located on land threatened by rising seas.

To better understand the implications of these projections for financial markets, Four Twenty Seven mapped the physical climate risks for 500 large and mid-cap constituents of an Asia ex-Japan listed equity index. We found that many companies are highly vulnerable to sea level rise in the region. China’s Pearl River Delta is already experiencing a higher than average rate of sea level rise and has many assets that would be exposed to flood risk in a two-meter flood scenario (see below). Many of these are energy assets which are long-lived and high value capital assets that cannot easily be relocated, requiring protection from rising seas if they are not decommissioned.

An explicit example of the economic impacts of extreme weather events and the resulting damage to assets can be seen in the Thailand floods of 2011. This event led to vast repercussions across industries, including car manufacturers, Thailand’s rice industry and even tourism. While these events were most damaging in Thailand, negative impacts were felt internationally. For example, the production of hard drive manufacturers like Toshiba and Western Digital was stalled due to the floods, which affected companies like Lenovo that depend on Asian manufacturing.

Accessing our Data

Four Twenty Seven’s ever-growing database now includes close to one million corporate sites and covers over 1800 publicly-traded companies. We offer subscription products and advisory services to access this unique dataset. Options include data feeds, an interactive analytics platform and company scorecards, as well as custom portfolio analysis and benchmarking.

Read the White Paper and contact us for more information about our products for financial institutions and corporations.

Art. 173: Lessons Learned from Climate Risk Disclosures in France

March 21, 2018 – 427 ANALYSIS. The first year of reporting under Art. 173 in France saw limited uptake of disclosures of physical risk and opportunities. Our review of disclosures from 50 asset owners in France shows only a quarter of respondents included substantial analysis and metrics on their exposure to physical impacts of climate change. We find insurance companies AXA and Generali provided the most detailed analysis for property portfolio, while FRR and ERAFP were the only pension funds to provide an initial assessment of physical risk exposure in their equity and fixed income portfolios.

Art. 173: the world’s first legal requirement to disclose climate risk

Article 173  of the French Law on Energy Transition and Green Growth passed August 2015 requires major institutional investors and asset management companies to explain how they take Environmental, Social and Governance (ESG) criteria into account in their risk management and investment policies. These institutions are also asked to report on the impacts of both physical risks and ‘transition’ risks caused by climate change on their activities and assets.

The law applies to French companies, meaning that French subsidiaries of large financial groups are potentially subject to requirements that do not apply to their parent companies. Its implementing decree invites these organizations to establish scenarios and models to take into account climate risks impacts on the value of their portfolios.

Article 173 covers publicly traded companies, banks and credit providers, asset managers and institutional investors (insurers, pension or mutual funds and sovereign wealth funds). In addition, asset managers managing funds above 500 M€ and institutional investors with balance sheets above 500 M€ are subject to extended climate change-related reporting obligations, including both physical impacts of climate change and transition risks (impact of the transition to a low-carbon economy).

The inclusion of physical impacts of climate change in financial risk analysis is in line with the industry-led Task Force on Climate-related Financial Disclosures (TCFD) recommendations report, released in July 2017.

What did financial institutions report?

We conducted a desktop analysis of the 2017 reports (applying to 2016 portfolios) to understand how financial institutions responded to the requirements laid out by Art. 173 in the first compliance year. We reviewed 50 asset owners in France, including public pension funds, sovereign wealth fund and insurance companies, with an aggregate €5.5 trillion euro ($6.8tn) under management. Our analysis included all the public entities covered by the Article 173, as well as private insurers with asset under management above €2bn. Insurance companies play a particularly important role as asset owners in France, where individual savings are massively invested in life insurance savings products. French pension funds, on the other hand, are relatively small due to France’s pay-as-you-go retirement system.

We were able to find Art. 173 reports for 36 out of 50 organizations. It is possible that, in spite of our best efforts, we failed to locate reports. However, Art. 173 has a ‘comply or explain’ provision which also makes it acceptable not to publish a report if one can justify climate change is not a material risk.

Among the Art. 173 reports, we found 29 from insurance companies and seven from public entities. Among them, 20 organizations (40%) discussed only their carbon footprint and/or their exposure to energy transition risk, without including physical risk disclosures.

A small group of organizations (8%) mentioned physical risk as a topic they were exploring but not yet able to report on. Most of them emphasized the lack of tools and models as a major impediment to reporting physical risk.

All in all, we found 12 financial institutions (24%) of the institutions under review made an explicit attempt to disclose their exposure to physical climate risk.

We broke down this latter group in three categories. Eight companies (16%) provided an analysis of the physical risks threatening either their operations or property portfolios (for insurance), ranging in scope from a few buildings to €15bn worth of assets in the case of AXA. Most of the reports contain limited details on methodology and findings.

Two companies (4%) performed what we call a “top-down” analysis, working with investment advisor Mercer to perform a multi-asset class, sector-level analysis of climate risk using Mercer’s proprietary climate risk model, which blends transition and physical risk. Finally, two high profile investors, pension fund ERAFP and sovereign wealth fund FRR, included an initial assessment of climate risk in their equity and fixed income portfolios, at the asset level.

 

 

Table 1 presents a detailed breakdown of how those organizations take physical climate risks into account:

 Case Studies: How do Investors Report on Physical Risk?

AXA

The best student in this 2016 reporting vintage is AXA France. AXA received the “International Award on Investor Climate-Related Disclosures” from the French Ministry for the Environment, for analyzing 15 billion euro of assets (real estate and infrastructures). The analysis takes into account most frequent European natural disasters and the geographical location of each individual asset as well as the destruction rate of their building materials. They found out that, over 30 years, the accumulated loss would aggregate to 24 million euro. The insurance company also reported that if a centennial storm was to occur, the portfolio would be impacted by a 15.2 million euro loss. While AXA provides some of the most detailed analysis,  it also noted that “this new kind of analysis needs to be improved in order to take into account more natural disasters and other portfolios”.

The following graphs demonstrate the physical risk exposure to windstorms for the analyzed infrastructures. On the left, the graph displays the annual average destruction rate, which is linked to the average loss generated by windstorms every year (0.8M€ on average). The map on the right shows the destruction rates due to a 100-year event, with an estimated loss of 15.2M€.

Source (Award on Investor Climate-related Disclosures, AXA Group, October 2016: https://cdn.axa.com/www-axa-com%2Fcb46e9f7-8b1d-4418-a8a7-a68fba088db8_axa_investor_climate_report.pdf)

Generali

Generali France also provided a complete and detailed evaluation of the potential impact of physical risks on their property assets. They analyzed 112 assets, mainly in the Paris Area, accounting for 60% of their owned assets. Generali took into account two kinds of physical risks, flood and drought, to rate their assets from “high” to “very low” risk. Regarding drought, 3 assets enter the medium-risk category. As only 12 assets have been analyzed (Paris and the overseas departments being excluded), this risk is important as it accounts for 25% of their analysis. On the other hand, 10 out of 112 buildings owned by Generali France are exposed to a high risk of flood. They are mainly located in the Paris Area and would be heavily affected by a Seine flood.

To sum up, both AXA and Generali reports are valuable examples of emerging best practices as they show the willingness of those organizations to take physical risks into account in their reporting practice. However, their analyses would benefit from being extended to a broader portfolio and to other natural events.

FRR

In November 2017 the French pension fund, “Fonds de Réserve pour les Retraites” (FRR), released a report addressing Article 173 requirements. Four Twenty Seven performed the analysis, and applied its proprietary methodology to measure the types and levels of climate risk embedded in FRR holdings. Portfolio exposure was evaluated according to their respective industry and sector. The analysis produced a sector risk score based on three indicators:

  • the sector’s supply chains’ geography ;
  • its dependency on climate-sensitive natural resources inputs ;
  • its sensitivity to weather variability.

This hotspot analysis gave FRR tools to get an initial understanding of its portfolios’ exposure. It highlighted strongly exposed sectors such as Materials and Consumer Staples, due to their dependency on natural resources, and Pharmaceuticals and Electronics hardware, due to their complex and global supply chains. Conversely, the results brought out the low exposure of service-based industries such as Media and Telecommunication.

Conclusion

Reporting on physical climate risk is a challenging task for financial institutions – many organizations lack the tools, models and data to perform a comprehensive assessment of their portfolios, whether they’re composed of real assets or equities. As TCFD reporting becomes standard for financial institutions and corporations, pressure will increase to report on physical risk. We expect fast changes in disclosures in this regard, starting as early as the 2018 reporting season.

This analysis was written with support from Thomas Poloniato.

Four Twenty Seven’s ever-growing database now includes close to one million corporate sites and covers over 1800 publicly-traded companies. We offer equity risk scoring and real asset screening services to help investors and corporations leverage this data.

Lenders’ Guide for Considering Climate Risk in Infrastructure Investments

Climate change poses multifaceted physical risks for infrastructure investors, affecting revenue, maintenance costs, asset value and liability. According to the New Climate Economy report, global demand for new infrastructure investment could be  over US$90 trillion between 2015 and 2017. It is becoming increasingly clear that climate change must be considered in all infrastructure investment and construction.

Four Twenty Seven, in collaboration with our partners Acclimatise and Climate Finance Advisers, published a “Lenders’ Guide for Considering Climate Risk in Infrastructure Investments” to explain the ways in which physical climate risks might affect key financial aspects of prospective infrastructure investments.

Climate Change and Infrastructure

The guide begins with a discussion of climate risk, acknowledging that climate change can also open opportunities such as improving resource efficiency, building resilience and developing new products. It provides a framework for questioning how revenues, costs, and assets can be linked to potential project vulnerability arising from climate hazards.

Revenues: Climate change can cause operational disruptions that lead to a decrease in business activities and thus decreased revenue. For example, higher temperatures alter airplanes’ aerodynamic performance and lead to a need for longer runways. In the face of consistently higher temperatures, airlines may seek airports with longer runways, shifting revenue from those that cannot provide the necessary facilities.

Costs/Expenditures: Extreme weather events can cause service disruptions, but can also damage infrastructure, requiring additional unplanned repair costs. For example, storms often lead to downed power lines which disrupts services but also necessitates that companies spend time and money to return the power lines to operating conditions.

Assets: Physical climate impacts can decrease value of tangible assets by damaging infrastructure and potentially shortening its lifetime. Intangible assets can be negatively impacted by damages to brand image and reputation through repeated service disruptions.

Liabilities: Climate change is likely to pose increasing liability risk as disclosure and preparation requirements become more widespread. As infrastructure is damaged and regulations evolve, companies may face increased insurance premiums and costs associated with retrofitting infrastructure and ensuring compliance.

Capital and Financing: As expenditures increase in the face of extreme weather events, debt is also likely to increase. Likewise, as operations and revenues are impacted and asset values decrease, capital raising may become more difficult.

The guide also draws attention to the potential opportunities emerging from resilience-oriented investments in infrastructure. There are both physical and financial strategies that can be leveraged to manage climate-related risks, such as replacing copper cables with more resilient fiber-optic ones and creating larger debt service and maintenance reserves.

Climate Risks and Opportunities: Sub-Sector Snapshots

The guide includes ten illustrative “snapshots” describing climate change considerations in the example sub-industries of Gas and Oil Transport and Storage; Power Transmission and Distribution; Wind-Based Power Distribution; Telecommunications; Data Centers; Commercial Real Estate; Healthcare; and Sport and Entertainment. Each snapshot includes a description of the sub-sector, an estimation of its global potential market, examples of observed impacts on specific assets, and potential financial impacts from six climate-related hazards: temperature, sea-level rise, precipitation & flood, storms, drought and water stress.

Commercial real-estate, for example, refers to properties used only for business purposes and includes office spaces, restaurants, hotels, stores, gas stations and others. By 2030 this market is expected to exceed US $1 trillion per annum compared to $450 billion per annum in 2012. Climate impacts for this sub-sector include hazard-specific risks and also include the general risk factor of climate-driven migration which drives shifts in supply and demand in the real estate market.

As heat waves increase in frequency, people will likely seek refuge in cool public buildings, leading to increasing property values for those places such as shopping malls that provide air-conditioned spaces for community members. Increasing frequency and intensity of storms may damage commercial infrastructure, leading to recovery costs and increased insurance costs. Real estate managers may have to make additional investments in water treatment facilities to ensure the viability of their assets in regions faced with decreased water availability. An example of the financial impacts of climate change on this sub-sector can be seen in Houston after Hurricane Harvey. After the hurricane hit Texas in August 2017, approximately 27% of Houston commercial real estate was impacted by flooding and these 12,000 properties were worth about US$55 billion.

Download the Lenders’ Guide. 

For more guidance on investing for resilience, read the Planning and Investing for a Resilient California guidance document and the GARI Investor Guide to Physical Climate Risk and Resilience.