December 4, 2019 – 427 REPORT. Scenario analysis is an essential yet challenging component of understanding and preparing for the impacts of climate change on assets, markets and economies. When focusing on the short term, the warming and related impacts we have already committed to calls for scenarios that are decoupled from economic and policy activities and instead focus on the impacts that are already locked in. This report explores which impacts are already locked in, identifies how Representative Concentration Pathway (RCP) scenarios fit into the conversation, and describes an approach to setting up scenario analysis for near-term physical climate risks.
As the effects of climate change increasingly threaten financial stability, investors and regulators are seeking to understand what impacts lie ahead, and calling for an increase in physical climate risk assessment and disclosure in line with the Task Force on Climate-related Financial Disclosures (TCFD). To assess the scale of financial risk posed by physical climate change it is important to quantify risks under different climate scenarios. How will changes in extreme weather patterns, longer droughts and rising seas differ under various scenarios? Answering these questions through scenario analysis helps uncover the range of risks, allowing investors to identify assets and markets that are more likely to become stranded over time and to begin developing forward-looking resilience strategies. However, science-driven, decision-useful scenario analysis poses many challenges for businesses and financial stakeholders today, due to complex feedback loops, varying timescales, and multiple interacting factors that ultimately determine how global climate change manifests.
Figure 2.Distribution of daily extreme temperature changes in 2030-2040, expressed as a percent change, relative to a baseline of 1975-2005 under RCP 8.5. This map shows statistically downscaled global climate models averaged together, for this time frame and scenario. NASA Earth Exchange Global Daily Downscaled Projections statistically downscales climate model outputs to a ~25 kilometer resolution (see full details here) White areas are excluded because they lack potential for significant economic activity.
This new report, Demystifying Climate Scenario Analysis for Financial Stakeholders, explores which physical impacts are already locked in, identifies how Representative Concentration Pathway (RCP) scenarios apply, and describes an approach to setting up scenario analysis for near-term physical climate risks. Scenario analysis is often approached from the perspective of transition risk, where policy developments and greenhouse gas (GHG) emission targets are the key drivers of risk pathways over the near-term, in the next 10 to 30 years. Physical risk, however, requires a different approach. Impacts over the coming decades are largely locked in, making the emissions scenarios less relevant. Unlike transition risk, GHG emission pathways play a minimal role in the behavior of the near-term climate and GHG emission pathways only begin to meaningfully influence global temperatures near mid-century. The uncertainty in physical climate risks in the near-term is driven by uncertainty in physical processes, rather than in policy decisions.
For organizations looking to construct physical climate risk scenarios for risk management and strategy purposes, it is critical to understand the scientific phenomena driving our plausible climate futures. This report outlines an approach called percentile-based analysis, which allows users to explore the range of potential outcomes based on climate model outputs within a single RCP. This offers a flexible, data-driven approach, suitable for portfolio-level screenings, reporting, and in some cases, direct engagement with asset managers.
Quantifying climate risks under different scenarios is a key element in understanding how physical climate risks pose financial risks.
Scenario analysis is often approached from the perspective of transition risk, where policy developments and greenhouse gas emission targets are the key drivers of risk pathways in the next 10 to 30 years. However, physical climate impacts over the coming decades are largely locked in, so physical risk requires a different approach.
Even if we stopped emitting carbon dioxide tomorrow, many physical climate impacts, such as increasing temperatures, more severe droughts, and rising sea levels, would already be locked in because of the time carbon dioxide stays in the atmosphere and the time it takes the atmosphere to respond.
The uncertainty in how physical climate risks may manifest in the next few decades is driven by model uncertainty, which should therefore be the focus of scenario analysis for physical climate risks in the near-term.
Percentile-based analysis offers a flexible, data-driven approach, suitable for portfolio-level screenings, reporting, and in some cases, direct engagement with asset managers.
OCTOBER 23, 2019 – BERKELEY, CA – Four Twenty Seven announces opening of Tokyo office and hires senior country representative.
Four Twenty Seven, an affiliate of Moody’s and the leading publisher of climate data for financial markets, is pleased to announce the opening of its office in Tokyo, Japan. Four Twenty Seven’s Tokyo office opens as investors and businesses in Japan and across the Asia-Pacific region face increasing market pressure to assess and disclose the risks physical climate hazards pose to their investments.
In conjunction with the opening of its office in Tokyo, Four Twenty Seven is also pleased to announce that Toshi Matsumae will serve as its Director of Japan. Toshi brings 30 years of experience leading financial services organizations in Japan. He leverages this expertise to lead Four Twenty Seven’s effort to provide climate risk screening to investors, asset managers, banks and corporations striving to understand their risk to physical climate hazards throughout Japan.
“We’ve seen growing demand from Japanese markets over the past year for transparency around exposure to physical climate risks in corporate assets, investment portfolios and in credit portfolios,” says Emilie Mazzacurati, Four Twenty Seven’s Founder and CEO. “Four Twenty Seven’s on-the-ground presence in Japan will allow us to bring asset-level risk data to support this demand and inform global resilience-building.”
“The opening of Four Twenty Seven’s Tokyo office comes at a time when the financial sector is calling for better integration of forward-looking climate data into decision-making,” says Toshi Matsumae, Four Twenty Seven’s Director of Japan. “I look forward to working with investors and businesses throughout Asia to better understand and serve the needs of this evolving market.”
Four Twenty Seven's monthly newsletter highlights recent developments on climate risk and resilience. This month we feature factsheets on regulatory action for financial climate risk, news from Four Twenty Seven and an update on the latest extreme heat.
In Focus: Financial Regulators Take on Climate Risk
Factsheets: Financial Climate Risk Regulation - What You Need To Know
Our new series, Financial Climate Risk Regulation, provides a summary of key recent and upcoming regulatory actions related to climate risk. From the European Union's directive on disclosure and the Bank of England's insurance stress tests, to France's surveys of its insurance and banking markets and the consultations of the European Supervisory Authorities around integrating sustainability into oversight requirements, regulators are moving quickly on climate risk with global implications for financial actors.
Staying up-to-date on these developments will provide early indications of regulatory action to come and give insight into potential rippling market impacts. Four Twenty Seven's factsheets on regulatory developments in the European Union, France and the United Kingdom, summarize each nation's stance on the financial risk of climate change, outline key actions and highlight upcoming dates to remember.
"This is a Big Deal" - Media Coverage of Four Twenty Seven's Acquisition by Moody's
“This means the old paradigm of discussing climate change as part of so-called ESG (Environmental, Social and Governance) risks is inappropriate. The risks are increasingly physical and specific – the heat waves, the tsunamis, phenomena like the effect on Germany’s economy of two consecutive years’ low water in the Rhine. Models need to be adapted to them, new hedging opportunities created and ratings adjusted. It’s not a matter of fashion or reputation management but of basics like sales, cash flow and profit. Moody’s acquisition is a sign that the financial industry is beginning to take this on board," Leonid Bershidsky writes in a Bloomberg op-ed.
"Moody’s Corporation has purchased a controlling stake in a firm that measures the physical risks of climate change, the latest indication that global warming can threaten the creditworthiness of governments and companies around the world." The New York Times' Christopher Flavelle writes.
Four Twenty Seven welcomes Lisa Stanton as our Chief Revenue Officer. Lisa oversees sales, client support, marketing and professional services globally. She brings over 25 years of experience in sales and client services for data analytics and investment products in the financial sector.
Previously, Lisa spent twelve years with Barra, Inc. leading their client service, sales, consulting and partner relationships globally. She has also led investment strategy and client relationship teams for Blackrock, AXA Rosenberg and, most recently, Grantham, Mayo, Van Otterloo, Inc., working with many of the world's leading institutional investors.
Four Twenty Seven Wins Wealth & Finance Award
Wealth & Finance Magazine recognized Four Twenty Sevenwith a Best in Climate-Related Economic Risk Reporting award. For six years the Alternative Investment Awards have acknowledged firms and individuals that positively shape the industry’s growth. “Historically considered an undervalued industry, the alternative investment has grown over the past few years. Behind this prominent growth and success, are the leading lights whose innovation, dedication and inventive ways has delivered some award-worthy results,” Wealth & Finance writes.
Sept 10 - 12 – PRI in Person 2019, Paris, France: Stop by the Four Twenty Seven booth to meet with Chief Development Officer, Frank Freitas, Chief Revenue Officer, Lisa Stanton, Director Europe, Nathalie Borgeaud and other members of the team.
July 29, 2019 – 427 FACTSHEET. Regulation on climate risk in Europe is likely to have a rippling effect across markets globally. There has been key legislation in the past few months, with more action on the agenda. Staying up-to-date on these developments will provide early indications of regulatory action to come. This factsheet on regulatory developments in the EU provides key background to the EU’s sustainable finance agenda, outlines key actions and highlights upcoming dates to remember.
Since establishing the High-Level Expert Group on Sustainable Finance (HLEG) in 2016, the European Union (EU) has positioned itself as a leader in sustainable finance. It has made rapid progress on integrating climate change into its financial sector, simultaneously addressing it from several angles, including risk disclosure, green bond labels, a taxonomy for adaptation and mitigation, and risk management oversight directives. As global financial actors operate, and are regulated, in Europe, EU regulations are likely to propel a development in best practices for addressing climate risk that reaches beyond the EU. Likewise, regulators and financial actors across the world are watching carefully as EU regulation may influence their own action. This factsheet, Financial Climate Risk Regulation in the European Union, summarizes the EU’s stance on the financial risk of climate change, notes key regulatory players and highlights recent and upcoming regulatory action applicable to financial markets.
The EC completed several milestones from its Action Plan in June 2019, including publishing updated nonbinding guidelines for incorporating climate risk into the non-financial reporting directive and releasing the Technical Expert Group report on a taxonomy for activities that contribute to climate adaptation and mitigation.
In April 2019, the European Parliament and Council agreed on text for regulation on disclosures relating to sustainability risks and investments, explicitly stating that climate change demands urgent action.
The European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority have provided technical advice on proposed changes to oversight requirements, suggesting that sustainability be explicitly integrated into risk management, operations, investment strategies and governance.
The European Banking Authority will spend two years assessing environmental, social and governance risks and their management in the banking sector. The assessment will be used to develop a draft amendment requiring “large institutions” to disclose their risk and the disclosures will be required three years after the regulation is implemented.
July 29, 2019 – 427 FACTSHEET. In 2015 France laid the groundwork for legislating climate risk disclosure with Article 173 of its Energy Transition Law, mandating that publicly traded companies and asset managers report on their physical and transition risks from climate change. Building on its track record as an early mover, France’s financial regulators are now actively involved in national and international endeavors to frame climate risk as a financial risk and determine the most effective response. Staying up-to-date on these developments will provide early indications of regulatory action to come. This factsheet on regulatory developments in France provides background on France’s sustainable finance agenda, outlines key actions and highlights upcoming dates to remember.
France’s Art. 173 helped build support for the Taskforceon Climate-related Financial Disclosures recommendations, prompted firms to begin disclosing climate-related risks early and set an example for other nations considering regulation on climate risk disclosure. Since this landmark legislation, French financial regulators have become engaged on addressing financial risks from climate change and the Banque de France was a co-founder and provides the Secretariat for the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), which is focused on propelling the transition to a low-carbon and sustainable economy. By providing the Secretariat for the NGSF, the Banque de France identifies itself as a key player in international efforts to address climate risk. This factsheet, Financial Climate Risk Regulation in France, summarizes France’s stance on the financial risk of climate change, notes key regulatory players and highlights recent and upcoming regulatory action applicable to financial markets.
Banque de France was the first central bank to release an assessment of its climate risks in line with the TCFD and Art. 173, aiming to set an example of best practice for the French financial sector.
ACPR’s fall 2018 survey of the French insurance sector found that disclosures in Art. 173 reports varied between firms and lacked reporting on long-term climate strategies and yearly progress. ACPR made suggestions for insurers to improve their climate risk management based on this review.
In summer 2018, ACPR surveyed its banking sector on banks’ climate risk management, identifying “advanced institutions,” larger banks with ample resources that have integrated climate into risk management, and “wait-and-see” institutions, which are largely domestic, retail-oriented banks still focused on a corporate responsibility approach to climate change.
France’s stock market regulator, AMF, released a report asserting that climate change has been identified as a financial risk, it is still not sufficiently assessed by the market, and the regulator’s role is to inform and raise awareness on the topic.
We’re excited to announce that Four Twenty Seven has received a majority investment from Moody’s Corporation. The acquisition bolsters Four Twenty Seven’s mission to help investors and corporations integrate climate change risk into investment decisions.
Four Twenty Seven will continue to be headquartered in Berkeley, CA, operating under its existing brand, and will be an affiliate of Moody’s Investors Service.
“Four Twenty Seven’s climate risk analytics, combined with Moody’s global coverage and extensive analytical capabilities, provides an ideal path to help market participants integrate climate impacts into risk management and investment decisions,” said Emilie Mazzacurati, Founder and CEO of Four Twenty Seven.
Four Twenty Seven scores physical risks associated with climate-related factors and other environmental issues, including heat stress, water stress, extreme precipitation, hurricane and typhoons and sea level rise. Its scores and portfolio analytics feature extensive global coverage and quantify climate risk exposures across asset classes, with detailed data covering over 2,000 listed companies, one million global corporate facilities, 320 REITs, 3,000 US counties, and 196 countries. Four Twenty Seven’s data and indicators are used by asset owners, asset managers, banks, corporations and government agencies to understand and evaluate the potential climate risk they hold in their portfolios and activities.
The addition of Four Twenty Seven enhances Moody’s growing portfolio of risk assessment capabilities and underscores the company’s work to advance global standards for assessing environmental and climate risk factors. Four Twenty Seven will also strengthen Moody’s growing thought leadership and research on incorporating climate risk into economic modeling and credit ratings. The deal complements Moody’s recent acquisition of Vigeo Eiris, a leading provider of ESG research, data, and assessments.
“Four Twenty Seven has built a strong platform for quantifying climate-related exposures and producing actionable risk metrics, which are essential to understanding and informing climate risk and resilience measures,” said Myriam Durand, Global Head of Assessments at Moody’s Investors Service. “Moody’s is committed to offering global, transparent standards for assessing environmental risk, and the acquisition of Four Twenty Seven advances our objective of integrating climate analytics into our offerings.”
About Four Twenty Seven
Four Twenty Seven (427mt.com) is the leading provider of market intelligence on the impacts of climate change for financial markets. We tackle physical risk from the ground up 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.
Four Twenty Seven’s ever-growing database includes over one million corporate sites and covers over 2000 publicly-traded companies. Four Twenty Seven also produces climate risk scores for Real Estate Investment Trusts, U.S. Munis and Sovereigns. We offer data products and software solutions to access these unique data offerings, as well as reporting services, scenario analysis and real asset portfolio risk assessments .
Four Twenty Seven has won multiple award for its innovative work on climate risk and resilience and our work has been featured by Bloomberg, Reuters, NPR and the Financial Times. Four Twenty Seven was founded in 2012 and is headquartered in Berkeley, California with offices in Washington, DC, Paris, France, and soon, Tokyo, Japan
JULY 8, 2019 – LONDON, UK – Four Twenty Seven receives Wealth & Finance Magazine’s Alternative Investment Award for Best in Climate-Related Economic Risk Reporting 2019.
Wealth & Finance Magazine recognized Four Twenty Seven among the winners of their 2019 Alternative Investment Awards. For six years these awards have acknowledged firms and individuals that positively shape the industry’s growth. “Historically considered an undervalued industry, the alternative investment has grown over the past few years. Behind this prominent growth and success, are the leading lights whose innovation, dedication and inventive ways has delivered some award-worthy results,” Wealth & Finance writes.
The Best in Climate-Related Economic Risk Reporting award highlights Four Twenty Seven’s climate risk scores for listed instruments and on-demand scoring of real assets, that assess financial firm’s exposure to physical climate risk and inform risk reporting. Our analysis leverages best-in-class climate data at the most granular level and scores assets on their exposure to physical climate impacts based on their precise geographic location. Investors use this data to drive investment strategies, forward-looking risk management and TCFD/risk disclosures.
Four Twenty Seven's monthly newsletter highlights recent developments on climate risk and resilience. This month we feature developments in scenario analysis for physical risks, highlight the European Union's guidance on climate risk disclosure and share the latest on financial climate risk and the need for resilience.
In Focus: Scenario Analysis for Physical Risk
Bank of England Publishes First Climate Risk Stress Test
The guidance lays out potential impacts by providing sector-specific percentages of potential loss under three scenarios by sector and by region. These quantitative financial impact assumptions are not a projection but a starting point for the insurance industry to explore potential impacts of climate change on their portfolios.
The Bank of England leveraged Four Twenty Seven's analytics on climate risk exposure in equity and real estate markets to inform its assumptions about which sectors will experience the largest impacts. We explain how data on risk exposure in equities can be leveraged for this type of analysis in our new blog series on scenario analysis.
Blog Series: Scenario Analysis for Physical Climate Risk
Our new blog series provides our reflections on how corporations and financial institutions can integrate physical climate risk into scenario analysis. Scenario analysis for physical risk is fundamentally different from transition risk. Corporations and investors increasingly recognize the need to integrate physical risk into scenario analysis but are looking for guidance and best practices on how to proceed.
Our first blog focuses on the foundations, demonstrating how characteristics of climate science affect how climate data can be used to inform scenario analysis. We argue that because physical risks over the next 10-20 years are largely independent from policy decisions and emission pathways, investors would be better served by scenario analysis that focuses on the inherent uncertainty of projected impacts, independent from assumptions on GHG emission scenarios.
The next blog focuses on Equity Markets, with concrete examples of how available data can inform financial stakeholders ready to start putting scenario analysis into action. We look at data on climate risk exposure by sector to explore how climate risk analytics can inform early developments of stress test assumptions, as done by the Bank of England.
The EU also released the Technical Expert Group (TEG) report on a taxonomy for activities that contribute to climate adaptation and mitigation. The taxonomy aims to help investors and policymakers understand which economic activities contribute to the transition to a low-carbon economy, through both mitigation and resilience. It outlines qualitative screening criteria to identify adaptation of economic activities and adaptation by economic activities, providing activity-specific examples for a range of sectors. The proposed taxonomy is still under legislative review.
Second TCFD Status Report
While more firms are releasing TCFD disclosures, investors call for an increase in informative disclosure of the financial impact of climate risks. The Task Force on Climate-related Financial Disclosures (TCFD) released its second progress report earlier this month, emphasizing that the quality of risk disclosures must continue to improve as firms build their understanding and capacity to address climate risks. 91% of surveyed firms said they plan to at least partially implement the TCFD recommendations, but only 67% plan to complete implementation within the next three years. This progress must be accompanied by continued knowledge sharing and research on financial risk pathways for climate impacts, meaningful exposure data and best practices for reporting.
Even as TCFD reporting increases, quantitative assessment of physical risk exposure lags behind. Explore physical climate risk reporting by French firms in our analysis of physical risk in Article 173 reports and stay tuned for Four Twenty Seven's forthcoming analysis on physical risk disclosure in TCFD reports.
Catastrophic Midwest Flooding Has Rippling Impacts
At the end of May only 58% and 29% of the U.S. corn and soy crops had been planted respectively. After persistent flooding beginning in Mid-March, inundated fields delayed planting. This means that some farmers will miss the planting window, which closes in June due to the heat and dryness of later summer months.
Those crops that do get planted will have to overcome soggy soil conditions and will remain at the peril of the summer's weather. It's already clear that this will be a below average crop yield, which translates into more expensive corn in cattle feed and higher prices in grocery stores.
From floods and heat waves to fires and hurricanes, federal recovery efforts for extreme events have cost almost half a trillion dollars since 2005. As disasters become more common and costs increase, there is an urgent need to invest in resilience proactively rather than spending billions on recovery. Last fall's Disaster Recovery Reform Act made an
"There is a silver lining to our climate challenges — economic growth. Americans are very good at innovating and building and we can leverage our need to be more resilient by growing the economy with good resilient and sustainable jobs," Sawislak wrote.
Join the Four Twenty Seven team at these events:
June 19 – Columbia University and PRI Private Round Table, New York, NY: Founder & CEO, Emilie Mazzacurati, will discuss scenario analysis for physical climate risk at this workshop.
In this second installment of our blog series of scenario analysis, we focus on how investors can start exploring impacts on portfolios of listed equities/fixed income with existing climate risk analytics. The series provides our current reflections on how corporations and financial institutions can integrate physical climate risk into scenario analysis. The first installment, on foundations, focuses on important characteristics of climate science that affect how climate data can be used to inform scenario analysis for economic and financial risk. A forthcoming post will discuss scenario analysis at the asset level for real asset investments and corporate facilities.
Scenario Analysis Serves Different Purposes
Scenario analysis serves different purposes for real asset investors and for equity or fixed income investors. When looking at a single real asset, scenario analysis can be used to inform very concrete decisions regarding the asset, working directly with the asset operator: whether and what flood protections to put in place, insurance requirements, anticipated impacts on operational costs from water and energy consumption, etc.
In contrast, for an equity or fixed income portfolio, investors’ influence on the resilience of the underlying asset (e.g. a corporation or a sovereign entity) is much more limited. In a previous publication we discussed the importance of shareholder engagement with corporations as a key channel for investors to help raise awareness of rising risks from climate change, and encourage companies to invest in responsible corporate adaptation measures. Investors, however, would be hard pressed to run scenario analysis on individual portfolio companies themselves, and disclosures from corporations on scenario analysis remain weak and fragmented.
Meanwhile, prudential authorities in Europe have been signalling expectations that insurers and banks perform scenario analysis on their portfolio to examine potential impacts of climate change, to understand how different climate-driven outcomes might prevent the insurers and lenders from meeting their financial obligations. Most recently, in April, the Bank of England Prudential Regulatory Authority (PRA) released a proposed set of specifications for scenario analysis that includes some simplified assumptions on climate impacts on financial portfolios.
In this piece we examine how available climate risk analytics can be leveraged to inform early attempts at developing stress test assumptions and simulate potential outcomes on investment portfolios aligned with the relative exposure of corporations by sectors and by regions.
Climate Risk Analytics for Equities/Fixed Income
We leverage our data on corporate physical risk exposure to determine what assumptions can be made in this type of early stress test. In this piece, we analyze the climate risk scores for 1730 of the largest companies in MSCI All Country World Index (ACWI). This physical risk assessment is based on the exposure of the underlying database of about a million facilities globally.
We score each company on three components of physical climate risk: Operations Risk, Supply Chain Risk and Market Risk.
A company’s Operations Risk is based on its facility-level exposure to hurricanes & typhoons, sea level rise, floods, extreme heat and water stress. The analysis also considers the sensitivity of different types of facilities. For example, manufacturing plants with their high energy demands are more sensitive to extreme heat than offices.
Supply Chain Risk is based on the risk in countries that export commodities that the company depends on and a company’s reliance on climate-sensitive resources such as water, land and energy, based on its industry.
Market Risk is based on where a company’s sales are generated and how its industry has historically been impacted by weather variability.
In line with considerations of relevant time horizons and of impacts being locked in over the climatic short term (detailed in Part 1), our standard equity risk score data considers projected climate impacts in the 2030-2040 time period under a single RCP scenario, RCP 8.5 (the worst case scenario, also known as business as usual), but leverages several climate models.
From Climate Hazard Exposure to Financial Impacts
Studies of how physical climate hazards translate into financial impacts at the company level are scarce. While a growing body of research explores the complex relationships between climate hazards and economic impacts, which vary by sector and by region, academic research on the relationship between climate events and corporate/stock performance, at scale, is still limited.Our approach focuses on leveraging what can be estimated in a robust, data-driven way: relative exposure of companies to climate hazards.
Our analysis of global corporations shows the relative exposure of industries to climate related risks across all three dimensions: operations risk, market risk and supply chain risk (Table 1). This table shows the sectors with the highest exposure, including manufacturing, infrastructure (utility, energy, transportation), and industries with high dependency on natural resources (food, apparel).
Table 1. Industries most exposed to physical climate risks . Source: Four Twenty Seven.
Services, not shown in the table, are not only less exposed, they’re also far less sensitive to changes in climatic conditions, with the exception of the financial sector, which holds the risk of all the other sectors in its investment, lending or insurance portfolios. Note that real estate is not included in this analysis, but data on regional exposure in that sector can be found in our white paper on climate risk in real estate.
These differentiated impacts by sectors can lay the foundations for a stress test, as industry risk levels can be used to set initial assumptions on sector-wide impacts. Following the example set out by the Bank of England’s PRA, for example, investors could assume that sectors with high exposure might see a 10% or 20% drop in value, whereas sectors with medium exposure would see half of that impact. These assumptions are not intended to substitute for financial impact modeling, but provide a shortcut to test how a portfolio might perform under climate-driven duress.
Drivers of Exposure to Physical Climate Risk
While some sectors overlap with those examined in scenario analysis exercises for transition risk, such as utilities and energy, other sectors with high exposure are not typically included in scenario analysis, like tech manufacturing or pharmaceuticals. Understanding the nuances of the risk pathways in each sector and their relative exposure to different hazards is critical to refining assumptions and developing models that can quantify value-at-risk by sector with some accuracy.
Manufacturing companies in the tech sector rely on complex value chains that can be interrupted by extreme weather events, particularly in Asia, which is a region highly exposed to typhoons and extreme precipitation. They also often produce expensive and water sensitive products using costly machinery and can incur costs and damages from extreme events on site. Pharmaceuticals are particularly exposed because of the prevalence of their manufacturing in water-stressed regions (India, California) and regions highly exposed to hurricanes & typhoons. For example, damaged manufacturing sites in Puerto Rico had rippling impacts on pharmaceutical operations globally during Hurricane Maria in 2017. Pharmaceuticals is also one of the groups with the most weight in the MSCI ACWI, making this exposure particularly significant (Fig 2).
Figure 2. The average company risk score by GICS Industry Group, with Operations Risk on the y-axis and Market & Supply Chain Risk on the x-axis. Red represents those industries with the highest exposure, green represents those with the lowest exposure and the size of the bubble signifies an industry’s weight in the MSCI ACWI. Source: Four Twenty Seven.
In the utility sector, the nature of the exposure is very different from that observed in transition risk analysis: carbon neutral power generation can be as exposed as thermal generation – for example due to water stress or floods for hydro facilities. In addition, utilities rely on expensive equipment, such as cables, poles, fuel storage and pipes that are often exposed to severe weather and sensitive to extreme conditions. Their operations are also resource-intensive, relying heavily on energy and water for cooling. They can experience operations disruptions during peak energy demands or due to equipment damage during storms.
The exposure of the automobiles & components sector has been illustrated by recent flooding in Japan. Automobile companies rely on manufacturing processes and machinery that can be interrupted due to flooding or hurricane damage, but their reliance on employee labor also makes these companies vulnerable to the wider regional impacts of extreme events. For example, during Japan’s extreme flooding in July 2018, Mazda was forced to halt operations at some of its facilities that were not physically damaged themselves, because its employees could not travel safely to work.
Climate change calls for a better understanding of impacts of physical hazards on financial markets, which remains a topic largely unexplored. Yet as regulators push insurers and banks towards the integration of climate scenarios into stress testing, robust, data-driven views on the relative exposure of sectors or regions provide a helpful foundation from which to explore the potential impacts on equity and fixed income portfolios.
Over time, better data will become available as academic and industry providers develop models that capture the nuances of climate impacts on different industries and geographies, but also as companies make a concerted effort to disclose better data on their past and anticipated financial exposure to extreme weather and climate-related events.
Four Twenty Seven’s data products and portfolio analytics support risk reporting and enable investors and businesses to understand their exposure to physical climate risks across asset classes.
The TCFD Status Report published early June 2019 reiterates the need for corporations and financial institutions to perform scenario analysis in a context of uncertainty over climate risk. It notes that while about 56% of companies use scenario analysis, only 33% perform scenario analysis for physical risk. Even fewer firms (43% of those using scenario analysis) disclose their assumptions and findings. The report contains useful case studies, but most focus on transition risk.
Yet a growing number of corporations and financial institutions recognize the need to integrate physical risk into scenario analysis and to develop resilience strategies that address imminent challenges from climate impacts. For example, the most recent IPCC report illustrating the impact of 1.5˚C increase in global temperatures on mean temperatures, extreme temperatures, extreme precipitation and sea levels shows that there will be significant implications for economies even with a 1.5˚C increase in global temperatures. This is still a best case scenario compared to impacts of 2˚C or 2.5˚C warming.
Scenario analysis for physical risk is fundamentally different from transition risk in its challenges and assumptions. This blog series provides our current reflections on how corporations and financial institutions can integrate physical climate risk into scenario analysis. This first blog presents the Foundations, focusing on important characteristics of climate science that affect how climate data can be used to inform scenario analysis for economic and financial risk. The next blog focuses on Equity Markets, with concrete examples of how available data can inform financial stakeholders ready to start putting scenario analysis into action. A forthcoming post will discuss scenario analysis at the asset level for real asset investments and corporate facilities.
The Science: Uncertainties and Relevant Time Frames
Rapid developments in atmospheric and climate science over the past 30 years enable us to understand how these physical hazards will evolve over time due to climate change. Sophisticated global climate models project expected changes in key physical phenomena affected by greenhouse gas (GHG) concentration: heat, humidity, precipitation, ocean temperature, ocean acidification, etc. Like any other models, climate models have limitations in their accuracy and ability to correctly simulate complex and interrelated phenomena. However, it is worth noting that since 1973 models have been consistently successful in projecting within the range of warming that we have experienced in the past twenty years. More details on climate data and uncertainties from global climate models can be found in our report, Using Climate Data.
The Bad News: Impacts Are Locked In
Global climate models project different possible outcomes using scenarios called Representative Concentration Pathways (RCPs). RCP scenarios capture differing GHG emissions trajectories based on a representation of plausible global policy outcomes, without specifying the details of the underlying policies that could generate this outcome. These scenarios show that GHG emissions generated over the coming decades will influence the severity of impacts in the long-term, but also that we are already committed to some impacts through 2100 and beyond.
This is particularly noticeable over the “short term.” When looking at the next 10 to 20 years, projections for temperature and other physical hazards do not present significant differences under different emissions scenarios (Fig 1). This is due to the massive inertia of the Earth’s systems, and the life expectancy of the stock of greenhouse gases already in the atmosphere. To put it simply, significantly reducing GHG emissions is akin to applying the brakes on a rapidly moving truck. It won’t stop instantaneously. Even if we were to stop emitting GHG altogether, climate change would persist. In the words of the Intergovernmental Panel On Climate Change (IPCC), climate change “represents a substantial multi-century commitment created by the past, present, and future emissions of CO2.”
This is by no mean an invitation to give up on reducing GHG emissions. Quite the opposite. Emission reductions are critical to curbing long term impacts and avoiding irreversible effects to our environment (Fig. 2). But for organizations looking at climate data and scenario analysis for risk management and strategy, with a focus on the coming decade(s), this is a critical fact to understand.
Aside from RCP-driven scenarios, there is, of course, a broad range of possible increases in temperature (and other climate hazards) even when looking at the 2030-2040 time frame. These plausible differences are not so much policy-driven as science-driven, demonstrating the different possible responses from the Earth’s systems to the existing stock of GHG.
These differences have significant implications for businesses and investors. For example, a model of sea level rise developed in 2018 incorporates accelerated rates of melting and recent advancements in modelling ice-cliff dynamics to capture extreme risk of coastal flooding. The model shows the Atlantic rising by 1.2m (3.9ft) by 2060 on the Florida coastline, which would equate to widespread flooding of coastal properties with potential domino effects on real estate prices across the state (Fig 3). The ‘intermediate’ scenario, however, most often used for planning, predicts only a 55cm (1.8ft) rise in water levels. While reducing GHG emissions does reduce the risk of more extreme sea level rise millennia into the future, year after year, scientists find that the Antarctic is warming faster than anybody predicted, and there is increasing concern that the process of ice sheet melt may be too far advanced to be stopped.
Thus, performing scenario analysis where the key variable is GHG emission reduction targets may not be an accurate representation of the range of possible outcomes for the near future. Rather, looking at high and low warming projections across a large set of models to understand the range of potential outcomes (independent of the underlying RCP scenario) is a better way to understand potential risk. In other words, physical risks over the next 10-20 years are largely independent from policy decisions and emission pathways, and a rapid, orderly, effective transition to a low-carbon economy could still come with massive physical impacts as these processes are already under way, fueled by the past 150 years of GHG emissions.
The Worse News: Tipping Points
Another challenge is that climate scientists are not currently able to model certain possible impacts from climate change, commonly known as “tipping points.” Tipping points is a catch-all term for a wide range of phenomena that may accelerate feedbacks due to climate change, though the timing or probability of their manifestation is currently not well understood. The phenomena are known as tipping points because past a certain threshold, they may not be reversible, even with a dramatic reduction in GHG emissions. Tipping points of most concern to the scientific community are presented in this report from the Environmental Defense Fund.
Some tipping points catalyze “feedback loops” which can worsen and dramatically accelerate climate change beyond human control. Such is the case, for example, with melting ice sheets, which would not only lead to catastrophic sea level rise, but would also further heat up the planet as the poles’ albedo (reflectivity) is reduced after the ice disappears. Thawing permafrost could lead to massive amounts of methane, a particularly powerful GHG, to be released from the frozen tundra into the atmosphere (in addition to many direct impacts for local communities, infrastructure and ecosystems in the region).
Tipping points further reinforce uncertainty about severity and timing of these extreme impacts and the limitations of using RCP scenarios to understand the range of outcomes for physical risk.
These indirect or second-order hazards are as relevant as first-order impacts to understand the implications of physical climate change on economic outcomes, but they’re not captured by RCP scenarios and many require stand-alone models that cannot easily be integrated into one clean set of scenarios.
Scenario analysis is often approached from the perspective of transition risk, where policy developments and GHG emission targets are the key drivers of risk pathways over the next 10 to 30 years. Physical risk, however, requires a different approach. Impacts over the coming decades are largely locked-in and are only marginally influenced by GHG emission pathways. In contrast, uncertainty looms large regarding how severe these physical hazards will be, and exploring a range of possible outcomes for physical risk, including looking at tail-risks, provides important insights for risk management and financial analysis. In summary, the current state of scientific knowledge and the nature of the Earth’s atmospheric systems call for the developments of scenarios that are decoupled from transition/policy scenarios and instead focused on key scientific drivers of uncertainty and risks that may be experienced regardless of policy decisions over the short to medium term (2020-2040).
While efforts to develop easy-to-use tools for physical risk analysis are nascent, organizations can still extract important insights from climate data and leverage estimates of risk exposure across portfolios. Our next blog in this series provides examples of how financial institutions can leverage data on physical risk exposure in equities to inform some early scenario analysis in equity markets.
Four Twenty Seven’s data products and portfolio analytics support risk reporting and enable investors and businesses to understand their exposure to physical climate risks across asset classes.