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In Ernest Hemingway’s novel The Sun Also Rises, one character asks another how he went bankrupt. The second character replies, “Two ways. Gradually, then suddenly.” This is how climate change may affect capital markets, eventually reaching a tipping point that could move asset prices quickly, and in big ways.
Two types of climate risk
One category of climate-related risk is physical: Coastal flooding, wildfires, droughts, and rising sea levels are a few examples. The other category is transition risk, which refers to policy action, regulatory changes, technological disruption, social pressure, and litigation. These two forms of risk are related: As the physical consequences of climate change become more frequent, severe, and costly, additional policy, regulation, lawsuits, and technological innovation follow.
In our team’s research, we examine both types of climate risk. While transition risks are trickier to quantify and discount because of human elements such as political will and social acceptance, we believe these risks will affect asset prices sooner than physical risks will. A growing number of central banks, governments, and stock exchanges recommend, require, or are planning to require proof of regulatory compliance and/or expanded climate disclosures, such as the recommendations from the Task Force on Climate-related Financial Disclosures (TCFD). Since, more than 1,000 legislative and executive orders have been enacted globally.1
An investment-horizon mismatch
The near-term risks associated with the rapidly shifting regulatory environment present a time-horizon mismatch for asset owners with long-lived assets. This misalignment is forcing conversations about how asset managers invest with long-term value in mind. Asset owners and asset managers will want to ensure that their investment portfolios are prepared for structural changes caused by climate change, and will likely do so by pressuring companies to think strategically about climate in the context of their capital allocation. We believe this domino effect could move asset prices long before the worst physical effects of climate change are felt.
Examples of recent regulation and policies
- The European Union’s (EU’s) far-reaching Sustainable Finance Action Plan, launched in 2018, has climate as a top priority, inclusive of climate-risk-assessment requirements.
- In the US, a California law requires the state’s largest pensions to start reporting in 2020 and every three years thereafter on climate-related financial risks in their public-market portfolios, on their alignment with the Paris Agreement and state climate goals, and on their engagement with carbon-intensive companies.
- China’s Ministry of Environmental Protection and the Securities Regulatory Commission will require listed companies to disclose environmental information, including climate risks, by 2020.
- The Hong Kong Securities and Futures Commission (SFC) announced a framework aimed at enhancing companies’ environmental disclosures, with an emphasis on climate-related risks and opportunities. The SFC will also encourage asset managers to clarify how they factor environmental criteria into their investment processes and risk assessments.
Engaging with companies on climate risks
Wellington’s investment professionals, working closely with our Environmental, Social, and Corporate Governance (ESG) Research Team, have been engaging with companies for many years. While we work to extend our knowledge of climate science and the many economic consequences of climate change, we continually encourage companies to think long term about improving their climate resilience. We have begun to develop insights into which assets may be most negatively or positively affected, how soon, and to what degree. While we have much more work to do to arrive at these answers for our clients, we have reason to believe that the effects of climate change may show up in asset prices sooner than many people may think, in large part because of the shifting policy and regulatory landscape.
We believe climate risk — and resultant asset repricing — will become top-of-mind issues for investors along the lines of central bank actions, trade policy, or geopolitical tensions. As we know from other market cycles, including the lead-up to the global financial crisis, “gradually, then suddenly” is often how markets respond to existential change, and this is how we see a wide variety of asset prices responding to the growing risks associated with a changing climate.
1Climate Change Laws of the World database, 2018; Grantham Research Institute on Climate Change and the Environment; Sabin Center for Climate Change Law.