Climate Risk Assessment: What next?
We expect climate change to be a disruptive factor for the value and income generating potential of assets. The risk factors relate to regulation for reducing and decarbonising energy use as well as how asset values will hold up to natural events such as extreme weather. In addition, legal challenges to corporates for inaccurate or misleading climate disclosure are rising. This report sets out a framework to assess climate risk and provides investor strategies.
Climate analysis warrants focus: The rationale for taking climate into account in investment decision making is on the rise. The preparation for the Paris climate talks and the outcome itself established climate change as a topic on the global diplomatic and economic circuit. China and the US have partnered to ratify the Paris Agreement (see ‘Carbon giants join forces’, 5 September 2016) and China has used its presidency of the G20 to promote green finance. We expect Germany to continue with the green finance theme during its presidency, but also to push for stronger disclosure on climate risk from corporates and financial sector participants. We think investors will increasingly be pushed to demonstrate how their capital management strategies are aligned with supporting the transition to a low-carbon economy, rather than hindering it. The rationale for increased climate analysis is set out in Chapter 1.
Value preservation: The long-term nature and uncertainty around how the consequences of warmer temperatures will play out has historically hampered thinking on integrating climate factors into asset valuation. Based on our estimates however, the carbon budget for a 2°C world, which was the minimum goal agreed at the Paris talks, (i.e. ideally temperature rises will be less than that) runs out in 2040. Limiting temperature rises to 1.5°C means the budget expires by 2023 on current trends. We think it is important to establish expectations around future asset value resilience to the changing norms brought about by climate change – the HSBC Climate Risk Analysis Framework provides the toolkit to do this.
Establishing expectations around future asset value resilience to the changing norms brought about by climate change is difficult, but critical
Triple whammy: The risks associated with climate change come from moving to a low-carbon economic framework, adjusting to warmer temperatures and being accountable for action that is detrimental to the climate. These risks are inter-dependent, in the sense that the likelihood of one playing out changes the likelihood of the others. For instance, if the move to a low-carbon world happens quickly, the likelihood of disruption from changing weather norms will be reduced, but the risks related to the transition to a low-carbon world, like lower demand for high carbon goods and services, will be higher. If no changes are made to become more energy efficient and decarbonise energy supply, the risks in relation to transitioning to a low carbon economy are lower, but the risks related to the potential disruption potential later are higher. We look at types of climate risk in Chapter 2 from page 15.
A framework to analyse risk: Ultimately, our aim with this analysis is a framework mechanism that asset managers can use to better-assess the risks related to future asset values, income generation potential and returns in the face of uncertain responses to climate change. Figure 1 provides the big picture backdrop of the approach, which in our view comprises three steps:
- choosing an over-arching narrative with scenarios of how the future might look,
- identifying relevant metrics that provide a basis for monitoring what is happening,
- estimating what the intersection of scenarios and metrics means for climate risk in a portfolio
These three steps can be used at an economy-wide level, for sectors, or for individual stocks. We step through this process in Chapter 3 from page 21.
Figure 1: HSBC Climate Risk Analysis Framework
Investor preferences: We think investors can tailor the Climate Risk Analysis Framework for their own circumstances, such as beliefs on how the transition to a low-carbon economy will develop, as well as risk appetite and investment horizon in relation to their own specialist area. For instance, an index tracking fund manager might want to look at high-level, broad scenarios similar to the ones we set out from page 25. Alternatively a utilities analyst will probably want to assess a more specific future around how the demand for high carbon coal in power will evolve in the future. We set out climate risks in a sector context on page 34.
Investor strategies: In Chapter 4, on page 36, we map out an investor strategy for integrating climate change. In the past, climate discussion mainly centred on a high-level commentary of which sectors fit into ‘high-carbon’ and ‘low-carbon’ buckets. In addition, carbon foot printing (the measurement of how much CO2 is emitted by the company in the course of day to day operations) has been used as a tool to assess company willingness to understand and address operational climate factors. While still useful, this type of analysis is no longer enough to identify and endorse a climate based company differentiation in our view. As investors are put under more pressure to demonstrate their own climate credentials, we expect them to be asked to provide increasingly sophisticated rationale to defend portfolio holding decisions, particularly for energy and industrial sectors. We think a comprehensive climate strategy has three equally important considerations:
- Assessing the climate risk embedded in portfolio holdings (as set out by the HSBC Climate Risk Analysis Framework)
- Identifying climate solution providers (as set out by the HSBC Climate Solutions Framework)
- Differentiating between companies within sectors to assess the likely winners in the transition to a low-carbon economy by adopting a company engagement strategy
Figure 2: HSBC Climate Frameworks
In the accompanying report ‘HSBC Climate Solutions Framework’, 12 September 2016 we put forward a separate framework for identifying climate solutions. This is a comprehensive methodology that helps to screen and analyse global companies that focus on addressing, combating and developing solutions to mitigate and overcome the effects of climate change. The resulting database from that solutions framework lays out the investment opportunity set in the climate change space.
Investor engagement: Much of this type of climate analysis hasn’t been done before, and as such a lot of the information needed to differentiate between companies within a sector is not yet disclosed. We expect regulation and investor coalitions to provide the catalysts for more comprehensive climate reporting. As both climate risks and opportunities become more prevalent, and investors become more demanding, we expect a new phase in integrated climate analysis.