Supported by Impax Asset Management
Flooding, wildfires, massive storms, droughts — the physical effects of climate change are real, and getting worse. Beyond the human toll, these events also present large risks to companies’ operations and profits. That means these physical risks of climate change can have a big impact on the investment portfolios of asset owners that hold stock in those companies.
It can be hard to determine just how great that impact will be, and what to do about it. But things are starting to improve, as managers and investors pay increasing attention to the physical risks of climate change, or P-ROCC. They’re increasing pressure for companies to boost risk disclosure and figuring out the best way to use that information. These are necessary steps as climate change continues unabated.
“The physical risks from climate change are material, and they are material right now,” says Phil Duffy, executive director of the Woodwell Climate Research Center, which works with asset owners and managers to help assess companies’ P-ROCC risk.
There are several ways these material risks manifest themselves. Real estate is one obvious example: flooding, wildfires, and storms can damage or destroy a company’s factories, offices or investment properties. Physical risks can also disrupt supply chains, which can also hit a company’s profits.
These risks aren’t just theoretical. A severe drought in Taiwan earlier this year caused production challenges for water-reliant semiconductor manufacturers, adding to the global chip shortage. And in 2017, Hewlett Packard Enterprise announced it would relocate its Houston offices, and move its manufacturing out of the city entirely, after two straight years of unprecedented flooding kept disrupting their operations.
Despite these examples, P-ROCC has largely lagged behind other risks in the minds of asset owners and managers.
“At the moment, there is little evidence that physical risk is being priced in capital markets, except possibly in special circumstances like CAT bonds,” says Julie Gorte, Senior VP for Sustainable Investing at Impax Asset Management. “In part, this is because we often don’t have sufficient or sufficiently precise information from companies to price it properly.”
Similar words come from Duffy. “This is relatively new territory for a lot of investors,” he said at CleantechIQ’s virtual climate workshop in June. It’s important to develop ways to properly attach a price to those physical risks, “Which we think the market hasn’t really priced, or at least not priced adequately so far.”
Investors and Managers Need More Disclosure
Adequate pricing needs a full understanding of those physical risks. “Any effort to understand physical risk begins with an assessment of what hazards companies are exposed to, at any operating location worldwide,” Gorte says. A good P-ROCC model can assign probabilities to these events for any location in the world, which an investor can then use when making investment decisions.
It’s not easy though. “There are some significant challenges at all stages of the process,” says Alex Bernhardt, global head of sustainability research at BNP Paribas Asset Management. Those include the complexities involved in hazard evaluation, difficulties in collecting relevant risk exposure data, and uncertainties around the results of the analysis.
The data collection remains the primary challenge for now. “At the moment, it’s rare to find a company that provides enough information to do it accurately,” Gorte says.
A key part of that problem is that most companies don’t disclose all their physical sites, or the location of their infrastructure, or the key nodes in their supply chains, fully enough to be able to figure out what sites are at risk for those various stress events.
Investors also need companies to tell them their plans to adapt or mitigate those physical risks. “There are very few companies that provide that kind of reporting now,” Gorte says. Those that do usually do so using the TCFD framework, which encourages the use of scenario analysis for both physical and transitional climate risks. The annual CDP survey asks for “a bit of physical risk reporting” but doesn’t call for scenario analysis, she adds.
Information is more available than it used to be. “There are now a number of investment and insurance industry initiatives, and data vendors focused on better analyzing physical risk,” Bernhardt says. Such firms include Jupiter Intelligence and Moody’s Four Twenty Seven.
But gaps remain. Some asset owners and managers are working to fill those gaps, by lobbying regulators, pressuring companies, and otherwise working to expand the use of P-ROCC.
For example, Wellington Management has worked with Woodwell since 2018 “to analyze and better understand how and where climate change may impact global capital markets,” says Chris Goolgasian, the firm’s director of climate research. The goal is to “identify climate related risks and opportunities and to incorporate them in portfolios that we manage on behalf of our clients.”
Separately, Wellington works with asset owners like CalPERS and the Ontario Teachers’ Pension Plan to incorporate Woodwell’s research into those pensions’ portfolios.
The P-ROCC Framework
Wellington and CalPERS have also developed a tool, the P-ROCC Framework, to help companies to disclose their exposure to P-ROCC. Among the goals, Goolgasian says, is to help a company “better relay information to capital providers, investors, markets, and regulators,” as well as to “assure investors that it takes these risks seriously.”
The framework “describes five categories of potential risk to a company from physical climate change: demand, expenditures, logistics, talent and acquisition,” CalPERS documents state.
Earlier this year, Wellington released an updated version of the framework; it now encourages companies to “disclose the physical location of assets and operations to help investors better assess climate risks.” Goolgasian says. “We ask that companies disclose a complete list of addresses of all owned, leased, or otherwise operated physical assets in a publicly accessible format.”
Because that level of granular detail is crucial to properly identifying physical risks, and properly pricing securities based on those risks, it’s clearly going to be a focus going forward.
Pressure for more physical risk disclosure is coming at companies from all angles. “Government entities, including regulators and central banks, as well as capital market participants, are seeking increased climate-risk disclosure,” Goolgasian says.
That includes the Securities and Exchange Commission, which is expected to decide on mandatory climate risk disclosures by year-end. Managers like Impax are lobbying the agency to include P-ROCC in those regulations.
Pensions are applying similar pressure, including officials from CalPERS and New York State Common Retirement Fund. “This information would allow investors to understand which companies have supply chains and critical assets in geographies expected to experience increased frequency of severe weather events due to climate change and position portfolios accordingly,” CalPERS CEO Marcie Frost wrote the SEC in June.
New York Common and Impax also asked member companies of the S&P 500 to provide that kind of reporting voluntarily. The results have been less than overwhelming: “So far, we’ve talked to or heard back from about 13% of the companies in that index,” Gorte says, “and we have found exactly three that have really thought through physical risk.”
Regulations aside, pensions are taking their own steps. For example, Dutch pension APG has reportedly hired a meteorologist to increase its understanding of P-ROCC.
Corporate disclosure is nearly certain to improve. “This is being driven in part by recent experiences [like this summer’s heat domes] which are demonstrating that climate change is happening now,” Bernhardt says.
Goolgasian says: “Disclosure is likely to improve over time, as more companies aim to comply with emerging global regulations or voluntarily present climate-related data and assessments in support of existing frameworks.”
The pressure from investors is not going to ease up. “We are seeing broad and rising interest in understanding and addressing both physical and transition risks and opportunities,” Goolgasian adds. “Asset owners, especially those with long investment horizons, are likely to require additional transparency on companies’ physical locations, enabling them to better evaluate the potential impact of longer-term climate risks on their investments.”
Bernhardt agrees. Spatial finance — the integration of geospatial data into financial analysis — “represents the next major frontier for the sustainable finance industry.,” says. “Going forward, understanding these dimensions will only grow in importance.”