3 steps to prepare your portfolio for climate change
The pressure is mounting for the finance sector to disclose climate-related risks.
Our Sustainable Investment Manager János Hidi breaks down how to understand, quantify and manage your portfolio’s risks, including the data insights that are needed for an effective risk assessment.
1 Understand your climate-related risks
Investors will need to have a clear picture of how the revenues and costs of firms, as well as the financial valuations of their assets, will be affected by climate related risks. This may vary largely by geography and sector, and by the strategic position and preparedness of individual companies.
Climate related risks can impact financial assets in many ways. There are two broad categories:
- Physical risk – directly threaten physical assets and value chains
- Transition risk – related to regulatory, legal, technological and market responses given to the physical threats
While the growing threats of chronic and acute physical risks may seem to be a problem only in the long-term, there are risk factors which will be material over the short term, too.
In the short term it is primarily the transition risks which are of a major concern. These transition risks largely depend on the answers we give to this climatic challenge and are exposed to potentially large swings in policy and market sentiment.
On a practical level, the understanding of companies’ exposure to climate related risks involves:
- The collection of data at a company level on GHG emissions
- Market exposure at a product or sectoral level
- An assessment of the potential stranded assets in their portfolios
2 Quantify and disclose climate-related risks
Once the exposure of each company is well understood, it needs to be quantified in a way that the exposure can be incorporated into regular risk analysis and asset valuations.
The best tool available is to perform informative climate stress tests.
Climate stress tests are based on well-designed and detailed macroeconomic climate scenarios. These tests should assess credit risks, market risks, liability risks, as well operational and liquidity risks.
Since there are many possible climate transition pathways ahead, the stress testing should be based on several climate scenarios, covering a wide range of regulatory interventions and technological advances.
Models used for climate scenario analysis must consider the fact that the economic pathways are path dependent, and that inertia and induced innovation are important characteristics of the energy systems, all of which must be reflected in the modelling of the transition.
Investors should keep in mind that this forward-looking method of climate scenario analysis should replace traditional risk management techniques.
Traditional approaches lack the right data to make good and sound projections when it comes to coordinating a successful climate stress test, because historical data do not reflect the climatic events that lie ahead.
Instead, a truly forward-looking methodology can quantify the impact of various regulatory, technological and market changes on the performance of economic sectors and regions.
3 Manage the climate-related risks
Once an organisation has understood the risks and opportunities it faces and have quantified its impact on its future revenues and cost, balance sheet and financial valuation, it needs to establish a process and organisational setup which will be able to manage this exposure.
The investment portfolios may need to be reallocated, or investors need to actively engage with the boards of companies currently in their portfolios to adjust their long-term strategies, making sure they are resilient to the physical and transition risks.
Organisations should avoid relying excessively on long-term sustainability goals and instead turn their attention to carrying out a short-term action plan.
Given the occurring market volatility, it is increasingly less likely that we will experience a smooth transition
Both climatic and economic research shows that delaying action will only increase the cost of the transition, because the delay not only risks the escalation of physical damages but can also lead to a disorderly response by regulators and the financial markets.
By taking steps such as the ones highlighted above, investors alongside following the TCFD guidance have the potential to contribute greatly to improve the pricing-in of climate related risks and opportunities into the current asset prices.
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