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Hurricanes, wildfires signal rising challenges to investment landscape

September 28, 2017
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With the world in flux amid rising concerns about hurricanes, flooding and wildfires, how will institutional investors rise to the challenges climate change presents? And what opportunities exist along the way?

Understanding physical risk

Climate change affects every industry worldwide, says Sanjay Wagle, managing director at the Lightsmith Group, an investment firm focused on environmental, social and governance issues. “Energy, agriculture, transportation, manufacturing, tourism, insurance, every sector of the economy. And there are already businesses addressing the needs of dealing with physical damage, risk, volatility and resource scarcity.”

Physical risk is twofold says, Karen Lockridge, a principal who deals with responsible investment at Mercer. It includes more acute, one-time events like flash floods, hurricanes and forest fires as well as slower changes like long droughts, fluctuations in seasonal temperatures and rises in sea levels.

Risk often varies according to location, she says, as certain regions can suffer more from similar events. “If there’s a natural disaster, it’s easier for developed markets or developed economies to respond and support their communities. Whereas in emerging markets, they may not have the resources to respond.”

When it comes the various sectors, natural disasters can hit retail and manufacturing particularly hard. Disruptions of supply chains and damage to factories can throw operations into turmoil, says Greg Lowe, global head of resilience and sustainability at Aon.

Global commodities are also at risk. During hurricane Harvey, for example, the market reaction to production cuts by oil refineries in the Gulf of Mexico area was instantaneous, says Sandy Fieldan, director of research, commodities and energy at Morningstar Inc. Prices for refined products like gasoline jumped, while crude prices sank as demand from the refineries fell.

Read: CPPIB commits equity to U.S. oil and gas acquisition company

Until recently, the United States imported far more of its crude oil needs, so it made sense for refineries to be on coastal locations, says Fieldan. Now, however, that density in a vulnerable area presents a problem as the cut from Houston-area refineries represented a significant chunk of total national production. And that concentration isn’t easy to change since setting up new refineries further inland is both costly and impractical and has potential to run into regulatory concerns.

“People do not want to have refineries in their backyard,” says Fieldan, adding that building new and large enough facilities in well-populated locations is “an almost insurmountable barrier.”

Such location-specific risks also exist for real estate, of course. “If you’re a [real estate investment trust] and you have a lot of property in expensive cities around the world, [climate risk is] certainly going to be something to pay attention to,” says Lowe.

While warmer weather could boost agriculture in some regions in the short term, there could be negative impacts as well. “Of more concern, we have increasing droughts or less water where there used to be water or more water in places than it can handle,” says Lockridge.

“Even the renewables sector itself can underperform as a result of weather volatility,” says Jay Koh, managing director of the Lightsmith Group. He cites a pattern that arose in early 2015. “Several wind farms in the western U.S. underperformed by up to 16 per cent, and they believe that was because of a wind drought: 30-year, record-low set of wind speeds.”

Regulatory and sentiment risk

So what are the implications for institutional investors? “Increasingly, we’re seeing investors clarify their point of view on climate change,” says Lockridge.

“We’re seeing increasing climate policy regulation, and this is of all types,” she adds. “It could be fuel-efficiency standards, carbon tax, renewable energy targets, phasing out of thermal coal mining or thermal coal plants.”

As a result, carbon assets and fossil fuel reserves are at risk of becoming uneconomical at some point, she notes. “So some investors are changing their portfolio to reduce the exposure,” she says, suggesting the most carbon-intensive sectors — energy, materials and utilities — could therefore find themselves on the chopping block.

Stricter carbon policies present less of a problem for investors than an unpredictable regulatory environment, says Lockridge, who emphasizes some of the key questions to consider. “What’s the business strategy for a particular company? Are they being proactive? Are they acknowledging climate change as an issue, acknowledging that they need to evolve their business strategy?”

Measuring risk

A company can’t be transparent with investors about risks it doesn’t measure, says Koh. But determining how to do that isn’t always easy.

Some tools, such as the Task Force on Climate-related Financial Disclosures, chaired by Michael Bloomberg, are emerging.

Read: Sustainable investing on cusp of a renaissance

As well, The Global Adaptation & Resilience Investment Working Group is creating an investor guide that aims to provide practical and simple options for addressing physical risks, says Koh. The group aims to show how investors with large portfolios can identify and act on climate risk.

“We think there’s a big trend towards this,” says Koh. “It’s a genuine financial risk: that underperformance or impairment of asset value. . . . So it’s a chance to assess that so you will start to hedge or retrofit or rebalance.”

Opportunities in resilience

Of the 20 market segments most closely linked to physical climate change risks, the value is “about $130 billion of current spending, current addressable market size,” says Wagle. “And they happen to be fast-growing market segments just organically.”

Koh offers an example. “There’s a major retrofit going on for the New York Subway system. They issued a several hundred million-dollar resilience bond after hurricane Sandy.”

Renewable energy solutions may seem like the obvious investment choice. But some investors may choose to wait before diving in since so much technology is still in development, says Lockridge.

“Certain investors, depending on their risk profile, might want to wait until, for example, battery storage is more evolved or it’s clear which technologies may take off at scale,” she says. “There’s no lack of solutions to invest in.”

On the flip side, some investors believe financial markets have a responsibility to back up their ideals by actively funding ecologically beneficial projects, she says. “I don’t mean they’re going to sacrifice returns to invest in some of these solutions. But they may work harder with these various partners,” to get projects off the ground, she adds.

It’s hard to predict which new technologies could be the next big thing in addressing climate change, says Lowe. “Manufacturing, 3D printing, machine learning, these are happening for all sorts of other reasons. But how might climate impacts change or accelerate the opportunities in that space?”

And in some cases, a company may not even have intended to profit from climate change resilience, says Wagle. “They’re just dealing with specific needs that their customers have. And you’re realizing this is part of a much bigger trend, where their services are just in much greater demand, because of climate change.”

Read: New PSP team aims to ‘integrate ESG’ in all investment decisions

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