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Are climate change risks quantifiable?

Of all ESG risks, climate change is the one destined to become a mainstream risk to investment, according to MSCI.
Polar bear global warming concept

Both regulators and institutional investors have started to explore ways of understanding whether climate change has an impact on investment portfolios, according to David Lunsford, executive director and head of climate policy and strategy for ESG research at MSCI.

Pension funds have become one the drivers of the initiative, given that they have the longest investment horizon of 25-30 years, he said during a recent webinar organised by the index provider.

For example, a group of global institutions and regulators established in 2015 the Task Force on Climate-Related Financial Disclosures, in a move to standardise climate change risk reporting, according to Lunsford. These include institutions from Asia-Pacific, such as China, Singapore, Malaysia and Japan.

While the initiative is driven by asset owners, asset managers would then have to follow. Lunsford explained that institutions will ask asset managers to tell them the metrics they use to account for climate change.

However, the problem lies in how to quantify climate change risk and in understanding the material impact it has on a particular company.

The process

Lunsford believes the risk can be quantified through historical data that managers can use in the investment process.

He said that MSCI has started to measure climate change risks by using data such as policy risks, technological opportunities (such as company patents that address ESG concerns) and physical risks, which include how a company’s physical operations are vulnerable.

Taking coastal flooding risk as an example, Lunsford explained that the first step is to determine whether a company has different facilities globally.

“What you do is you overlay risk data on a map. You can do it on a year-on-year basis and see if the weather in a particular location has changed over the last 20 years.

“What these climate models do is they take that change in the past and calculate the possibilities of the different changes in the future,” he said.

The next step is to determine how vulnerable a particular facility is in a particular location. Various factors are taken into consideration, including policy risks and the extent of how much revenue that facility contributes to the company.

In the case of coastal flooding, policy risks include whether the country has taken different steps to protect its coastline, Lunsford said.

“In Asia, for example, facilities in Thailand are vulnerable as they still need to spend more to cover most of their coastlines,” he said.

However, he noted that while there are a lot of facilities at risk in Thailand, the revenue they produce is not that significant.

Companies that have facilities in China are more vulnerable. Like in Thailand, the country needs more spending to protect the coastlines, but China operations tend to account for a large portion of a company’s revenue generation.

In a separate report, Lunsford said that globally, 62% of the MSCI ACWI Index constituents have at least one facility in a flood-prone area. Asia has the most coastal flooding exposure globally, with $2.25trn of revenue at risk between now and 2050.

In terms of integrating various ESG risks into the investment process, Lunsford believes that climate change risk is the “frontrunner.

“Asset owners and asset managers can make use of climate change risks to tilt their portfolios for downside risk protection,” Lunsford said.

MSCI is now exploring ways to cover other climate change risks, including wildfires and droughts, he added.

Part of the Mark Allen Group.