Designing portfolios to cope with physical climate risk

Companies: Bank of England

People: Mark Carney, Michael Lewis

Partnered Content

What is physical climate risk?

It is the risk of financial loss as a result of climate change-driven weather events, such as flooding, drought, a rise in sea levels, hurricanes and wildfires. We look at the risks that investments face during those types of events.

Bank of England Governor Mark Carney gave a speech in September 2015 which developed risk classifications around climate change. These included physical climate risk as well as transition risk and liability risk. Transition risk is the risk to companies as they transition to a low-carbon economy as production methodologies, regulations and consumer tastes change. Liability risk is the risk of a company being sued because its products or services were contributing to climate change and so caused damage.

Why is it important to be aware of the physical climate risk in an investment portfolio?

I like to use the example of the 2011 floods around Bangkok – a large number of hard drive suppliers to the Korean electronics sector were flooded at this time. Some Korean electronics companies sourced their hard drives globally, while others sourced entirely from these regional Thai suppliers. The stock prices of the Thai-sourcing Korean electronics companies fell 30-35% because of the incredible production disruption, whereas the global companies saw their share prices rise 9-10% because they picked up market share from the regional companies. It's now possible to look at a climate event and link it directly to the relative performance of equities.

What kinds of risks are within the subset of physical climate risk?

The most important is operational risk – where are the production sites, are they vulnerable to climate events? Another important element is supply chain risk – where is that company getting its widgets from, and are those widgets coming from a region that is very vulnerable to climate change?

The third one is market risk – where are the company's customers? Certain segments of the economy can be hit hard when there are particular physical climate risks. There is also country risk – how well a country can bounce back after a climate-driven event?

How do you assess physical climate risk?

We work with Four Twenty Seven, a California-based market intelligence and research firm specialised on the economic risk of physical climate change. They supply us with information about companies, their production sites and supply chains, and the vulnerability of those elements to climate risk. Using this data, we can assess the specific company and sector risks when it comes to such things as droughts, hurricanes, seal level rise and flooding.

How are you helping investors manage physical climate risk?

We are creating passive equity indices based on companies' physical risk and transition risk scores. We then overweight companies that are more resilient and underweight those who are less resilient. We have done back-testing on this approach – such that when there are climate events, these portfolios should be more resilient.

We are also a part of Climate Action 100+, which is a five-year initiative led by investors that engages with large corporate greenhouse gas emitters to improve governance on climate change, curb emissions and strengthen climate-related financial disclosures.

In addition, we are chairing one of the working groups convened by the European Bank for Reconstruction and Development and the Global Centre of Excellence on Climate Adaption, which is looking at improving corporate disclosure of physical climate change risk to business models.

How will the measurement and management of physical climate risk evolve over the next decade?

Disclosure is important and it needs to improve. At the moment, investors and data climate specialists have to dig up the climate change risk information that companies are facing.

Central banks and regulatory authorities are an important driver of the debate because they are concerned about economic and financial stability. We will see more regulation – in Europe, governments are taking action to boost sustainable finance and greening the financial system.

Right now, we are the only asset manager incorporating physical climate risk metrics into investment products. I expect over the next five years the industry will become much more intelligent about physical climate risk and how it is priced.