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Rewards of Resilience

Jan. 11, 2024
Climate change is causing more extreme weather events and more damage to nature, communities, and infrastructure coming at a cost of $1.3 trillion in the last decade.

The implications of climate-related events extend well beyond the natural environment, reaching economies, infrastructure, and financial markets. But even as physical climate threats become more frequent and severe, asset owners and investors still find themselves without an effective way of forecasting these risks and mitigating potential losses. 

Climate change is causing more extreme weather events and more damage to nature, communities, and infrastructure. According to the IMF, direct damage from climate-related disasters between 2010-2020 came at a cost of around $1.3 trillion. That figure is only expected to grow as the rate of greenhouse gas emissions continues to rise and global temperatures keep climbing.

As the impact of climate change increases exponentially, asset investors need to incorporate these new realities into risk analysis, asset management, and investment strategies.

This shift is imperative for a multitude of reasons. First, climate change affects every organization and every investor on earth. Additionally, the inherently large-scale and long-term characteristics of infrastructure assets mean they are uniquely exposed to the risks of climate change.

Climate-related risks can be divided into two broad categories – physical risks and transition risks. While forecasting transition risk often requires speculation on how policy reflects pricing in the cost of externalities, forecasting physical risk is less underpinned by uncertain regulatory outcomes. Rather, it is based on the physics of how the Earth’s weather will behave under varying degrees of warming.

Further, the advantages of mitigating transition risk by an individual company are socialized globally, allowing everyone to profit as carbon emissions are abated and physical risk exposure is reduced further into the future. Conversely, the benefits of mitigating physical risk, often called climate adaptation, are enjoyed exclusively by the individual company that makes the investment.

Climate adaptation is relevant for asset investors and owners because through their portfolios they are exposed to climate change risk both directly – such as extreme weather events damaging portfolio companies – and indirectly, for example, through supply chain disruptions. Investors also have a fiduciary responsibility to account for physical risks in their investment decisions, and in cases where risk is present, asset owners must ensure they are proactively working to address it via adaption.

By building a more nuanced understanding of physical climate risks, informed by asset-specific vulnerabilities and geographical considerations, and by pricing these risks into their investment decisions, private equity and infrastructure funds can better protect their assets and allocate their capital more effectively.

Ultimately, only those companies who price in the physical risks of climate change and meaningfully address them will enjoy the rewards of resilience.

The gathering storm

With every passing year, “once in a lifetime,” billion-dollar-weather events are occurring with higher frequency and with increasingly devastating impacts. The 2019-2020 Australian bushfire season was unprecedented in its scale and destruction. In 2021, winter storm Uri left behind an estimated $195 billion of damage in Texas. The 2023 summer heatwave in the UK defied forecasts and broke temperature records.

While extreme events like these are becoming more common, they still have a very small likelihood of occurring, statistically speaking. As such, they are easy to dismiss as a remote possibility that only needs to be dealt with in the future. However, even if the odds of a disaster are small on an annualized basis, they still pose a risk – one that asset owners and investors must account for, especially given the typically multi-decade useful lives of infrastructure assets.

Pricing the physical risk of climate change is no easy task. It requires asset owners to estimate the likelihood of many different events across various locations and the cost of failure, inclusive of both asset repair costs and downtime costs by asset.

Moreover, due to the complex and interdependent nature of climate-related threats, the uncertainty of physical risk forecasts typically increases over time. This poses a challenge for investors seeking to price physical climate risks into assets with decades-long lifespans – a much longer time horizon than most investors, even long-term funds, are used to considering.

Imagine, for example, an energy company installs new generation facilities with 50 years of expected useful life. When forecasting the risk of an extreme weather event with a 1% annual likelihood, it means there is actually a 39% chance of such an event happening at least once during the asset’s useful life. Adjusting that percentage to 2% annual likelihood increases lifetime probability of failure to a staggering 64%.

It’s not just asset owners that need to be aware of these dynamics. From the investor side, those holding investments with longer time horizons, such as a 10-year fund, need to ensure they are pricing in physical risk in a similar way.

The bottom line is that climate risk has a major business and financial impact. Asset owners’ operations may be disrupted due to the physical damage to properties, equipment or data centers. Organizations need to understand that risk at the asset level in order to guide sound investment decisions.

Regulatory pressure

The material risks of climate change are becoming more real every day – but they are not the only thing captivating action. Regulators increasingly expect asset owners and investors to demonstrate that they are effectively managing and acting on climate-related risks.

Under the SEC’s proposed new requirements for climate change disclosures, public companies will be required to disclose any climate-related risks that are, “reasonably likely to have a material impact on the registrant’s business or consolidated financial statements.”

The proposed rule would mandate disclosure of detailed and specific information relating to physical climate-related risks, such as the location (by zip code) of the assets, processes and operations subject to a physical risk. They would also require quantitative disclosure of the impacts of severe weather events and other natural conditions on individual financial statement line items – at a threshold of 1% of the impacted line item.

The list of potential items that need to be considered here is extensive. It includes the impact of singular weather events like floods, wildfires and storms, as well as incremental shifts in climate patterns, such as changing annual temperatures, rainfall and sea levels.

Naturally, in order to assess the materiality of these risks, a company would first have to forecast the financial impact. They would also need to disclose strategic, financial and operational impacts.

There are likely few, if any, companies that are prepared for disclosure at this threshold today. Many will need to enhance their existing reporting systems to accurately capture all of the information that would be required, as well as adapt their governance and risk management processes to manage these risks.

While it may be tempting to think that such rules are a long way off from being mandatory, the requirements are immense. Organizations are going to need all the time they can get to put the necessary processes, tools and structures in place.

More importantly, shareholders will expect that, if the risk is material, companies should already have plans in place to be actively mitigating it. Companies that wait will get caught flat-footed, and be forced to disclose physical risk without an active adaptation plan. This could lead to reputational and liability risks, while the share prices of those companies will also likely reflect this delay.

Actions asset owners can take to protect against physical risk

Many asset owners are already taking steps to assess, prioritize and manage climate risks in their portfolios. But, they truly want to de-risk their investments, physical risk assessment must be integrated into how they do business. 

Reducing physical climate risks in the asset investment plan currently poses a significant challenge. Climate forecasts will need to be translated into financial implications across the short, medium and long term. This requires high-quality climate impact data, scenario analysis and related disclosures to adequately assess investees’ adaptive capacity to manage this risk.

Steps to safeguarding against physical risk

1.      Assess asset vulnerability
The complexity of the infrastructure lifecycle must be addressed such that climate adaptation and resilience interventions can be timed and structured for maximum return on investment. Investors and asset owners are bound by capital constraints and customer affordability, respectively. As such, they must quantify at the asset-level the financial impact from physical climate risk to inform their forecasted exposure.

2.      Develop a resilience investment plan
Investors have a responsibility – as stewards of risk mitigation – to send signals to the market with the expectation that this type of risk is actively being assessed and mitigated. Investors will benefit by investing in and engaging with companies that develop sustainable adaptation plans that cost effectively manage climate risks. Conversely, companies that fail to do so could become stranded assets or worse, fail prematurely.

3.      Execute the plan to enjoy the rewards of resilience
Although climate risk is typically discussed in terms of threat management, it also offers opportunities to identify new streams of value creation. An integrated approach to identifying, assessing and adapting to physical climate risks can yield substantial benefits. It will allow asset owners to enhance resilience and reduce losses, especially when compared to their competitors that are lagging in their risk assessment maturity.

Reaping the rewards

It is critical for an organization to learn how to convert asset-level climate forecasts into financial impact and incorporate this data into day-to-day investment decision-making. But these changes, such as physical risk becoming a routine part of due diligence, won’t happen overnight. Physical risk assessments will require the use of scenario analysis and downscaled climate forecasts to assess climate adaptation and resilience measures, focusing on key drivers of revenue and/or capital and operational expenditures. Physcial climate risk is expected to grow and consequently, so are the requirements for disclosure and expectations from shareholders to mitigate it. The time is now for investors and asset owners to price in physical risk and reap the rewards of resilience.

Michael Levy is the U.S. Networks Lead and Head of Global Asset Resilience at Baringa. He advises utilities, energy companies, and infrastructure funds on the energy transition with a focus on climate resilience and adaptation, regulatory innovation, grid and asset analytics, and commercial and operational due diligence.

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