A Canadian investor’s guide to navigating climate change

As momentum behind decarbonization and net-zero objectives builds around the world, asset owners are increasingly engaged in addressing the investment implications of climate change. The focus thus far has largely been on implementation at the security- and manager-selection levels, but there is a growing recognition of the need to factor climate change into broader investment policy and asset allocation decisions. 

Here, in collaboration with the Woodwell Climate Research Center, we’ve provided relevant climate research and investment insights designed to help Canadian investors navigate the potential impacts of climate change.

Canadian climate change: Here and happening

There has been a pronounced shift toward more extreme weather in Canada over the past decade or so. Consider Alberta, where 6 of Canada's 10 costliest natural disasters have occurred. Two of the worst storms in Alberta’s recorded history have taken place since 2013, both linked to climate change and centered on Calgary: flash flooding on June 19, 2013 and a hailstorm on June 13, 2020 that caused CAD$1.25 billion of property damage—the fourth costliest natural disaster in Canada since records began. And consider the recent record flooding in Vancouver that took out the main highway.

Looking at Canada as a whole, climate change has caused the country to warm at nearly twice the global average rate. (Parts of western and northern Arctic Canada have warmed at 4x that rate.) This warming has led to more frost-free days and longer growing seasons in Canada, trends that are expected to persist. However, it also implies that the length and severity of the wildfire season have increased and will continue to do so. Drought and heat waves will likely also follow recent patterns seen in Canada by becoming longer and more severe over time.

Canada will also continue to feel ongoing climate change impacts from the US, where the recent severe wildfire seasons in California pushed smoke (and resulting toxic air quality) into British Columbia and Alberta. 

Physical climate risks in Canada: A deeper dive

In collaboration with our partners at Woodwell Climate Research Center, we studied multiple aspects of physical climate risk in Canada out to mid-century. We examine several climate (and climate-related) perils: agricultural yield, heat extremes, permafrost loss, extreme precipitation (Figure 1),  flooding, sea level rise, biodiversity loss, drought, and wildfire. We also examine the potential of renewables. Our focus out to mid-century requires the use of global climate models (or Earth system models). Here we use a fossil fuel intensive scenario that simulates historical (2005 – 2020) total carbon dioxide emissions within 1%. This trajectory is also the best match out to mid-century as compared to the World Energy Outlook forward-looking scenarios of climate policies currently in place.

Figure 1

Here are some key findings from our latest joint climate research with Woodwell:

• Warming along Canada’s southern border will allow agriculture in previously non-arable/uncultivated lands. These new croplands will have yields comparable to present-day breadbaskets due to changes in temperature and precipitation. A 200 km northward expansion of high-yielding croplands will occur in Ontario and Quebec for maize and soybean by mid-century. There will be a decrease in wheat yield in Saskatchewan and Manitoba, but also yield increases in British Columbia and Alberta.
  
• Extreme and recent heat waves, as typified by the 49.6°C temperature reading in Lytton, BC, will continue to grow in frequency and severity. The distributions of summer temperatures in Ontario and British Columbia will continue to warm, increasing the likelihood of extreme heat events. Impacts will be skewed toward urban centers and among the aging population. As heat waves become more frequent, Canada’s population will be increasingly vulnerable to these extreme events; by 2030, 23% of Canadians will be 65 years or older.  
• Extremes in rainfall, which inform flood risk, will change under anticipated warming. A historical (1971 – 2000) 100-year event will be 2x more likely by 2035, and 3x more likely by 2065, for most major cities. Halifax will see materially worse risk multiplication factors, 4x and 7.5x for 2035 and 2065 whereas Vancouver’s risk factors will increase by only 1.3x and 2x changes for 2035 and 2065 respectively.
• Floods are the most common disaster in Canada, 5x as common as wildfires. The Canadian federal government spends 75% of disaster recovery funds on floods. Due to development in the floodplain, sections of Calgary in particular have a high risk of flooding. In Vancouver, levees prevent annual SLR-based inundation by 2050 but are not high enough by 2100. Vancouver’s airport location and low elevation makes it vulnerable to coastal flooding. On the other hand, steep topography in eastern Canada leads to minimal sea level rise (SLR) risk. Overall, less than 1% of Canada’s population will be affected by SLR by 2100.
• About 45% of Canada is underlain by permafrost, frozen soils. Permafrost extent is shrinking rapidly and will decrease by 20% by mid-century.  As permafrost recedes it thaws, releasing carbon dioxide into the atmosphere and destabilizing land which can damage infrastructure. There are 160 years’ worth of current levels of fossil fuel emissions (c. 10 GtC per annum) in permafrost soils.
• Canada, across a wide band near the US border from western Ontario to southwestern BC, is currently in a multi-year drought of historic proportions. As one example, the exceptional drought in southern Manitoba is already a once-in-fifty-years or rarer phenomenon. Such events will likely occur more often by mid-century , especially in the southern and interior regions of Canada, with negative impacts on agriculture, hydro, and forestry industries. 
• Fire risk will increase across the Territories, Pacific Coast, and northern Manitoba and Ontario by 2035, with an additional three weeks or more per year in high-danger wildfire days in some areas. Much of southern and eastern Canada will experience about the same, or a slight decrease in, fire risk by 2035. 2021 has been one of the worst fire years in Canada’s record history; as of September 15, burned area is 61% above normal (10-yr average). The season is currently ranked as third-worst for British Columbia, behind 2017 and 2018.
• As of 2018, 67% of Canada’s electricity was coming from clean, renewable electricity, mostly hydroelectricity. Despite Canada’s Net Zero by 2050, oil production is expected to increase from 4.7 mil b/day (2019) to 5.8 mil b/day (2030) with c. 80% exported to the United States.
• There is significant upside for solar energy in Canada. Germany, with worse solar resources, has already achieved c. 9% of electricity generation whereas Canada is at less than 1%. Canada’s solar resource may decline (on average less than 5% by 2050) due to increased cloud cover and aerosols.

Integrating climate change into capital market assumptions

A logical next question here is: How do we seek to integrate climate change research findings (like those presented above) into our capital market assumptions and asset allocation approaches?

In fact, our Investment Strategy team has been generating robust capital market assumptions (CMAs) – including various asset return, risk, and correlation metrics, for many years now. These CMAs play an important role in many of our firm’s asset allocation processes and are subject to ongoing analysis and enhancements as new research findings come to light. We have a basic but important philosophical starting point for this work: Simply put, we believe climate change impacts investment outcomes. It affects macro-level variables, such as economic growth; company-specific dynamics, such as corporate costs and future activities; and decisions around industry regulations and fiscal policy. These, in turn, all impact asset prices to one degree or another.

Our framework for thinking about the climate inputs that should be integrated into the CMA process begins with attempting to quantify and incorporate both transition and physical climate risks (Figure 2).  To learn more, please see our Investment Strategy team’s January 2022 white paper: Integrating climate change into capital market assumptions: Our approach and findings.

Figure 2

2022 and beyond: Climate adaptation, mitigation, and engagement

Looking ahead, climate change and investing remain top priorities for our firm in 2022 and beyond, with particular focus on three key areas:

1. Climate solutions
   
2.  Biodiversity and carbon offsets
3.  Climate engagement

To learn more, please see our  2022 Climate Change Investing Outlook, featuring actionable insights from our Investment Strategy and Climate Research teams.

Drawing on Woodwell’s climate projections and our proprietary geospatial mapping tool, we evaluate the potential impact of key climate variables including heat, drought, water scarcity, wildfire, floods, hurricanes, and sea-level rise for each known company address. These climate projections are subject to many assumptions as specified by the climate scientists at Woodwell. 

Projections vary over different time periods and are subject to change. Materiality assessments are communicated via Low/No risk, Potential risk, and Material risk (defined below) and reflect potential physical risk identified by Wellington’s Climate Research Team as of a specific time. If the company’s disclosure of location data is more general than provincial or state level and we are unable to find additional information from supplementary sources, it would be insufficient to produce a rating based on our criteria. In this case, we would look at qualitative factors to assign a rating and flag the rationale with the statement (Qualitative assessment applied due to insufficient location data). Importantly, these ratings do not reflect our assessment of how company management teams plan to manage these risks over time. Ratings are not intended to signal buy or sell investment decisions. Ratings should only be interpreted as a potential input into an investment team’s research mosaic. Other investment teams at Wellington Management may disagree with the Climate Research Team’s materiality assessment.

Material risk identified: Typically defined as a company with greater than 10% of its key locations at risk, or greater than 5% of revenue at risk from climate-related events.

Potential risk identified: Typically defined as a company with some level of climate risk to its key inputs or critical facilities (1% – 10%, or below 5% of revenue at risk), or a company with more than a 30% net property, plants, and equipment (PP&E) to total assets ratio.

Low/No risk identified: Typically defined as a company with little to no level of climate risk due to either its locations, diversification, the nature of its business, or the industry/sector in which it operates.