Countering climate risks through collaboration

Connecting insights from the worlds of investment management and climate science is key to advancing today’s solutions to the global climate crisis. In this transcript, based on a recent AVPN podcast hosted by Tech for Impact founder and CEO Teymoor Nabili, Wellington Management’s Alan Hsu and Dr. Philip Duffy of Woodwell Climate Research Center discuss the importance of close cooperation when addressing climate action.

Q. How severe is the risk of climate change to investors and their clients today, and how is the Wellington Management-Woodwell Climate Research Center tie-up helping us better understand that climate risk is investment risk?

Alan Hsu: Climate change is a mispriced risk. It’s taken the investment community a very long time to recognize it as a systematic risk. Whether you define climate change as a set of physical risks or transition risks, it impacts companies and sectors across asset classes. Climate change also impacts existing asset values, influences how companies invest, and challenges certain business models. It’s a material risk because it can impair the ability of companies to grow.

Many years ago, Wellington Management’s leadership recognized that climate modeling can shape institutional portfolios, and that this can happen at scale. Our collaboration with Woodwell Climate Research Center began in 2018, with the purpose of better understanding how climate change impacts capital markets and, ultimately, investment returns.

Dr. Philip Duffy: Human well-being depends on the natural world, and we’re actually more dependent on it than we sometimes realize. A rapidly changing climate affects different societal sectors that are very finely adapted to a certain climate type. If this changes, we will have to rethink all kinds of fundamental things like the way we construct buildings, how we grow food, and how we manage water resources.

When we first started talking to Wellington Management three years ago, there was a big disconnect between the climate world and the investment world. Climate change is real, and the investment community is rapidly grasping the idea that these physical risks are a “now” problem, not a “future” problem. The investment risks of climate change need to be properly evaluated in prices at some fundamental level.

Q. What are the consequences of this disconnect between climate change and investment decision making?

Phil: Wildfires, extreme heat, and floods will become more frequent with climate change. There is no question that climate change is tilting the odds for these kinds of events. Some of the recent events that we’ve experienced have been not just record-breaking, but record-breaking by enormous margins. In California, for example, 2020 was a bad fire year where the affected area was more than twice that of any previous year. These events suggest that there may be something fundamental going on that even the scientists don’t understand. It’s likely that these sorts of extreme events will unfold more rapidly than anticipated.

Alan: When you think about the problems associated with climate change, there is no real price signal from markets that can even remotely quantify the magnitude of the problem. Think about the lack of a price on carbon. Think about the lack of a price on water. Prices are useful, because they mobilize capital to address inefficiencies, solve problems, and alleviate supply-demand mismatches. In the absence of these signals, you get sustained abuse of the natural environment and the resources that go along with it.

Q. How do we bridge the current divide between climate research and investing?

Alan: We’ve found significant value in identifying climate-driven pressures that require some form of remediation. For example, with snowpack levels falling to zero in California, hydroelectricity output statewide is about 70% less than usual — and people are using their air conditioning more because it’s become hotter. These types of interconnected climate-related pressures could lead to investment opportunities in backup power-generation assets or alternative forms of power. We might also identify solutions for making the natural environment more resilient, for example, with forestry development and more effective wildlife management.

Phil: It takes a sustained engagement between the scientific community, research community, and the investment decision makers. Each party has to understand enough about what the other party does and how they do it, so that they can communicate effectively. With some minimal understanding of the decisions that need to be made, we scientists can go back and produce information that is properly tailored to help make those decisions.

Q. What climate threats do we face in Asia, and how might these shape an investment thesis?

Phil: Asia is a big place, and the risks vary from location to location. In South Asia and Southeast Asia, heat and humidity are significant risks, which are increasingly impeding the ability to work outdoors. Economies in these regions are highly dependent on outdoor labor, and we project future losses in labor output because of extreme heat and humidity. A growing number of tropical storms, causing river and coastal flooding, is also a significant risk in some countries. As too are grain yields, where year-on-year volatility makes them more unpredictable. And in Australia, the number and size of wildfires are growing annually. Exacerbating these risks, many of these extreme weather events are happening in heavily populated places as well.

Alan: If you think about some of the water shortages in Taiwan, which have contributed to the inability to produce sufficient amounts of semiconductors, this in turn has impacted multiple sectors around the world. Equally, if you think about air pollution in countries like China or India, this is impacting the quality of life for people in these countries. In both instances, we explore the types of products, services, or technologies that can remediate these. Being able to pair insights from Woodwell with how these risks might impact investment portfolios is what we’re attempting. The important point is that what used to be viewed as one-off climate events are now seen as a repeating pattern, which will require sustained capital to curate investment portfolios in response.

Q. Where do you see investment opportunities today, and how might these change over time?

Alan: We think about investment opportunities in two ways: climate mitigation and climate adaptation. The first attempts to solve a longer-term problem around decarbonization, while the second is recognition that no matter how much we spend on climate mitigation, we may not be able to reverse the crisis sufficiently over time, and therefore we need to develop resilience.

The kinds of investments that we should see more of in the future are those designed to adapt and help the global economy navigate through long-term physical risks. The magnitude of the need for climate resilience and managing climate risk means that we need to be developing strategic, longer-term adaptation solutions, rather than creating ones that are more tactical in nature. The problems associated with climate change are significant, and they are getting worse. For example, the type of investment that was mobilized in the aftermath of Hurricane Katrina 16 years ago would probably need to be more ambitious today. (The recent Hurricane Ida severely challenged the resiliency of New Orleans’s flood prevention system. A future hurricane will probably overpower it at some point.) It might be that over time, we begin to view certain locations as being so at risk that no amount of capital spent on resiliency is better than migration away from high-risk areas.

Phil: It’s uncomfortable to contemplate what’s happening. However, despite having no warnings, it’s true that in many cases, well-designed, adaptation spending upfront is very cost-effective. Investing money pre-disaster can save multiples of that amount of money post such a disaster.

In terms of decarbonization, there are a lot of things we already know how to do. The electricity sector can easily decarbonize with technologies that we have today. Further investment in this area would drive the agenda forward. In addition, there are still unsolved challenges: How do we decarbonize aviation, heavy industry, or shipping, for instance? There are some interesting technological challenges where the investment industry can allocate capital to help develop viable solutions.

Q. How are climate risks impacting society, especially at the grassroots level?

Phil: Something we’re starting to do in our work is to look at the ripple effects of these risks. It’s easy to assess wildfire risk in terms of the real estate value that’s at stake, for example. But what are the broader societal ramifications in terms of smoke or power outages? We’re starting to see wealthy and highly educated people migrate out of California. And we’ve never seen that before. Historically it’s been the opposite, a place where the wealthy and educated converge. The long-term ramifications of this could be profound.

Q. What advice would you give to companies and other investment managers that are eager to mobilize capital to the climate crisis?

Alan: Looking at the steps that we took to get to where we are today, the first of these is to expand one’s research sources. Our partnership with Woodwell allowed us to gain foresight into some of the risks that we’ve since seen in the past year or so.

The second step is to begin to think about a company’s physical dependencies. I don’t think people would have understood a year ago that semiconductor companies, which are concentrated in Taiwan, need significant amounts of water. The worst drought on the island of Taiwan in 100 years exposed these companies, which are vital for the operations of many other industries, to acute climate risk. Companies and investment managers must ask how today’s many climate risks — and regulations — can impact their businesses. How might a new carbon tax impact profit and loss, for instance? Being able to think broader, more expansively, and incorporating other viewpoints helped us get to the point where we are at today.

Q. The pace of regulatory change is likely to accelerate in the coming years. How should organizations like yours engage with regulators, and what types of measures would you like to see rolled out?

Alan: Regulation and incentives are all a part of this mix of carrots and sticks. The carrots are mechanisms like subsidies, and the sticks are things like rules and policies. To better assist regulators to make the right decisions, investment managers like us must work with them to not just recognize the risks, but also understand their pain points, and help them solve issues in a capital-efficient way. Over time, this should lead to better climate outcomes.

Phil: There is a clear need today for a standardized and transparent climate risk disclosure framework. Disclosing risk is only helpful when it’s standardized, so that investors can confidently compare the risks of company A to those of company B and company C. We also feel that this should be done in a way that’s transparent, where the methods are made publicly available so that investors can assess the quality of climate risk reporting.

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