The underappreciated real world impacts of climate change

And the role investors can play in reducing these risks

Laasya Shekaran

Investment Consultant

David Wrigley

Partner

By 2100, if climate change continues the way it is going, 74% of the population is projected to be exposed to deadly heat for more than 20 days per year. This means that, under this scenario, three quarters of the population will live in areas that are uninhabitable during those days. This may seem like a long time away, but we are already starting to see the physical impacts of climate change come to life with more forest fires, natural disasters and unusual weather patterns.

As a society, we’ve become very aware that climate change is one of the biggest catastrophes that we are all facing. Countries around the world have come together to declare that they will commit to ‘net zero’ – to doing something about this looming catastrophe.

The finance and investment industry is no stranger to this – net zero and climate change have become key parts of investment processes. But currently, when investors are pricing in and measuring climate change risk they tend to focus on the transition risks associated with climate change – the risks that seem nearer term, those associated with government and industry adapting to transition to a net zero world.

The physical impacts of climate change are likely to be huge

But these risks do not come near to covering the full potential of the economic damage of climate change – to do that we need to understand how the real world physical impacts of climate change can affect the economy:

Damage to buildings: A rise in natural disasters will lead to expensive damage of property and infrastructure which investors may hold directly, or may be used in the supply chains of the companies they invest in.
Quality of life and productivity: Pollution, uninhabitable environments and high temperatures will negatively impact the health of workers and consumers, leading to lower productivity and therefore lower economic output from whole countries. While developing countries tend to feel the biggest impact of these physical risks, we are seeing them manifest in developed countries too, with rises in forest fires in Canada and polluting smog in the US.
Water and food scarcity: Changing rainfall patterns and higher temperatures are likely to lead to water shortages, lower agricultural yields and crop failures. This is likely to lead to higher inflation, social unrest and mass migration, all of which could severely impact the stability of economies.
Biodiversity loss: Many animal and plant species will fail to adapt to the rapid changes in the climate – and nature underpins over half of global GDP, providing the fundamentals for our existence (food, water, oxygen, medicines, fuels, clothing fibres etc). Indeed, you could argue that all economic activity is underpinned by a functioning and healthy natural world.
Supply chain disruption: For example through pandemics such as Covid-19, which are primarily treated as social issues but may stem from an environmental issue – biodiversity loss – which is exacerbated by climate change, as well as other supply chain disruptions like weather-related damage, crop failures and more.
Conflict and war: The MoD’s 2021 Climate Change and Sustainability review highlighted that impacts of climate change such as water and food scarcity will almost certainly lead to more conflict. There are already conflicts linked to climate change such as in Sudan.

All of these would lead to severe economic impacts, so investors need to do what they can to mitigate these risks.

By 2100, if climate change continues the way it is going, 74% of the population is projected to be exposed to deadly heat for more than 20 days per year.

Is the finance industry doing enough to understand these physical risks?

Based on the scientific understanding of the physical impacts of climate change, financial modelling of some climate scenarios (including those of a failed transition) should be showing a significant negative impact on economic outcomes.

But often it is not.

When we look at some of the most mainstream climate scenarios used, such as the Network for Greening the Financial System scenario which many investors, and indeed central banks use, we do not see these serious negative outcomes. In fact, in these scenarios some investors are projecting that they will actually be financially worse off in a net zero scenario than in one where temperatures rise by four degrees centigrade.

This scenario analysis is mainstream, and doing scenario analysis is mandatory for many investors who are subject to TCFD requirements.

Are the models wrong?

Not entirely, as they do capture relevant transition risks, but they certainly do not offer a comprehensive view of the risks. Modelling tipping points and tail risks is difficult and cannot currently be captured adequately by financial models, so they shouldn’t be relied on alone to measure and monitor climate risk – especially when it comes to physical risks. Furthermore, a more holistic approach can look at the consequences for investors/beneficiaries in the fund. Take the example of a pension scheme, how good is a high funding level if the negative impacts outlined above have come to pass?

What should we focus on?

Importantly, we need to understand the limitations of quantitative scenario analysis and shift our focus to thinking about physical risks, tail risks and the real-life impacts that we can have in addressing climate change.

Great challenges often present opportunities too – there’s a lot investors can do to drive real change to avoid the potential devastating impacts of a world where temperatures rise by four degrees centigrade such as:

Setting a net zero ambition and then using your influence with managers and other participants in the financial system to achieve it
Investing in the solutions that are needed for the transition to a net zero economy and for climate adaptation
Using systemic stewardship, for example influencing governments if you are an investor in government debt, to get the policy and systems level change that is needed
Encouraging managers to increase their focus on physical risks, which are generally underappreciated
Designing portfolios that actively help protect us all against both the physical and transitional risks of climate change by use of climate solutions and impact funds, as well as a strong stewardship approach

Conclusion

If we shift our focus on scenario analysis to look at the real world impacts of a failed transition, then investors are much more likely to work together to take action to mitigate physical climate change - resulting in a safer world and a more resilient economy.