Climate change

Sooner and more severe than anticipated

Jay Holley

Associate Consultant

The escalating trajectory of climate change demands immediate attention.

Physical climate risks are likely to materialise earlier than previously expected and be even more catastrophic. Recent evidence, which relates to extreme temperatures, climate sensitivity, aerosol demasking and tipping points, paints a bleak picture of what could be to come. I explore some of this evidence below, before suggesting practical steps that investors can take.

The physical risks of climate change

Climate transition risks refer to the financial, operational and regulatory challenges that arise from the shift towards a low-carbon economy. When considering climate change and its effect on the investment industry, there is a lot of focus on these transition risks and getting to net zero. This is not the only issue we should be considering - physical risks are important too. So why are physical risks being overlooked? Well, there are two possible reasons for this – firstly, transition risks are often thought of as the more immediate issue, with physical risks not needing to be considered until the distant future, and secondly transition risks are easier to quantify, resulting in them taking precedence in climate risk analysis.

The physical risks of climate change vary geographically and temporally which means areas that are currently low risk may encounter increased risk in the future. Throughout the economy, these risks manifest in direct and indirect effects such as damage to buildings, reduced productivity, and supply chain disruption. These physical impacts of climate change are likely to have severe effects on the economy and to add to this, they are likely to be sooner and more severe than first thought. Investors are consequently affected by changes in earnings and heightened default risks resulting from these impacts. We need to stop overlooking physical risks and start ensuring they are priced into investments by translating them into measurable financial impacts much like we do for transition risks.

Climate scenarios

Greenhouse gas scenarios are usually very important when considering climate risks. However, they become redundant when talking about imminent physical climate risks because even if we are successful in reducing greenhouse gas emissions over the next decade, it will not have a material impact on the physical risks of climate change we see over the same period. This allows us to consider the short-term impact of physical climate risks, without having to debate which greenhouse gas scenario is mostly likely.

Extreme temperatures

The year 2023 was the hottest year on record, 1.48°C warmer than the 1850-1900 pre-industrial level, and lots of experts are predicting that 2024 will exceed this. As illustrated in the chart below, initial data is supporting this, with January and February this year also reaching record breaking temperatures.

Source: Copernicus

The impact of these changes in climate were also seen last year, with wildfires, major floods, droughts, and tropical storms occurring with increased frequency and severity. This signifies that the physical impacts of climate change are not something we only need to worry about in 2050. Instead, we need to mitigate these impacts now, because they are happening currently.

Climate sensitivity

To add to this accelerated global warming, evidence is emerging that suggests the Earth’s climate may be more sensitive to greenhouse gas emissions than previously estimated, meaning greater warming for a given level of greenhouse gases. The sensitivity of the climate is a key parameter when looking at climate change, but it has a wide uncertainty range which has significant ramifications for the severity of climate change. If the true value is towards the higher end of the range, like some scientists are now estimating, the physical impacts of climate change will be more severe than current models are showing. To put it another way, we need to decrease greenhouse gas emissions even more rapidly if we are to limit temperature rises to 1.5°C.

Aerosol demasking

Aerosols – which are small particles that float in the air - have a significant effect on climate change. They can come in natural forms such as sea spray and mineral dust, but they also come in unnatural forms such as air pollution and soot. The air pollution produced from burning fossil fuels results in a cooling effect on the planet, counteracting the effect of greenhouse gases. This is called the masking effect and might sound like a good thing, but it is not and leaves us in a difficult predicament: air pollution is detrimental to humans and the environment so needs to be reduced but reducing it will cause global warming due to the removal of the aerosol cooling effect. As shown in the charts below, it is estimated that aerosol pollution has been cooling the planet by about 0.4°C.

We need to stop overlooking physical risks and start ensuring they are priced into investments

Source: IPCC

If reversed, we could easily breach the 1.5°C and 2°C rises in global temperatures we are desperately trying to avoid. In 2020, international regulations imposed strict limits to the sulphur content of shipping fuels, resulting in significantly fewer aerosol particles being released. Some researchers suspect this is already resulting in aerosol unmasking, and is the causal factor of recent record-breaking temperatures.

Tipping points

A climate tipping point refers to a critical threshold within the Earth's climate system, beyond which a relatively small change in external conditions can cause a significant and often irreversible shift in the state of the system. As depicted in the map below, examples include the melting of the Greenland and West Antarctic ice sheets and the die-off of warm-water coral reefs.

Source: Global Tipping Points

Recent research has found that these tipping points could be breached at lower temperatures than previously predicted. In fact, several are thought to be at risk if we reach 1.5°C-2°C warming which, as mentioned above, is not far away. If breached, the outcomes are likely to be catastrophic. To make matters worse, triggering one tipping point could result in another being triggered, creating a tipping point domino effect with devastating physical outcomes.

What can we do?

As a society, we need to invest more in adapting to the physical changes that are coming and double down on emissions reductions to prevent worsening impacts in future decades. Investors can play a role in this by using their influence with investment managers, companies, and the government to encourage the right investments to be made and climate action to be taken to result in real world decarbonisation.

Investment managers have greenhouse gas emissions data which allows them to make better decisions concerning transition risks and enables them to price these risks into assets. We need the same to be done for physical risks. Investment managers need to collect data on physical risks, measure them and look at the impact they will have on the portfolios they hold. Investors can encourage them to do this by asking managers the following questions:

How do you assess exposure of the portfolio to physical climate risks?
How would the portfolio be impacted by physical climate risks?
Which holdings in your portfolio have the biggest exposure to physical climate risks?
Give some example of assets that you have chosen not to own due to physical climate risks?
How are you engaging with companies to reduce exposure to physical risks?

Conclusion

Physical risks of climate change are often overlooked and underappreciated. There are strong indications that these impacts are going to be sooner and more severe than many people are anticipating. We need to ensure investment managers, companies and the Government are fully aware of these risks and are assessing and mitigating them.

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