Getting physical: Scenario analysis for assessing climate-related risks
There has been a gap between understanding climate change and the implications it has for finance and the broader economy. This paper provides insight into scenario analysis – using data and climate science to provide more transparency on their financial risks in the medium and long term.
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OVERVIEW
The physical risks of climate change, while not necessarily evident, will have significant implications on investments in the medium to long term. The number of natural disasters in the United States causing $1 billion-plus in damages has been rising steadily over the past 20 years, which could lead to insurers ‘pricing out’ underwriting risks.
Through research, Blackrock inferred that, despite the fact that climate risks are far more amplified compared to a few decades ago, risks are not being priced into investments for two main reasons:
- Financial markets tend to be short-sighted
- Limited tools and data
To better price these risks into financial applications requires a scenario-analysis and data-driven approach as opposed to observing historical data.
A framework for assessing climate-related risks was developed, using three investment applications:
- Municipal Bonds: Climate-related risks have a significant effect on the creditworthiness of financial institutions. For example, economic and physical damage natural disasters could erode the tax base of a municipality and over time cause a shift in employment composition. Analysis shows a growing proportion of municipal areas will suffer larger losses due to increasing temperature, if “no climate action” is taken. Furthermore, coastal and Southern states of US were affected more-Miami is expected to suffer GDP losses of more than 1% today, and possibly 4.5% by end of 2100. To assess if markets were already pricing such risks, BlackRock compared the spreads (difference of yields of 2 bonds) of similar municipal bonds in two areas with varying climate risks. It was noted these bonds had nearly identical yields.
- Commercial Real Estate: Extreme weather poses significant threats; many loans have significantly large life spans and are in areas of high vulnerability. For example, there is predicted 275% rise in Category 4/5 hurricane risk by 2050- which have negative indirect effects such as higher insurance premiums, rising operational costs and decreases in valuation and notably increased energy and utility expense. Energy/utility expense for commercial buildings are expected to increase by 15% as energy prices rise, as such the loss rate on CMBS deals increase to 3.8% from 3.2%.
- Electric Utilities: The frequency of power outages could be heightened as ageing infrastructure leave power plants vulnerable to extreme weather events. By studying 233 extreme weather events, it was noted that hurricanes do not have a significant effect on prices of utilities, and investor reaction to events is initially muted. The following framework was used to assess climate risk exposures:
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- Rank each hazard based on their relative impact to power plants.
- Assign weight (percentage) to each fuel source, based on how much they are impacted by the natural disaster. For example, source of solar energy would be severely affected by increased temperatures.
- Aggregate average physical risk across all power plants to attain a climate risk score. The most resilient utilities traded at a premium to their peers, while the most affected carried a small discount.
Overall, it was noted the pricing of climate risks within investment applications is not evident and does not reflect the fair price.
KEY INSIGHTS
- While physical climate risks are well-known and prevalent, their implications for investment portfolios can be quantified using big data techniques. By implementing scenario analysis for municipal bonds, commercial mortgage backed securities and electric utilities, it is evident that physical climate risks vary by region.
- There is considerable "climate complacency" when pricing financial assets. Although risks and frequency of events have increased, financial markets tend to be "short-sighted" and thus underestimate risks which are uncertain. Furthermore, there is currently limited tools and data - and can these may be outdated.
- Global climate scenarios are vital to analysis of the risks climate events pose and how to mitigate them.
- When incorporating climate risks into policy/decision making, both transition and physical risks must be considered. Transition risks refers to risks to businesses or assets from policy, technological or market changes during the transition to a lower-carbon economy. While physical risks are risks to entities or assets from climate changes currently occurring and expected to continue.
- Increases in temperature have detrimental "knock-on" effects on society and the economy, such as: lower productivity in regions reliant on outdoor labour, rising mortality rates and higher energy expenditure.
- Extreme weather events present risks for credit worthiness for state and local issuers within the US bond market. Under a no "climate action" scenario, a growing proportion of municipal bonds will be issued in urban areas where there are high percentage losses in GDP.
- Risks to commercial real estate are significant, and assets underlying CMBS loans are in regions with high vulnerability to severe storms. It is estimated there will be a 275% rise in Category 4/5 hurricane risk in the United States by 2050. Furthermore, with rising energy and utility expenses, under a "no climate action" this would result in average expected loss rate from CMBS would rise from 3.8% to 3.2%.
- Extreme weather events are not priced into equities for US electrical utilities. By aggregating physical risk across power plants, a climate risk score is attained for each utility. Investors can use such measures to assist with risk management for extreme weather events and to engagement purposes- to assess the risk mitigating strategies of companies.