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ESG Analytics

Floodlight in Quantifying Future Climate Change Risk

An investor will invest money in a business enterprise in the hopes of making a profit however, the risk of losing money if the business fails or underperforms always needs to be a consideration. For this reason, investors expect bigger potential rewards for riskier investments because of this trade-off between risk and return, which is a fundamental aspect of all investments.

As climate change warms the earth and steps are taken to cut emissions, financial institutions must consider new and shifting risks to assets and the larger financial system. The dangers that climate change poses to financial institutions and stakeholders will be covered in this explainer, along with steps that may be taken to properly account for these risks.

According to preliminary estimates from Cambridge researchers, climate change could increase the worldwide cost of extreme weather by roughly 20% by 2040. These increased costs will push businesses to assess their own exposures to the growing risk with the goal of improving resilience and sustainability.[1]

Physical Risks VS Transition Risk

Climate change poses a serious risk to investors because it may have a detrimental effect on inflation, economic growth, and investment returns. We must distinguish between the physical risk and transition risk categories of climate risk. 

Physical risk refers to the effects of climate change-related occurrences on property, infrastructure, and supply chains for commercial enterprises. For instance, firms that are affected by an extreme weather event could suffer financial losses due to property damage and, as a result, would not be able to pay back debts securitized by these properties. Climate change-related events in this scenario exacerbate credit and market risk for businesses, banks, investors, and insurers rather than creating a new category of financial risk. Physical risk also covers the expenses incurred by insurers in response to property damage claims and the losses suffered by investors when assets lose value due to physical damage.

Transition risk describes the danger that results from taking steps to move toward a sustainable economy, such as changes in climate policy, the implementation of green finance tools, the introduction of new disruptive technologies, or investor perceptions of investing in businesses that harm the environment. Early adoption of sustainable practices may benefit disruptors and early adopters financially, while some those corporations lagging behind early adopters may face penalties for actions that don’t follow a sustainable model. An illustration of the impact of transition risk is stranded assets. A stranded asset is an asset that has experienced write-downs because of physical climate change, changes in laws, regulations, policies intended to address climate change, or a shift in consumer attitude before it has reached the end of its expected life cycle.

The Analysis Process of Investing with Climate Risk

Understanding the process of investing with the potential of climate risk has become much more important as a result of the previously mentioned factors. In order to take a holistic view of investing with these risks present, an investor may act in accordance with the following: 

Step 1: Create a detailed assessment of the asset or portfolio to determine which physical and transition risks are most important and which are less important. Floodlight can help investors across different industries specify the most important risks of future climate change by using science backed benchmarks based on our independent database. Our Data Delivery is in line with TCFD, UNPRI, or matched to key UNSDGs

Step 2: Map building exposures. Understanding future climate risk at an individual asset level is necessary. This begins with mapping each and every asset within your portfolio to a latitude and longitude. Understanding where your assets sit geographically will allow for a better understanding of the potential climate risks that may impact each asset. Geospatial asset level data from Floodlight has been thoughtfully cleaned, mapped, and enriched to maximize coverage and ESG insights. Available via API, Flat-file or S3 bucket. Floodlight’s Dashboard contains geographic and statistical outputs and provides intuitive cross-comparison functionality.

Step 3: Quantify portfolio impact. Floodlight focuses on quantifying the different climate risks to make them comparable across assets and enable calculations for more specific purposes and use cases. We also bring climate stress testing to life, providing insurers with new tools to explore the impact of climate change for strategic planning and regulatory reporting.

Step 4: Act. Floodlight can provide our clients a net Zero & Impact Reporting. Clients can make decisions by themselves or use the scientific and academic Floodlight team for any suggestions after assessing the whole investment or asset portfolio.

Methodology for Physical Risks[2]

An overview of the methodology is presented in the figure below:

Graphical user interface

Description automatically generated with low confidence

*Source: UN Environmental Finance Initiative

The first step is to identify the physical climate risk scenarios. The scenarios include changes to the climate as well as a time frame for when these changes will take effect. Each scenario has been examined to see how it will affect the likelihood of extreme weather in each region where an asset is owned. For example, temperature rise will increase the likelihood of both protracted droughts and flooding.

The second step is to convert these scenarios into modifications in productivity for each sector. Take the agricultural sector as an example, the projected effects of the scenario on crop prices and agricultural production are examined in this situation.

For the third step, productivity changes influence a sector’s revenues and costs. Based on the calculated impact from the second step, these are estimated. The calculated changes in the properties’ values have an effect on the LTV in the real estate sector.

In the final step, banks can then use the projected impacts as input for their credit risk models to assess changes in the portfolio’s credit risk. Banks will need to adapt their models to account for all these variables and perform calculations for each industry separately.

Methodology for Transition Risks[2]

The first step is transition scenarios. Not all academic levels of research behind climate scenarios are useful. A consistent baseline scenario is necessary to understand the incremental risk. The scenarios must also offer enough detail while covering every part of the globe where banks have exposures. The IEA World Energy Outlook and Integrated Assessment Models (IAMs) are regarded to be the most appropriate after taking all of this into consideration.

The second step is investment-level calibration. In short, it specifies the relationship between climate scenarios and investment outcomes. This module builds on scenario variables and adds expert judgments and existing market risk tools to assess the changes to the probability of loss of stranded assets.

The third step is portfolio impact assessment. In this last step, the expected loss is calculated for the entire portfolio. We can use VaR to quantify the specific amount of portfolio loss in different probabilities. 

Climate Stress Testing[3]

What Floodlight can provide to protect your investments from future climate risks:

  • Scenarios of various seriousness, such as a smooth transition, a chaotic transition, a failing climate policy, and others.
  • Relationship between change and physical risk as well as other risk sources.
  • Examination of the various potential dates for market effects that a scenario might have.
  • Numerous portfolio risk assessments, such as VaR and Excess Climate Risk.

How the Industry Can Improve

As a result of the impending climate change, numerous industries will experience seismic adjustments that will alter investor and customer demands, the value of individual assets, and the fundamental methods for building and managing real estate. By recognizing the implications for asset prices, looking for possibilities to decarbonize, and creating opportunities by aiding the shift, smart investors will get ahead of these trends and acquire climate intelligence early.

[1] https://www.cam.ac.uk/research/news/new-approaches-to-help-businesses-tackle-climate-change

[2] https://www.riskquest.com/news-events/climate-risk-how-to-quantify-it[3] https://www.conning.com/software-and-services/climate-risk-analysis

Shirley Li
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