Climate Risk Is One of the Most Urgent ESG Factors

ESG is a financial investment category that considers a company’s policies and practices relating to the Environment, community and employee relations (Social), and corporate Governance. All three categories are included in one measurement in part to quantify and compare the positive impacts various companies within and across sectors offer society. Yet when considering the various ESG factors, the environment is considered the most urgent as climate risk simultaneously threatens and offers opportunity in the ESG investment landscape.

There is no doubt that climate risk poses an existential threat to every sector. In fact, 80% of the world’s largest companies are exposed to climate risk in some form (1). Climate risks present themselves in three primary ways. First is the physical risk of climate change, both as chronic risk in the form of rising sea levels, drought, and rising temperatures, and as acute risk like floods, hurricanes, fires, and heat waves. The frequency and intensity of both types have increased over the past several decades as the planet has warmed by an average of 1.1 degrees Celsius since the 1880s (2). Every sector from home insurance and energy to health care and agriculture are impacted by the physical risks of climate change. The average area burned by large forest fires increased 1200% between the 1970s and the 2000s (3), with roughly $3.5 billion in property and crop loss alone between 2011 and 2016 (by one estimate (4)), not including other costs associated with health, environmental damage, and loss of life.

Physical risks are the basis for two other types of climate risks. Transition risk acts as a response mechanism to physical risk in an effort to mitigate climate change. Various policies and regulations like a carbon tax, technological developments like electric cars, and changing consumer preferences like the substitution of meat with plant-based protein, all present transition risks, particularly for companies and portfolios emphasizing carbon-heavy alternatives. According to Deloitte, the largest renewable energy stocks rose in value in 2020 by 145% while the largest oil, gas, and coal equities fell by 30%. (5) These economic shifts during our transition to a low-carbon economy will have winners and losers, with the carbon-heavy hitters facing the most risk.

Liability risk rounds out the types of climate risk that should be considered when pursuing ESG investing. Physical risks that might damage property and infrastructure, not to mention the services and industries that rely on them, have serious implications for insurance companies faced with more frequent claims and more extensive damages. For the financial sector as a whole, climate risk poses a huge risk to banking, with a recent study estimating that climate change will increase the frequency of banking crises from 26% to 248% (5).

We believe climate risk is the most holistic and urgent factor within ESG investing as the products, policies, and practices impact (and are impacted by) climate change. And while financial systems are designed to withstand a certain level of risk, they will become more vulnerable as those risks surpass reasonable systemic thresholds. The most compelling strategy for mitigating such risks is for companies to become genuinely compatible with a low-carbon future. Companies that factor climate risk into their risk management frameworks may not only benefit from higher ESG ratings, but might be able to better withstand market shifts. Any assessment of investment opportunities should focus on both decarbonization (to prevent the worst scenarios from occurring in the future) and adaptation (to effectively respond to current risks) as we urgently look for climate risk mitigation within ESG.

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