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Role of Climate Data in Assessing Portfolio Risk

Nov 6, 2024

Climate-related factors are increasingly being incorporated into financial analysis, with a growing consensus among financial institutions on the importance of understanding the risks and opportunities emanating from climate change. In financial analysis, climate data focuses on metrics that primarily impact asset value, operational costs, and investment returns. These metrics may be qualitative or quantitative, such as greenhouse gas (GHG) emissions and targets, extreme weather events tracking, climate scenario analysis, and climate-based regulatory changes and market trends.

Collecting, reporting, and analyzing such climate data is essential for portfolio assessment for the following reasons:

1. Rising Physical Impacts: The number and severity of extreme weather events, such as wildfires, hurricanes, and droughts, have increased over time, especially in the last few years. While financial institutions have limited exposure to physical impacts through their physical assets, they need to consider the indirect effect on their financial assets depending on their exposure and vulnerability to climate hazards.

2. Regulatory Changes: With the rise of policies and regulatory frameworks, such as the Corporate Sustainability Reporting Directive (CSRD) and Task Force on Climate-Related Financial Disclosures (TCFD), which mandate reporting on the effects of climate change on a company’s operations and vice versa, the need for a strategy to collect and analyze climate data has become more prominent.

3. Investor Demands: There has been a growing demand from investors for more visibility into climate-related variables in their portfolios. While the reasons for investor interest in climate data may range from risk adjustment to sustainability tilts, overall, this trend has resulted in a higher demand for climate data-based analysis, especially from shareholders, debtors, and other stakeholders.

4. Reputational Risk: Public concern about climate change has grown profoundly, and customers and stakeholders are increasingly urging institutions to participate in the transition toward a low-carbon economy. Hence, it is important to incorporate climate data into due diligence practices to avoid any climate-related controversies attracting negative media attention.

These elements have brought climate impact data solutions to the forefront of financial and corporate strategy. As climate risks escalate, the relevance of accounting for climate-related factors in environmental, social, and governance (ESG) portfolio analysis for investors, asset managers, portfolio managers, and financial institutions has grown, along with the need for more comprehensive data reporting.

Recent developments in climate change data reporting standards and frameworks, such as the International Sustainability Standards Board (ISSB), Global Reporting Initiative (GRI), CDP, Sustainability Accounting Standards Board (SASB), European Sustainability Reporting Standards (ESRS), etc., have enabled companies to report on their climate change data more effectively. This makes it easier for portfolio managers to incorporate climate data solutions into risk assessment and harmonize portfolios with long-term sustainability goals. This analysis is integral for investors and portfolio managers, as it helps them reduce their exposure to climate risks and identify avenues for opportunities by offering insights into how environmental factors affect future earnings and asset value.

Here are some key ways financial institutions can use their climate data to inform portfolio risk analysis:

1. Geographical and Physical Risk Analysis: The insights provided by climate data allow investors to assess the exposure and vulnerability of their assets. With advanced tools, portfolio managers, investors, or financial institutions can identify the location of their investments and compare these with climate forecasts. For example, the risk of rising sea levels can be understood in terms of the vulnerability of a real estate portfolio. The possibility of assessing these impacts may allow managers to hedge against potential risks, divest from assets at risk, or explore insurance options to curtail their financial exposure.

2. Carbon Footprint and Transition Risk Analysis: As governments and regulatory bodies move toward aligning with a low-carbon economy, there is high transition risk for businesses, and consequently for portfolios that are fossil fuel reliant. In such cases, climate data can help assess the carbon footprint of companies and sectors within a portfolio. An investor can then analyze the extent to which a company will face future regulatory pressures, higher carbon taxes, or stranded assets as fossil fuels become less viable, and evaluate the efficacy of its current transition strategies.

3. Climate Scenario Analysis: Portfolio managers can conduct scenario analysis to validate how different climate pathways may impact the financial performance of companies. For instance, in a 2°C rise scenario, firms that are closer to a low-carbon economy, such as renewable energy-based ventures, may perform better, potentially rewarding those equity exposures. Such analysis can be key to understanding the positioning of a portfolio and developing energy transition pathways.

4. Data on Biodiversity and Natural Capital: For investment portfolios across several industries, such as agriculture, forestry, and pharmaceuticals, information related to biodiversity and ecosystem services has become increasingly important. Since climate and nature are inherently interlinked, their risks intersect and compound with one another, necessitating a combined strategy for both. With the rise of nature-based frameworks such as the Taskforce on Nature-related Financial Disclosures (TNFD), there is a move to view both nature- and climate-related data through the same lens and to incorporate them collectively in investment decision-making.

5. Social and Economic Impact Data: Climate change has wide-ranging social and economic implications that can drive portfolio returns. Data showing how climate change affects migration, economic disparity, or health outcomes can help portfolio managers and investors identify risks associated with sectors such as healthcare, consumer goods, and insurance. On the contrary, climate data can also serve as a starting point for evaluating potential opportunities. The transition toward a low-carbon economy opens investment opportunities in avenues like sustainable agriculture. Investors and portfolio managers may use climate data to choose companies that emerge at the forefront of such a transition.

Conclusion

Integrating climate-related data into the assessment of portfolio risks is essential for every portfolio manager or investor aiming to become more resilient and ensure long-term growth. Advanced climate models and data tools have increased in sophistication, allowing investors, asset managers, and portfolio managers to make better estimates of physical and transition risks. This capacity enables investors to defend their portfolios against the increasing effects of climate change while also seizing new opportunities in a rapidly changing global economy.

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