One of the most pressing problems of our day, climate change, has economic and environmental implications. Businesses, governments, and consumers are all adapting to these new realities. But, inevitably, the climate will play a role in determining which business ventures succeed and which fail.
Trends in climate change cannot be predicted with complete certainty, as is the case with most other forecasts. As a result, it's possible that the weather may get much worse than expected or that traders would respond in ways that were not anticipated. Different outcomes like these are instances of climate risk, and they can shake up investment returns.
To what extent do we face danger because of the climate?
Learn about the conventional view of financial risk to grasp how climate change may shake things up in this area. What is meant by "investment risk" is the possibility of a negative return on investment or the potential range of future investment outcomes. It is also reasonable to think of investment risk as the spectrum of possible future outcomes. For example, imagine you threw dice, and whatever number came up was the return on your investment. The median is 4, but you may also get a one or a 6. This is the danger of investing.
Generally, climate threats are categorized as either "physical" or "transition."
Physical risks
The term "physical risks" describes the possibility of asset price declines due to natural disasters. The rising expenses associated with natural catastrophes and extreme weather events, including floods, storms, drought, hurricanes, and fires, are a key cause for worry in relation to climate change.
External factors such as those listed below can affect the investment value.
- Crops are being wiped off due to drought.
- Water damage from flooding
- Catastrophic damage caused by hurricanes
- Lessening of Snowfall at Ski Areas
- The effects of sea-level rise on coastal tourist destinations
It's common sense to invest responsibly.
Responsible investment incorporates your most important goals, whether they are driven by individual or investor values, the reduction of risk, or the fulfillment of regulatory requirements.
Transition risks
We face transition risks as we make the change to a low-carbon economy. As the weather worsens, market players are likely to adjust their behavior. Carbon emissions taxes and subsidies are anticipated to gain support from governments worldwide.
Here are a few transitional events that can have a significant influence on the value of an investment:
- Sectors that may be subject to increasing levies on carbon emissions
- Companies that may need to invest to lower emissions
- Companies with a high carbon footprint that perceive a shift in customer demand toward more eco-friendly options
Insights from the market on climate change
The destructive effects of climate change are simpler to understand when discussing physical hazards. The challenge is estimating how much these expenditures will be throughout a company's existence. The more time passes between now and when the forecast is made, the less reliable it becomes.
The uncertainties of the transition are significantly more significant. To what extent consumers, companies, and regulators will respond to changes in the weather and climate is transition risk, just as the range of possible physical outcomes results from the range of possible climatic and weather outcomes. This increases the level of uncertainty.
Finally, it's worth remembering that reactions in the market are influenced not just by the weather but also by investors' peculiar psychological idiosyncrasies. For instance, it is debatable whether or not investors effectively price in climate risks when valuing securities.
This is why estimating climate risk is so tricky.
The difficulty of making accurate climate risk estimates stems from the lack of knowledge about how climate risk is distributed.
In contrast to investment risk, investment uncertainty indicates both present and future uncertainty. Using the same analogy, uncertainty is like rolling a die without looking at the numbers. In this scenario, a potential investor would not know the range or likelihood of possible future outcomes. Climate factor forecasts become increasingly risky and unclear the further out in time we look.
