Investors Are in a Race to Find the Best Models of Climate Risk

Sustainable finance is having a reasonably good pandemic. Environmental themed funds have had fewer outflows, and companies with better environmental, social, and governance ratings have tended to fare more lucratively than their peers.

It makes sense on an intuitive level. The pandemic reminds us of the fragility and importance of the physical world, and also of the threat of sudden, non-linear risks. This has dramatically accelerated the emergence of a hot new finance trend: assessing how potential climate change outcomes such as rising sea levels or heatwaves might affect the performance of an investment.

“Physical risk” or “climate impact risk” used to be a niche concern, mostly consisting of bespoke analysis for companies big investments in massive infrastructure. (This category includes, ironically, oil companies.) That’s changed quickly. Scientists have spent decades refining models of the Earth’s climate, and financial institutions—increasingly conscious that the effects of climate change are already costing them money—want to use sophisticated tools to get an edge on understanding their level of exposure in the years to come.

There’s now an array of companies offering portfolio-wide assessments of physical climate risks, ranging from specialist startups to mid-sized sustainability consultancies to shops within the big global advisory firms. The idea has become so popular, it’s now tough to find a consultancy in the financial services sector that isn’t offering some kind of physical risk analysis. Some investment managers such as BlackRock are even developing their own capabilities in-house as a service for clients.

That said, there’s a steep learning curve with assessing physical climate risk. In the last two years there have been around a dozen guides published by investor networks, consultancies, and research institutions that aim to walk financial institutions through the process. The most recent is from the London-based Institutional Investor Group on Climate Change, published in late May. It advises, for example, that investors not rely on disclosures of physical risks from an investee itself, as most of the reports published by companies don’t contain “decision useful information” for investors.

In other words, those sophisticated climate risk maps now starting to appear in company reports are pretty worthless.