The industry is now seeing an expansion in data-driven practices, with new ESG and climate datasets emerging and becoming mainstream. We explore what climate risk metrics are and how they are used today.
Data plays an important part in investments. Through the analysis of data, investors can better understand the risks they are exposed to and are able to construct portfolios that are positioned relatively efficiently in their risk/return trade-off. Recent advances in data availability and analytics have allowed for improved analysis of risks and the setting of more accurate expectations. The advances of new datasets include ESG metrics and new analytical tools, such as machine learning.
Climate change is an example of a risk that is now being mapped with quantitative data. Climate change itself is a phenomenon comprised of many interlinked processes, each with their own risks and uncertainties. As a trend, investors are becoming more aware of the risks and opportunities that result from climate-related shocks and are starting to appreciate the importance of formal, quantitative risk metrics. To cater to this growing demand for quantitative climate change risk metrics, vendors have begun to explicitly model climate change risk, and some now include climate change risk data as a part of their overall offering.
The physical and transitional risks of climate change1 are also economic risks and are closely linked to long-term portfolio performance. Like the more traditional measures of portfolio risk, climate change risk is of relevance to risk-averse investors; however, climate data is different. As a relatively new area of risk analysis, climate data is still developing; consensus views in many aspects of risk modelling are yet to be established. Climate change also consists of many complicated sub-processes that interact with one another through flow-on effects, which increases modelling complexities. Many of the underlying processes that govern climatic variables are dynamically evolving over time,2 resulting in modelling difficulties when solely using historic climate data to forecast the future3. Despite these hurdles, there have been major increases in the sophistication of available climate change risk metrics, and we continue to see development in this area.
What are climate change risk metrics?
Initially, climate risks were proxied mainly using portfolio carbon exposure; this was typically limited to equity securities. Limitations of such an approach are that carbon emissions are predominantly backwards looking, while investment risk is concerned with the future. Furthermore, carbon emissions only reflect a portion of total transition risk, which is itself only a subset of total climate risk.
Developments in climate risk metrics now allow investors to consider multiple avenues of climate risk, in which multi-asset exposures to various climatic variables (i.e., both physical and transitional factors) can be used in risk analysis. As a result, investors are now able to use quantitative data that maps their portfolio sensitivity to climate change scenarios.
Climate change risk metrics are indicators of investment exposure to a variety of climate risks. These climate risks include various physical risks (broadly categorized by the acute and chronic physical processes that might play out in climate scenarios)4 and transitional risks (categorized by the Task Force on Climate-Related Financial Disclosures as policy and legal, technology, market and reputational risks).5 Both physical and transition risks are comprised of separate factors that investors should be concerned with, as each individually poses their own risk.