Factoring Climate Risk into Financial Valuation

  • Dr. Blair Feltmate
  • Natalia Moudrak
  • Kathryn Bakos
  • Brian Schofield
Close shot of flood Protection Sandbags with flooded homes in the background

The Global Risk Institute provided funding for the research and the preparation of this paper. The authors are independent contributors to the Global Risk Institute. They are solely responsible for the content of the article.

Executive Summary

The Task Force on Climate-Related Financial Disclosures (TCFD), and the Expert Panel on Sustainable Finance (EPSF), both advised that climate change and extreme weather risk should factor into institutional portfolio management. This paper offers a practical means to execute on that advice, that conforms well with the risk management protocols that have become convention since the financial crisis (2008).

Climate Risk Matrices, presented herein for two industry sectors, identify the top 1-2 physical climate risk impacts that portfolio managers should prioritize as most material to affect performance of companies within a given sector. These 1-2 impacts reflect the expert advice of operations officers or similarly experienced subject matter experts within industry sectors – based on their collective experience, these practitioners are best positioned to identify a short list of material means by which flood, drought, fire, wind, etc., may convey risk to companies within a specific sector. Within this paper, climate risk reflects the magnitude of an impact, juxtaposed to its probability of occurrence (which includes tail risk). Prioritized impacts presented within Climate Risk Matrices provide standardized guidance to portfolio managers, in user-friendly language, which can be used to determine if, and how, issuers are mitigating climate change and extreme weather risk satisfactorily.

Two Climate Risk Matrices – Electricity Transmission & Distribution (T&D), and Commercial Real Estate (CRE)
– presented in this paper, illustrate the user-friendly and interpretable information that a portfolio manager would receive. The protocols used to develop both the T&D and CRE Climate Risk Matrices are transferable to any industry sector.

Guidance is presented to help ensure that issuers profile climate risk data, relative to each industry sector, in a manner that is readily predisposed to five common financial valuation methods: (1) Ratio Analysis, (2) Discounted Cash Flow, (3) Rules of Thumb Valuation,

(4) Economic Value Added (EVA®), and (5) Option Pricing Models. Utilizing these methods, a quantitative case study is presented whereby climate risk impact on share price is presented for a publicly traded issuer, thus illustrating that so-called “non-financial” measures of performance are predisposed to valuation.

Relative to next steps, all major industry sectors were reviewed (utilizing publicly available climate risk/ESG reports) to determine which offer the greatest predisposition to develop additional industry-specific Climate Risk Matrices going forward. Those sectors were determined to include (1) Materials, (2) Energy, (3) Utilities, (4) Industrials, and (5) Real Estate (See Appendix 1).

Although the utility of Climate Risk Matrices discussed herein focuses on institutional investors, the matrices offer value to securities commissions (to guide expectations on climate risk related disclosure), credit rating agencies (to identify a borrower’s key climate risk liabilities) and Boards of Directors (to set a framework for Board members to ask appropriate climate risk related questions of management).

Time is not a luxury in reference to applying climate risk to portfolio management. The development of industry specific Climate Risk Matrices offers an immediately executable and practical means to incorporate climate risk into portfolio management now, which in turn will drive GLOBAL preparedness to arrest the future impact of irreversible and largely debilitating climate change.