Physical climate risk isn’t a distant concern. For long-term investors, climate impacts are already proving more frequent and costlier than anticipated. This is prompting a reassessment of how and when these risks will materialize. On this episode of The OMFIF Podcast, Richard Manley, Chief Sustainability Officer at CPP Investments, sits down with Yara Aziz, Senior Economist at OMFIF, to discuss why the present value of physical climate risk is rising for long-term investors. They discuss how CPP Investments integrates those risks into decision-making, the barriers the industry still faces and where climate resilience creates opportunity.
*The following has been edited for clarity and brevity.
Why is physical climate risk becoming a bigger priority for long-term investors right now?
Richard Manley: It’s a great question, and probably the question of the moment. Historically, the focus of policy makers, corporate boards, and investment committees was transition risk. As the policy environment over the last few years has slid from anticipating roughly 1.8°C, post-COP26, to the mid-2s and low-3s degrees of warming, post-COP29, the present value of physical risk is now potentially equating to that of transition risk.
We’re seeing more frequent and tangible manifestations of physical risk impacting securities prices and asset values. The certainty of physical risk is, in many instances, happening sooner than assumed, with return rates of climate events happening more frequently and with the damages proving to be greater than were anticipated. That’s compelled institutions to conclude more effort needs to be invested in understanding physical risk, identifying where it resides, quantifying how large it might be, and working out how to mitigate it.
How does CPP Investments integrate physical risk into due diligence?
Richard Manley: Our approach to any component of sustainability is grounded in materiality. If our first review of diligence concludes there is no material transition risk or there is low physical risk, we don’t spend a lot of time diligencing it. Where we conclude either or both factors are material, we dial up the diligence to understand the quantum of the risk, where it resides, and the cost to mitigate.
The tools that are emerging to help us understand physical risk are location-specific models. If you know where the asset is located, you can see the current perils that are prevalent in those locations and how they are likely to evolve over time under different scenarios. Using these tools in conjunction with insurance advisors, we can understand the level of risk, the likely increase of risk, and the cost of that increasing risk to the company.
But location-specific risk is often a small fraction of the total exposure to physical risk for any specific company. We need to understand what the raw materials are, where they’re coming from and which acute or chronic climate risks might impact their future availability. How does the raw material get to the customer, where are the manufacturing facilities and how are they exposed, what is the infrastructure that the product moves along over the life cycle of its manufacture, where is it sold, and what is the potential impact on demand?
What are the biggest barriers to integrating physical risk more effectively?
Richard Manley: First, and I think the report draws this out well, is the raw data on assets: the location of supply chains and end customers, and how products get from A to B. Second, the models that translate weather into damage are backward-looking. As evidence of climate risk builds, their projection of damage increases.
There are two elements that are particularly hard to model: migration of populations as a potential byproduct of global warming and the potential dislocations in the insurance markets.
In some areas hard-hit by recent climate events, the cost of insurance is quickly increasing and the availability of insurance is proving harder to secure. This becomes a potential tipping point for securities prices because, in most instances, having an insurance policy is a covenant term. If insurance costs are going up, pressure on earnings can constrain the ability to borrow slightly and a move to self-insure would likely increase earnings volatility and with it the cost of equity, lowering valuation multiples.
Therefore, while we understand where risk resides, the ability to translate it into robust estimates of value impairment is proving harder. Today, most macro models that translate changes in climate into impacts on economic activity and securities prices are more than likely underestimating risk rather than overestimating it.
Where do you see the biggest opportunities, especially around resilience?
Richard Manley: At the system level, I’d say the biggest opportunity is forward insurance pricing, which can start to inform policy decisions, corporate strategy, and underwriting standards. Not just the price for the next 12 months, but an indication as to how that cost might change over time. I think providing a lens on the opportunity cost if we don’t adapt will be a valuable signal.
At an individual investor level, physical risk is not as well understood today so it is not yet translating into pricing. This presents two opportunities. First, there are companies that are relatively insulated from physical risk, where future impact on their operations and operating costs are quite benign, so there is real potential for them to gain market share if competitors suffer business interruption. Identifying those companies to capture the tailwinds from increased top line growth as they gather that market share is certainly one investment opportunity. The second investment opportunity is understanding where physical risk is likely to present itself and seeking to underwrite what the cost of adapting the business is to either insulate it or at least underwrite more accurately.
In specific areas in the portfolio where we identify physical risk exists, in many instances, the cost of adaptation is actually quite modest.
For more, read OMFIF and the Insights Institute’s jointly published report: Investing in a changing world: How public funds are addressing climate-related physical risks.
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