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Evaluating Your Investment Portfolio for Climate Change Risk

By September 29, 2021No Comments

Private equity fund managers, unlike their corporate peers, have generally been on the receiving end of standards imposed on them by investors with regards to ESG aspects. This has resulted in confusion on how to respond to the multitude of ESG standards, especially when investors have different standards. European and US investors, in particular, have greatly different expectations from their fund managers when it comes to ESG reports.

We are seeing the same patterns emerge when it comes to climate change reporting. The explosion of climate change reporting requirements since 2017 has put fund managers under pressure to develop technically sound and financially prudent approaches to reviewing their portfolio, and to do so in a manner which does not require an update of the methodology every time a new standard is issued.

In this first article in the series on climate risk and portfolio management, EBS has developed the following set of recommendations to assist fund managers with achieving an appropriate balance between reporting compliance against the various standards (such as TCFD and UNPRI) and practical portfolio valuations:

1. Determine your sectors of greatest exposure:

While it is true that there are certain sectors that are more exposed to climate risk than others, such as agriculture and property-based investments, it is prudent that an investor considers all sectors and the consequential liabilities that may accrue from changing weather events. A few examples follow:

  • While private equity tends to avoid investing in primary mining and energy, supply chains into any fossil fuel linked investments are unlikely to attract positive attention from shareholders and consumers
  • Hospitality occupancy rates depend on accessibility and consistency of weather
  • Distribution and logistics are vulnerable to physical risks such as flooding
  • Construction is exposed to interruptions in manual labour in periods of extreme heat or cold.
  • Forestry is affected by fire, and the knock-on effects of runaway fires in peri-urban areas affects transportation, public health, insurance, supply chains, etc.

In our experience, almost every sector has a unique blend of risks resulting from climate change, many of which are only manifesting now as climate-related impacts intensify in different ways across the planet. Performing a detailed and holistic review of each sector’s exposure forms an important part of governance and risk management procedure for any fund manager.

2.Determine your timeframes:

The science and modelling around climate change are evolving rapidly as data capture and processing improve, and investors will be called upon to decide which scenarios and research they will choose to drive their decision-making, objectively and credibly. However, as with all models, these climate models are projections into the future and thus subject to varying levels of uncertainty. Determining your risk horizons and updating these periodically as climate change models improve, is therefore another aspect of periodic risk assessment protocols that we would recommend. These timeframes also need to be considered in terms of regulatory pressures, as different governments in different regions have different expectations on targets being met.

Timeframes are also important in distinguishing between acute and chronic climate change impacts. The former impacts manifest in a short time in the form of extreme events, such as hurricanes and floods. By contrast, chronic climate change impacts manifest over longer timeframes, such as sea-level rise and long-term droughts.

3.Determine your boundaries:

Climate change could affect not only your individual investee company, but the entire social fabric upon which that investment depends. This may include that company’s staff, their dependents, neighbours, communities, customers, suppliers, and local regulators. The knock-on effects from social disturbances can be extensive, and a holistic yet practical view of the interrelationship between these risks and the investors’ sphere of influence would be another prudent approach.

For example, droughts constrain a community’s purchasing power by changing domestic spending patterns. Such reduced consumption may affect an agricultural company’s revenue more than the climate-related costs of lower yield and water security. Similarly, linkages exist between climate change and political instability, introducing new risks to investors, lenders, and insurers.

As is evidenced from above, establishing one’s climate risk exposure is more involved than just counting how many plane tickets have been purchased by executive management.

If you need assistance with unpacking which aspects of climate risk and disclosure are specifically relevant to your organisation and portfolio, please schedule a call with EBS’s Climate Risk Specialist.