Let’s start with physical risks. A hurricane might damage assets, boosting capital costs as management invests in costly repairs or replacement. It could also increase operating costs—for example, storm damage to vendors’ facilities that disrupts supply chains. Lower productivity, a knock-on physical risk from rising temperatures, makes in-house and outsourced capabilities pricier. Severe weather damage to brick-and-mortar facilities can reallocate revenue among competitors, depending on local impacts.
Tracing transitional risks to financial statements requires some detective work, too. Investors can make inroads by analyzing issuers’ carbon footprints and the cost of carbon. This process involves looking at scope-one direct emissions from company-owned or controlled sources. It also includes scope-two indirect emissions from purchased energy sources, and scope three: all other emissions, upstream and downstream, in an issuer’s value chain. Most issuers report scopes one and two; very few report scope three.
The income statement is an important focal point for understanding a company’s emissions. Where on the statement are they? How could changing carbon prices affect them? Are there different elasticities or substitutions for different emission types? In other words, how much of carbon costs can be passed on and to what effect, substituted away and at what cost, or just absorbed by the issuer?
Several examples illustrate the wide range of effects on issuers’ financials.
For instance, changing consumer preferences can alter product demand. Animal proteins have a high carbon footprint, and meat-packing companies’ undeclared emissions are multiples higher than are their declared emissions. If consumers turn their backs on high-carbon food sources, and as carbon costs rise, revenue can suffer. Demand can also shift within animal proteins: from high-carbon beef to lower-carbon chicken, for example.
On the positive side of the revenue picture, relative winners from climate adaption and mitigation will include issuers producing more efficient technologies, whether it’s electric vehicles, biofuels, improved HVAC systems, smart grids or wind power.
As for the cost side of the income equation, the producers of animal proteins we mentioned could face rising costs from grain, the most critical input for raising livestock. As climate change advances, declines in crop yields will become more common, raising operating costs that issuers may or may not be able to pass through to end clients.
The Big Picture: If a Tool Can Help, Use It
Just because estimating climate-change impact and calibrating inputs to issuer-specific analysis is hard isn’t a reason for the investment community to throw up its hands. If anything, the repercussions of the COVID-19 pandemic demand that we accelerate our efforts—not put them on the back burner. It exposes some of the weakest links in value chains, the global economic system and the fundamental assumptions underlying both.
As investors, the pandemic has us thinking more broadly about risk from non-traditional sources. We’ve now seen many things that were previously considered low-risk but actually weren’t. The pandemic won’t cure climate change, but as businesses become aware of new and substantial risks, they may respond to risks that attack the system by creating more resiliency—or even by redefining themselves.
In other words, people and systems aren’t necessarily more vulnerable, but they’re more aware of their vulnerability. It’s possible to engineer the risks from the last crisis out of the system, and it’s not clear where the next crisis will come from, but investors may demand more resiliency as they become more sensitive to these independent, out-of-the-box risks.
The pandemic has also emphasized the unique opportunity for issuers—and investors—to rebuild better. A focus on developing resilient infrastructure, reshaping the modus operandi for employees and industries in a variety of sectors are supported by historically low interest rates, a nearly global need to decrease unemployment and a similar scale of behavioral shifts.
We can’t let the perfect become the enemy of the good. Any tool or analytical technique will endure a version 1.0, 2.0, 3.0 and beyond. For early versions, simply determining the direction of change in risk factors may make an impact, particularly versus passive investing. So, why not roll out these tools as soon as they can help?
Science also needs to take a larger role in such a process, and in the decisions facing governments, businesses and societies. AB’s collaboration with Columbia University’s Earth Institute focuses on better understanding how climate science can inform investment analysis. The Earth Institute’s interdisciplinary approach to climate has proved invaluable, as we establish dialogues between our investors and Columbia’s public-health experts and faculty. These conversations are helping us think through the meaning of the new normal for various sectors, industries and other stakeholders.
There will be no single, eternal answer for climate-change risks and opportunities for a company or industry. Human and physical systems will respond in ways we can’t predict, influencing both the climate and investment landscape. However, prevention is better, and more feasible, than a cure. We all need to keep learning and improving—and driving toward better outcomes.