Paying the Price: Climate Costs Outpace Corporate Preparedness

As the planet continues to warm, physical climate risk is no longer an abstract future concern. It is financially material today. The question now is where those risks will materialize and how are companies prepared for those risks. We can help you find out -  just by listening to this episode!

Report discussed: https://www.msci.com/research-and-insights/blog-post/the-bill-is-due-physical-hazard-revenue-losses-mount-plans-lag

Host: Mike Disabato, MSCI Sustainability and Climate Research

Guest: James Edwards, MSCI Sustainability and Climate Research

Transcript

Speaker 1 (00:00):

What's up everyone? And welcome to the weekly edition of sustainability now, where we cover how the environment, our society and corporate governance affects and are affected by our economy. I'm your host Mike Disabato, and this week we look at why climate hazards are already destroying the value of your investments. That is, of course, if you don't know how to look for them. Thanks as always for joining us. Stay tuned. A lot of our climate research lately has been trying to demonstrate in one way or another that climate risks for companies are no longer a future concern that at this moment asset valuations are being slowly chipped away by a more hazardous world. But recently what we've found is it's not the hazards that you might think of that are really eroding valuations, because usually when I talk to people about climate hazards, their minds flash to what are called acute events like the Los Angeles wildfires or Typhoon duri in Southeast Asia, those that grab headlines as examples of tail risks that can drive outside losses for companies.

(01:13):

But according to my guest and colleague today, James Edwards, it's the slower burning risks like hotter summers and pounding rains that are more relentlessly eroding enterprise value. Basically, he argues acute risks, test resilience in moments of crisis while chronic risks quietly erode enterprise value year after year. And he lays out this argument in a recently published blog, the link of which I put in the podcast description alongside his two co-authors, Matthew Lee and Chinch Wong. And what they keep hammering on about is that climate hazards are now financially material. They're already shaping supply chains, insurance costs, and corporate valuations. And their report lays out that for investors and risk managers, understanding both is essential to gauge which companies are adapting and which are falling behind. Now of course, after reading this, I was understandably alarmed and I wanted to know what I should do next if I should panic, sell and just buy all this gold or should I do something else? So I called up James and I asked,

Speaker 2 (02:17):

I mean, clearly this is material to your investments today, not tomorrow, today. So if you're monitoring a portfolio, if you're choosing what company to invest in doing due diligence, whether it's an equity portfolio, a loan portfolio, you do have to be aware of this, right? And not to say many people aren't already doing this, but if you're not, you should be. So that's kind of the bad news. So the good news is when we perform this risk analysis, and remember we're coming from the asset level assessment and building that up to an assessment of the issuer risk, what we see is a lot of concentration in risk. You'll see in the paper when we plot the distribution risk, there's this long tail, which means a lot of the risk is within, say, the top quintile firms. So if you look at your portfolio and rank your risk, you can identify that often.

(03:09):

A lot of that risk is being driven by say the top 10, 20% of firms. So you can zoom in on those names if you can identify them, and then determine if you're actually being properly compensated for the risks you identify from a physical perspective. And the second level of concentration of risk is when you look at specific companies, often a lot of the risk is concentrated in a specific hazard, a specific region, even a specific location, a specific factor or some industrial site. And this is helpful in two ways. First off, we do have information, although it continues to grow on the extent that companies are ready for these risks, they have accounted for them, they're integrating their risk assessments. So you can look into some of the data we have and also some of the data in their reports to say, are they accounting for these specific risks based on their disclosures? And secondarily, you can go directly to them and engage with them and discuss these specific risks,

Speaker 1 (04:05):

Right? So you can engage with the company and you could say, okay, this asset has this hazard that's coming at it. Do you actually have a practical plan in place that you've gone through and drilled into an employee's head so they can actually know what to do when disaster strikes? Or do you have some sort of highfalutin policy that just says, yeah, we pay attention to climate hazards. And the distinction between those two, the actual practical plan and the policy is an important one. It's a useful one. In talking with a company, or at least in analyzing a company and one that James and Hin and Matthew actively assessed, they looked at data from over 9,300 listed firms, and the issue is, is they found a worrying gap. While about two thirds of companies have assessed physical climate risk, only 56% of those companies have integrated those findings into a real risk management or strategy. That practical plan that I mentioned in sectors like utilities and real estate preparedness is improving, but in technology and healthcare adaptation still lags. I wanted James to zoom in as close as possible on this data to give me an example of a company that he and Matthew and Chichen looked at and explain to me how they could take, or an investor could take a large company's portfolio of assets, zoom into one site in one region that was facing a certain climate hazard and make sense of it.

Speaker 2 (05:26):

Alright, so say we took, as an example, a portfolio of the 30th largest integrated oil and gas companies globally by market cap. If you look at these names, what you'll see is by our estimates and focusing on acute risk that Petrobras is the highest risk name in terms of average annual loss in 2025 or in the next 12 months. And really its risk is about five times higher than the average or median name in this portfolio. So you're seeing that this Petrobras has this much higher risk for acute risk. If you are invested in Petrobras, you want to understand where that's coming from, and you can see most of that is coming from plumal flooding and then digging into their individual assets. You can see that the majority of that is being driven by the fact that they have three or four refineries, key refineries in Brazil that are highly exposed to this hazard. Now, if you're invested in petrobas, you want to understand that risk. Does that matter? Are they doing something about it? We do have information that they assess their physical risks, that they integrate climate risks and their business risk processes, that they have a climate specific risk management process. So that would be something that maybe mitigates that risk in your analysis. And then also you could engage with Petrobas and say, what are you doing about this risk? Is there any specific adaptation or mitigation in place?

Speaker 1 (06:54):

Or at least can you Petro boss representative or company X representative for hypothetical company X? Can you give me your thoughts on flood risk for the asset in this location that we've identified and seems to be something that you should be paying attention to? And if they can't, well then that average annual loss number that James was talking about, which by the way, is the loss of revenue from both business interruptions and asset damage. Well, that number might be more likelier than a hypothetical company that does have a plan in place or does have an opinion on the flood risk for the asset that we've identified. But the thing is, it might be that all companies actually need some sort of physical climate hazard plan in place in the future, doesn't it? If we are to assume that each tonnage of carbon that is released into the atmosphere increases global temperatures by a small percentage, and each small percent of increase of temperature leads to worse storms and a weirder overall climate, does that mean that the losses that James and his co-authors talk about in their piece are just the baseline that each year as it gets hotter and hotter, that asset values will be hit with an ever worsening set of a eroded valuations?

(08:06):

It's a question I put to James.

Speaker 2 (08:07):

Well, I think it's important to take these numbers in context. We estimate in the paper that the cost of firms over the next 12 months is $1.3 trillion, which obviously is a huge number. But that's not to say that firms weren't facing a good amount of these costs in previous years. There are always extreme heat events. There are always floods, tropical cyclones. What's changing is first, there are a lot of studies and evidence that these physical costs have in fact increased over the last five to 10 years. We expect that they're continued to increase year over year as the world continues to warm. And maybe most importantly, from an investor perspective, there are a lot more eyeballs on these events after the wildfires in la, the North Carolina floods, the Texas floods, European heat waves, et cetera. So if you're an investor, I think there's a reasonable expectation that these physical risks are going to have a larger and a larger effect, both on bottom lines and valuations of companies as we move forward.

Speaker 1 (09:15):

I mean, really what this is all about is proper asset valuations and how to better model these possible losses so we can actually account for them and know if these prices that we have to pay as investors are actually the right ones, or if assets are overvalued or undervalued or at risk for some catastrophic event. And it's those sneaky chronic risks that seem to be the ones that do not get priced into asset valuations and can actually erode value year after year quite quietly. And the louder acute risks that are catastrophic and devastating, but might be easier to factor into asset valuations are better accounted for and better planned for. What's going to be fascinating in the coming years, and well, maybe not fascinating, but mesmerizing in a painful way, is seeing where these risks really start to chip away at the locations that companies depend on.

(10:07):

The data center question seems to me everyone's main topic of conversation right now, because AI is gobbling up resources in its race to make everything more efficient, so many companies are starting to try to rely on that ability for AI to become more efficient. But what happens if the data centers that AI relies on are located in areas facing growing chronic risks? Does that mean that the valuation of companies relying on those centers gets more complicated by potential damages? Does that mean the companies that are helping to build these data centers are actually not going to be able to do so in the appropriate manner and there's just going to be losses all around? Who knows? But at the very least, paying attention to that possibility feels essential in this day and time. And that's it for the week. I wanted to thank James for talking to me about the news with a sustainability twist. I wanted to thank you for listening. If you liked what you heard, don't forget to rate and review us and subscribe if you want to hear myself or any of the other hosts of sustainability now each week. Thanks again and talk to you next week.

Speaker 3 (11:34):

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