Pricing climate risk is proving tricky for money managers

When investors contemplate risk, it’s straightforward to think about measurable economic shifts like rising interest rates, inflation and sales trends. The data are readily available and simple enough to incorporate into financial models. The looming risks from climate change, on the other hand, often elude money managers. While they know that it’s likely a mistake to not incorporate threats such as extreme weather into company valuations, and that climate change will impact most of the stocks already in their portfolios, few investors are making the calculations.

The problem? Access to comprehensive environmental data is expensive, corporate disclosures are inconsistent, and drawing links between climate science and financial returns is an interdisciplinary challenge. “There’s a market failure to really understand and appreciate the potential impacts of the physical changes that climate change will bring to the global economy,” says Rick Stathers, climate lead at Aviva Investors, a global asset manager. “I think that’s severely underplayed at the moment.”

There are, however, a handful of early adopters taking steps to grasp the impact of climate change on investing, including by hiring climate scientists to parse the numbers. Matt Goldklang is one of them. He joined Man Numeric, part of the world’s largest publicly traded hedge fund manager, Man Group Plc, after receiving a master’s degree in climate change and doing a stint building statistical climate models for the Natural History Museum of Denmark.

“Academics move at a slower pace because they’re so precise about the work they do,” he says. “Integrating climate science into markets becomes one really productive way of disseminating that information to where it matters potentially most: capital.” Along with his colleagues, Goldklang helps develop models for climate change pricing. With the assistance of global open-source climate models—some with more than 18,000 pages of code—the goal is to determine which companies will be the winners and losers in a world where weather disasters are mounting year by year.

Goldklang was first drawn to the work as a teenager during a family trip to Alaska. A tour guide explained that nutrients from the ocean were transferred to trees through salmon that were eaten by bears, which fertilized the soil with their scat. But higher water ­temperatures have meant fewer salmon in streams and, consequently, a changing diet for the bears and a rapidly shifting ecosystem in the forest.

For Goldklang and peers around the world, last year’s historic weather events—including the hottest August on record, unprecedented rainfall in Vermont and Libya, and wildfires in Canada that burned millions of acres—reinforce their conviction that markets are severely underpricing the physical risks from climate change. And just like in the Alaska ecosystem, each risk has complex ripple effects—on economic growth, supply chains, government policy and more.

The nuts and bolts of what Goldklang and his colleague Ben Zhao, a portfolio manager for long-term strategies, do with their team involves collecting a range of climate change data from outside providers, including information on extreme weather events, and combining it with Man Numeric’s internally maintained data to make the information more relevant to financial markets. The researchers look at physical risks like drought, as well as the potential impact of emissions regulations on a company’s bottom line. The goal is to go from a big-picture view of climate change to understanding how it affects individual companies.

Last year, Man Numeric’s physical risk models pointed to a larger negative impact on a large US food production company’s earnings than on those of its peers, based on its sensitivity to drought and heat waves. A few months later, the company’s shares plunged by double digits when its earnings results showed weakened demand and increased costs, with drought one of the factors. “The direct and indirect water use that Man Numeric tracked reflects the company’s heavy reliance on water in its supply chain,” Zhao says. “When drought hits, there is an increase in the cost of livestock feed, and that leads to an increase in the cost of livestock.” Man Numeric declined to name the company or any trades related to it for compliance reasons.

Drought is the costliest type of severe weather risk for companies, according to BloombergNEF analyst Danya Liu, based on an analysis of roughly 8,400 firms participating in a voluntary survey from CDP, a nonprofit behind a disclosure system concerning ­environmental impact. This is probably because droughts typically have a longer time horizon than other weather events, she says. Liu’s analysis found that each drought leads to a median loss equivalent of 0.3% of annual revenue, with flood and fire the next most costly.

The past decade has seen a sprouting of funds that apply environmental, social and governance (ESG) investment criteria. A few funds use their position as shareholders to push for change in corporate environmental practices. But there’s also been a political backlash against ESG investing in the US, with Republican officials in particular arguing that it harms states such as Texas and West Virginia that rely on fossil fuels, and that investment managers should stick to trying to maximize returns for clients.

In sectors where climate risks can be quantified, however, paying attention to them could become a simple matter of due diligence. Investors in the insurance industry have been looking at stark numbers for years: Insured losses from natural disasters were about $95 billion in 2023, according to estimates from German insurer Munich Re. Similarly, when Hurricane Ian hit, Carnival Corp. and other cruise operators in the US had to cancel departures, prompting a drop in their shares. And Impact Cubed, a data provider that works with asset managers, calculates that more than 70% of Tesla Inc.’s tangible assets—the dollar value of its property, factories and equipment—are exposed to the threat of drought, far higher than for its peers Ford Motor Co. and General Motors Co.

Man Numeric published research in June that looked at the risk-adjusted return of stocks that either got a boost from news about climate change or tended to fall following periods of heightened attention around climate risks. Goldklang, Zhao and their colleagues found returns that couldn’t be explained by a collection of well-known asset-pricing factors. In other words, investors, on average, had not fully priced in climate change risks.

Dutch wealth manager Van Lanschot Kempen NV is taking a slightly broader approach than Man Numeric by building a “heat map” that tracks natural disasters to help it screen its portfolio. The company took a model of natural disasters tracked by Munich Re and overlaid it with buildings owned by real estate companies in its investable universe to determine which properties are more vulnerable to climate change. The areas are color-coded by risk.

“The heat map will identify areas like Texas, where rising temperatures have created so many climate events that it starts to become worrying,” says Egbert Nijmeijer, co-head of real assets at Van Lanschot Kempen. That’s in contrast with northern US cities such as Boston, which “don’t face that many climate-related events like hurricanes and droughts and wildfires.” In one example of the heat map’s findings, the valuation of the San Jacinto Center in Austin, a commercial real estate development owned by Cousins Properties Inc., would slide 7% under a scenario that assumes emissions will peak around 2040. Conversely, 200 Clarendon St., an office tower owned by Boston Properties Inc., would drop just 2% under the same conditions.

For Geneva-based Pictet Wealth Management, the most viable way to quantify climate change’s impact on investments is to consider government targets around carbon emissions. The company then calculates the impact the pledges would have on demand for key inputs such as critical minerals that are used to generate renewable or relatively clean energy. It then estimates the effect on prices of these materials like copper, nickel and lithium, also considering such factors as the concentration of mines in a country or any change in extraction technology. The higher costs of these inputs are then fed into models for calculating a company’s profitability as one of the variables for determining the fair value of a security.

As companies spend more on the transition to renewable energy, their budgets for other investments will be increasingly stretched. “Because they’re going to use part of their cash flow to fund their capital spending, you take that into consideration for your long-term views on expected earnings,” which can eventually affect dividend or buyback policies, says Alexandre Tavazzi, head of Pictet Wealth Management’s chief investment office and macro research.

Money managers say there’s still a long way to go when it comes to getting the data they want. Lombard Odier Investment Managers, for example, has developed a way to measure soil health in different regions to determine risks to food systems and broader supply chains. But to make that information useful, the asset manager would need to identify the companies sourcing their agricultural products from those regions, according to Thomas Hohne-Sparborth, its head of sustainability research. “What you want to be able to do is go to a subregion or even a farm level,” he says. “That is a degree of disclosure that today doesn’t exist.”