Investors face headwinds in integrating physical climate risks

While investors are increasingly factoring physical climate risks into their decision making, there are several challenges to doing so, a review of public funds' experience has found.

A new report from CPP Investments and thinktank OMFIF looks at how public funds are addressing climate-related physical risks and the barriers they face, drawing on the experiences of five investors - CPP Investments, GIC, NZ Super Fund, Healthcare of Ontario Pension Plan, and Norges Bank Investment Management.

It found the primary challenge in integrating risk into investment decisions is data availability and robustness, or lack thereof, particularly for assets where location-specific data is limited.

The report said many models struggle with accurately capturing the financial materiality of assets. It said this is particularly the case in regions or sectors where risks are poorly understood or underpriced.

"Current market practice largely relies on climate scenarios and integrated assessment models that are 'inherently uncertain, particularly on multi-decade timespans with potential tipping points and second- or third-order downstream impacts'," the report said, adding that one fund noted an inherent tension in applying a broad number of scenarios to produce a range of results.

While this provides a broad perspective, it's difficult to use in practice, the report said. At the same time, a base-case scenario is easier but risks narrowing the focus when managing the climate risks of a portfolio, it said.

Another barrier highlighted in the report is the misalignment between the time horizons of physical risks and investment cycles.

While physical risks typically manifest over long periods, traditional valuation techniques generally price in near-term policy risk while underestimating the cost of long-term physical risk, one fund noted.

"This mispricing contributes to long-term systemic risk in the market and makes it difficult to fully incorporate long-term physical risks into investment decisions - even though private market investments, such as infrastructure, are less affected due to their longer time horizons," the report reads.

A further challenge was also identified in policy development, feasibility, budget and investment case, saying they're an important element of physical risk assessment but are the reasons adaptation, metrics, assessments, plans, and investments are lagging.

To overcome the barriers faced, and despite the lack of data, funds are expanding their analysis of physical risks, particularly for listed equities and corporate bonds.

In addition to advocating for better data and collaborating with research houses for it, the report noted some funds are investing in new geospatial and satellite-based climate risk analytics to improve the quality of location-specific risk assessments. Some are also integrating catastrophe modelling frameworks to better predict extreme weather events and the impact they'll have financially.

"We are working to integrate physical climate risk metrics into our base case underwriting to ensure that assets are priced correctly in consideration of long-term exposure," one fund said, while others are building dedicated climate risk teams.