IMF warns equity investors over climate risk

Equity investors will increasingly have to consider the physical impacts of climate change on their portfolios, according to recent guidance from the International Monetary Fund.

In a written update on its website, the IMF outlined the direct cost of severe weather events such as floods, forest fires and tsunamis.

As a case study, the IMF considered the impact of the extreme floods in Thailand in 2011, which caused a 30% drop in the country’s stock market for more than 40 days. That year, GDP fell by 10%.

In its research, the IMF found that such severe weather events cause direct damage worth an average $1.3trn a year. These are likely to increase in frequency and severity as climate change worsens.

The organisation’s latest Global Financial Stability Report, published in April, found that equity investors may not be adequately pricing in such risks. A comparison of 2019 equity valuations across different countries found these had not reflected any commonly-discussed global warming scenarios or incidence of physical risk.

Faced with the fact such weather events are likely to become more frequent, and with Covid-19 exposing how vulnerable some sectors and portfolios truly were, the IMF argued: “This apparent lack of attention could be a significant source of market risk looking forward.”

A daunting prospect

Fully protecting a portfolio against such risk is a daunting prospect for many equity investors. Estimating the likelihood of various climate scenarios - and how they could threaten a portfolio - poses a significant challenge. The length of time under which such assessments should be calculated may be longer than that of which some institutional investors are accustomed.

It’s no surprise then that a 2019 survey by Climate Change Collaboration and the UK Sustainable Investment and Finance Association revealed a lack of commitment across the asset management when it comes to these considerations.

Of the fund managers surveyed, 21% had a policy of aligning their funds with the Paris Agreement, with 46% having no such policy (with 57% of those investing oil companies admitting they haven’t considered their response if these fail on carbon targets).

Increased awareness

Greater public awareness of climate change is increasingly resonating with investors and has inspired some breakthroughs.

The Church of England recently launched a custom passive index as part of its £2.8bn retirement fund, focusing investment on companies aligned with the Paris Agreement. Upon launch, the index received an initial £600m investment from the church which means the Pension Board portfolio will have a 49.1% lower carbon intensity than in its current passive allocation.

And this month the largest private pension scheme in the UK, the £75bn Universities Superannuation Scheme, bowed to pressure and vowed to end investments in areas relating to coal and fossil fuels.

Similar changes can be expected across the British pension fund industry due to the upcoming Pension Scheme Bill. Once passed, trustees will be required to effectively govern their schemes in line with climate change risk (including monitoring exposure, rectifying where necessary and generally seeking portfolio alignment with the Paris Agreement). Unlike previous measures, these requirements will be mandatory and trustees could incur penalties of up to £50,000 in the event of a breach.

However, the IMF has argued more can still be done, suggesting policymakers consider the development of global mandatory climate change physical risk disclosure standards.

With access to better information, lenders, insurers and investors could better assess these risks. Overall, though, the IMF acknowledged the best long-term remedy would be the reduction of greenhouse gases and address the causes of global warming – steps that would have benefits beyond financial stability.