Climate change
How climate change can
impact investments

As one of the defining challenges of this generation, climate change is not just an
environmental concern, but also an economic one. Already, it’s changing how businesses
operate, governments regulate, and individuals consume. It’s no surprise, then, that certain
climate factors will ultimately influence which investments turn out to be successful - andwhich do not.

Unfortunately, as with most predictions, it’s
impossible to forecast climate change trends with
100% accuracy. The climate may worsen morethan expected, or market participants may react
differently than hypothesised. These diverging
outcomes are examples of climate risk and havethe potential to shock investment performance.

What is climate risk?
To understand how climate change may disrupt our
understanding of investment risk, it’s important to first learn
what investment risk is usually understood to be.
Investment risk can be thought of as the potential forinvestments to generate an unexpected return outcome, or
the range of possible future investment outcomes.
Investment risk can also be interpreted as a known range ofpossible future outcomes. Imagine you were to toss a die,with the resulting number being how much your investment
would return. The expected average roll is between threeand four - however, you might instead roll a one or a six.
This is investment risk.
Because we know that there are multiple future scenarios ofclimate change, there are also multiple possible
consequences on investments. Even if investors set
reasonable expectations of the future climate, there is still
the potential that it may play out differently than expected.
This is climate risk.
Climate risks are typically disaggregated into physical risk
and transition risks.1
1

Physical risks
Physical risks refer to the potential for weather and climaterelated damage to affect asset prices. A major concern
around climate change is the costs associated with anincreasing frequency and intensity of natural disasters andextreme weather, such as floods, storms, droughts,
hurricanes and wildfires. These impose costs by damaging
existing assets, destroying stock, constraining operations
and disrupting existing demand. Certain investments are
more sensitive than others when it comes to physical risks.
For example, agricultural companies are more at risk ofdrought-related costs than an information-technology firm.
Examples of physical events impacting investment value
include:•Droughts destroying agricultural crops•

Flooding damaging properties•

Hurricanes destroying infrastructure and buildings•

Reduced snowfall at ski resorts•

Coastal resorts being damaged by sea-level riseTransition risks
Transition risks are the risks arising from the shift toward a
low-carbon economy. As the climate continues to worsen,
the attitudes of market participants are likely to change.
Governments are likely to become increasingly open totaxing emissions and subsidising. Consumers may shift

A third type of climate risk is liability risk. Liability risks relate to the possibility that parties that have suffered losses from the previous types of risks seek
compensation from those they hold responsible. These risks are more relevant for the insurance industry as they are spill-over risks.

Russell Investments / How climate change can impact investments/1their demand towards greener products, while firms maychange their business models to accommodate trends.
These outcomes fall on a transition scenario spectrum,
which creates risk. An example of transition risk is a firmthat pollutes a large amount of carbon emissions, and faces
the prospect of future regulatory costs, or consumers
switching toward firms with better environmental trackrecords.

events is exponentially higher. Estimating how market
participants might change their behaviour in different futureclimate scenarios is fraught with uncertainty, as there islimited historical data from which future relationships can be
estimated. In addition, because climate change trends arelikely to structurally shift our global economy, historical
relationships between the economy and the climate might
not even be the same in the future.

Examples of transition events impacting investment value
include:•Industries that may have to pay higher carbon emission
taxes

•

Firms that may have to spend to reduce their emissions•

Carbon-intensive manufacturers that see consumer
demand switching to other environmentally friendly
products

Market reactions to climate change
When talking about physical risks, the worst impacts ofclimate change are easier to comprehend because they are
tangible. The real difficulty comes when trying to predict themagnitude of these costs over the lifetime of a business.
The further out the prediction, the less accurate they are.
Transition risks are even more up in the air. While physicalrisks are a function of the range of climate and weather
outcomes, transition risks are functions of how consumers,
businesses and regulators will react to them. This adds anextra layer of unpredictability.
Lastly, it is important to note that market reactions are not
only functions of the changing climate, but also of the
behavioural quirks present in investors. For example, it’s
still unclear whether climate risks are currently efficiently
factored into security prices by investors.

Why climate risk is difficult toestimate
Estimating climate risk is hard because of the uncertainty
around the true distributions of climate risk.
Unlike investment risk, investment uncertainty reflects
current and future unknowns. In keeping with the priorexample, uncertainty would be tossing a die without evenknowing the numbers that are painted on each side. In thisexample, an investor wouldn’t even know what the potential
future outcomes are, or their probabilities. The further out
we try to forecast climate factors, the more the risk as wellas uncertainty.
Climate science is a relatively young field of study. There’s
still much we don’t know about the future of the naturalenvironment, and we know even less about how the market
may react to a changing climate.
Even as climate science comes to a better understanding ofwhat has generated past climate patterns, there’s still a lot
to learn before we can make better forecasts of physicalevents. The difficulty in forecasting the impacts of transition

Russell Investments / How climate change can impact investments

How does the industry measureclimate risk?
There are currently several metrics that can be used tomeasure the different types of exposure to climate change.
Physical risk exposures are often measured throughquantitative modelling using either historical relationships
between climate factors, such as temperature or
precipitation and security returns, or through simulations ofwhat the future might look like under certain climate change
scenarios.
The most common measure of portfolio climate exposure iscarbon exposure. Carbon exposure refers to a company’s
carbon emissions and fossil fuel reserves and is generally
used to manage transition risk. Firms that emit large
quantities of greenhouse gases are more likely to face
additional costs of reducing emissions or paying fines. Many
investors, therefore, use carbon data as a method ofmanaging their portfolio transition risk exposure.
Carbon emissions are the releases of greenhouse gas
emissions - usually expressed as carbon dioxide
equivalents - into the atmosphere. These are typicallydivided into scope 1, 2 and 3 emissions. Scope 1 emissions
are those that are directly emitted during the production
process. Scope 2 emissions are indirect, arising whenelectricity, heat, or steam that has generated emissions
during production is then consumed by a buyer. Scope 3
emissions capture a wider range of indirect emissions which
occur during upstream and downstream activities in the
supply chain (such as transportation or waste disposal).
Fossil fuel reserves are the known and potential fossil fuelsthat a company holds as assets on its balance sheet. The
definition of these is more straightforward than that ofcarbon emissions. Fossil fuel exposures are largely
concentrated within specific industries, such as the oil andgas sector.
Despite the introduction of these measurement tools andmetrics, many still acknowledge that the investment industry
is still learning how to fully estimate climate risks.

Are we getting better at measuring
climate exposure?
There is reason to be optimistic about the future of climatechange risk management. As time goes by, climate scienceis becoming better at understanding complex climate
patterns. Climate economists are also developing a better
understanding of the potential impacts of climate on the
behaviour of market participants.

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The academic literature on climate economics and climate
finance is also a fast-developing field. There are also now
several large organisations that exist with the primary
purpose of improving data quality and availability on various

climate risk metrics. All of these factors are likely to makeassessing the climate risk of investments easier and allow
investors to better gauge the exposures their portfolios haveto climate change.

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