Pricing in climate risk could be a risk of its own

Investors claim consistent, verifiable data on climate risk is the missing piece to financing climate change mitigation and resilience. But what if integrating climate risk into investment decisions creates a new paradox that shifts capital away from communities and investment areas that need it most? We are running out of time to reflect on the question.

Demands from investors that fund managers, banks and companies account for climate-related financial risks are finally coming to fruition, with the Organisation for Economic Co-operation and Development (OECD), the Big Four accounting firms and other leading standard-setting organizations competing to publish decisive risk-disclosure guidelines. While this is a valuable and constructive development, it raises new questions.

When sophisticated and responsible investors analyze climate-related financial risk, they consider two broad categories: how the transition of social preferences to climate solutions will affect their investment, including how government regulation will change growth opportunities or profitability; and whether the physical impacts of climate change, such as increased storm volatility, will put their investment at risk.

Proper accounting for the first category, transition and regulatory risk, is a purely positive development that will likely incentivize capital into green opportunities. For example, sustainable consumer habits and a higher carbon price would diminish future financial returns in polluting industries — pricing in these transition and regulatory risks would show investors that high-emitting industries are not only immoral and unsustainable, but simply unprofitable.

When considering physical risk, however, the profitable decision does not neatly align with what is morally imperative. Here is where we confront the potential pitfall of pricing in climate risk. The public is increasingly learning of the physical hazards expected from climate change. Some of these are uncertain, others (such as aggravated flooding in Quebec, Ontario and New Brunswick) are unavoidable eventualities, and still others (such as wildfires on North America’s West Coast and melting permafrost in the North) are unavoidable present realities. When investors reference integrating physical risk into their investment decisions, this is the type of information being taken into account.

When investors confront risk, they either decline to make an investment or demand a higher return as compensation. Areas with greater exposure to climate-related damages would therefore be charged more when trying to get financing. With the physical burdens of climate change varying substantially between regions, this risks intensifying inequalities and leaving imperilled areas unsupported. If the communities and individuals who are most vulnerable to climate-related damage are unable to afford investment capital for adaptation and protection measures, their susceptibility and resulting cost of capital will only be compounded.

Climate change is affecting regions in materially different ways. This creates a question of inequity at the individual, local and international level — compounding environmental injustices with the added layer of economic injustice. For example, by pricing in the physical risks of climate change, a homeowner whose municipality can't afford flood-mitigation strategies may have higher insurance premiums than a homeowner in a higher tax bracket community whose municipality had the money to invest in preventive sewer remediation. Similarly, a community with a greater risk of climate-related flooding may pay higher interest to borrow capital for new investments in protective infrastructure.

These two examples show how, in the absence of controlling measures, pricing in physical climate risks could result in an asymmetric cost of capital. Of course, there are proactive ways to instead leverage information on the inequality of climate risk for smart policy measures that ensure equal access to insurance and adaptation finance. For example, the Flood Re scheme in the U.K., a joint not-for-profit effort between government and the insurance industry, pools flood-related home insurance across the country’s differing income brackets and flood threats.

The financial and ethical tensions become far more complex at the international level. The burdens of climate change are already concentrated more heavily in less affluent countries, with many experiencing more immediate and greater catastrophes. A 2018 report showed that countries with greater vulnerability to climate-related damage are already being charged an inflated cost of capital. This added expense makes it even more challenging to invest in protective adaptation planning, aggravating the existing disparities of climate-change vulnerability between countries.

Investors should be making data-informed decisions, and consistent and reliable climate-related data is imperative to do so. However, based on traditional risk and reward principles, pricing in physical risks imposes a surcharge for those most liable to climate damage.

Policy-makers must proactively ensure that individuals and communities needing to invest in climate adaptation are able to afford it.