Factoring Climate Risk Into Financial Valuation
Transcript Of Factoring Climate Risk Into Financial Valuation
CLIMATE RISK MATRIX
FACTORING CLIMATE RISK INTO FINANCIAL VALUATION
GENEROUSLY SUPPORTED BY:
Dr. Blair Feltmate Natalia Moudrak
Kathryn Bakos Brian Schofield
March 2020
ABOUT THE INTACT CENTRE ON CLIMATE ADAPTATION The Intact Centre on Climate Adaptation (Intact Centre) is an applied research centre at the University of Waterloo. The Intact Centre was founded in 2015 with a gift from Intact Financial Corporation, Canada’s largest property and casualty insurer. The Intact Centre helps homeowners, communities and businesses to reduce risks associated with climate change and extreme weather events. For additional information, visit: www.intactcentreclimateadaptation.ca
ABOUT THE UNIVERSITY OF WATERLOO The University of Waterloo is Canada’s top innovation university. With more than 41,000 full and part-time students (Fall 2019), the university is home to the world’s largest co-operative education system of its kind. The university’s unmatched entrepreneurial culture, combined with an intensive focus on research, powers one of the top innovation hubs in the world. For additional information, visit: www.uwaterloo.ca
ABOUT THE GLOBAL RISK INSTITUTE The Global Risk Institute is the premier organization that defines thought leadership in risk management for the financial industry globally. It brings together leaders from industry, academia, and government to draw actionable insights on emerging risks globally. For more information, visit: https://globalriskinstitute.org/
ABOUT SCOTIABANK Scotiabank is a leading bank in Canada and a leading financial services provider in the Americas. We are here for every future. We help our customers, their families and their communities achieve success through a broad range of advice, products and services, including personal and commercial banking, wealth management and private banking, corporate and investment banking, and capital markets. With a team of more than 100,000 employees and assets of over $1 trillion (as at October 31, 2019), Scotiabank trades on the Toronto Stock Exchange (TSX: BNS) and New York Stock Exchange (NYSE: BNS). For more information, please visit www.scotiabank.com and follow us on Twitter @ScotiabankViews.
ABOUT INTACT FINANCIAL CORPORATION Intact Financial Corporation (TSX:IFC) is the largest provider of property and casualty (P&C) insurance in Canada and a leading provider of specialty insurance in North America, with over $11 billion in total
annual premiums. The Company has approximately 16,000 employees who serve more than five million personal, business and public sector clients through offices in Canada and the U.S. In Canada, Intact distributes insurance under the Intact Insurance brand through a wide network of brokers, including its wholly-owned subsidiary BrokerLink, and directly to consumers through belairdirect. Frank Cowan brings a leading MGA platform to manufacture and distribute public entity insurance products in Canada. In the U.S., OneBeacon Insurance Group, a wholly-owned subsidiary, provides specialty insurance products through independent agencies, brokers, wholesalers and managing general agencies.
ACKNOWLEDGMENTS The Intact Centre thanks GRI, Scotiabank and IFC for their support of the report. We are grateful to Ernest Wiebe who offered substantial insight into producing the list of key T&D climate risk and mitigation measures, and to stakeholders across Canada who provided expert input to development of the T&D and CRE matrices.
CITATION Feltmate, B., Moudrak, N., Bakos, K. and B. Schofield. 2020. Factoring Climate Risk into Financial Valuation. Prepared for the Global Risk Institute and Scotiabank. Intact Centre on Climate Adaptation, University of Waterloo.
For information about this report, contact Kathryn Bakos: [email protected]
DISCLAIMER
The information stated in this report has, to the best of our knowledge, been collected and verified as much as possible. The Intact Centre cannot make any guarantees of any kind, as to the completeness, accuracy, suitability or reliability of the data provided in the report. This report has been prepared for general guidance on matters of interest only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and Intact Centre employees and affiliates do not accept or assume any liability, responsibility or duty of care for any consequences to you or anyone else acting, or refraining to act, in reliance on the information contained in this report or for any decision based upon it.
TABLE OF CONTENTS
Executive Summary
p. 3
Introduction
p. 4
Growing Cost of Climate Change
p. 6
Method: Developing Climate Risk Matrices
p. 8
Results
p. 9
Climate Change, Extreme Weather Risk and Financial Valuation
p. 11
CASE STUDY:
p. 14
Extreme Weather Impacts Applied To Financial Valuation
Role of Subject Matter Experts
p. 18
Beneficiaries of Climate Risk Matrices
p. 19
• Securities Commissions
p. 19
• Credit Rating Agencies
p. 19
• Boards of Directors
p. 19
Next Steps
p. 20
References
p. 21
Appendix
p. 23
Factoring Climate Risk into Financial Valuation
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Factoring Climate Risk into Financial Valuation
“ The framework presented in this report provides a solid and practical way to assess and value physical climate risks, supporting improved disclosure and better pricing of climate risks.”
Tiff Macklem Chair, Expert Panel on Sustainable Finance
EXECUTIVE SUMMARY
The Task Force on Climate-Related Financial Disclosures (TCFD), and the Expert Panel on Sustainable Finance (EPSF), both advised that climate change and extreme weather risk should factor into institutional portfolio management. This paper offers a practical means to execute on that advice, that conforms well with the risk management protocols that have become convention since the financial crisis (2008).
Climate Risk Matrices, presented herein for two industry sectors, identify the top 1-2 physical climate risk impacts that portfolio managers should prioritize as most material to affect performance of companies within a given sector. These 1-2 impacts reflect the expert advice of operations officers or similarly experienced subject matter experts within industry sectors – based on their collective experience, these practitioners are best positioned to identify a short list of material means by which flood, drought, fire, wind, etc., may convey risk to companies within a specific sector. Within this paper, climate risk reflects the magnitude of an impact, juxtaposed to its probability of occurrence (which includes tail risk). Prioritized impacts presented within Climate Risk Matrices provide standardized guidance to portfolio managers, in user-friendly language, which can be used to determine if, and how, issuers are mitigating climate change and extreme weather risk satisfactorily.
Two Climate Risk Matrices – Electricity Transmission & Distribution (T&D), and Commercial Real Estate (CRE) – presented in this paper, illustrate the user-friendly and interpretable information that a portfolio manager would receive. The protocols used to develop both the T&D and CRE Climate Risk Matrices are transferable to any industry sector.
Guidance is presented to help ensure that issuers profile climate risk data, relative to each industry sector, in a manner that is readily predisposed to five common financial valuation methods: (1) Ratio Analysis, (2) Discounted Cash Flow, (3) Rules of Thumb Valuation,
(4) Economic Value Added (EVA®), and (5) Option Pricing Models. Utilizing these methods, a quantitative case study is presented whereby climate risk impact on share price is presented for a publicly traded issuer, thus illustrating that so-called “non-financial” measures of performance are predisposed to valuation.
Relative to next steps, all major industry sectors were reviewed (utilizing publicly available climate risk/ ESG reports) to determine which offer the greatest predisposition to develop additional industry-specific Climate Risk Matrices going forward. Those sectors were determined to include (1) Materials, (2) Energy, (3) Utilities, (4) Industrials, and (5) Real Estate (See Appendix 1).
Although the utility of Climate Risk Matrices discussed herein focuses on institutional investors, the matrices offer value to securities commissions (to guide expectations on climate risk related disclosure), credit rating agencies (to identify a borrower’s key climate risk liabilities) and Boards of Directors (to set a framework for Board members to ask appropriate climate risk related questions of management).
Time is not a luxury in reference to applying climate risk to portfolio management. The development of industryspecific Climate Risk Matrices offers an immediately executable and practical means to incorporate climate risk into portfolio management now, which in turn will drive GLOBAL preparedness to arrest the future impact of irreversible and largely debilitating climate change.
Factoring Climate Risk into Financial Valuation
3
INTRODUCTION
“ Climate change and extreme weather risks can represent challenges for capital markets. This report provides practical guidance that will help the financial sector to better incorporate climate risk into financial valuation.”
Brian Porter President and Chief Executive Officer, Scotiabank
>
A warming climate (IPCC 2019) and associated extreme weather risks (e.g., flood, drought, fire, hail, wind, extreme heat, storm surge/sea level rise, permafrost loss) will be more challenging across Canada, and globally, as described in Canada’s Changing Climate report (ECCC 2019):
“There is overwhelming evidence that the Earth has warmed during the Industrial Era
and that the main cause of this warming is human influence. The observed warming and other climate changes cannot be explained by natural factors, either internal variations within the climate system or natural external factors such as changes in the sun’s brightness or volcanic eruptions. Only when human influences on climate are accounted for… can these observed changes in climate be explained.
This warming is effectively irreversible.” >
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Factoring Climate Risk into Financial Valuation
In response to irreversible climate change, global warming, and exacerbated extreme weather events, many companies spanning most (if not all) industry sectors will suffer disruptions to the continuity of their operations due to physical climate change induced impacts (Krueger et al. 2019, Roman 2019, Macklem et al. 2019, TCFD 2018). When these disruptions are material – for example, if an extreme weather event resulted in flooding that truncated supply chain, which subsequently impacted a company’s long-term cash flow – fiduciary duty would require that this information be disclosed, as it could affect the decision of an investor to buy/hold/sell stock in the company (Bank of Canada 2019, Giuzio et al. 2019, Tooze 2019).
The fiduciary logic of the above scenario is straightforward – however, there are practical limitations that prohibit corporations, spanning virtually all industry sectors, from disclosing climate-related risk that may be material to an investor. As articulated by Macklem et al. (2019) and CSA (2019), the challenge is this:
“ Institutional investors are dissatisfied
with the state of corporate climate-related
reporting in Canada, noting a general
inability to determine whether non-
disclosure reflects legitimate immateriality
or a lack of internal focus. Investors are
turning to third-party providers that face
the same information barriers, making
assurance difficult.”
Building on this observation, Krueger et al. (2019) highlight that despite growing empirical evidence that investors should consider climate stress, integrating climate risk into investment management can prove to be challenging, as investment tools and best practices are not yet well established. However, a few studies are beginning to record the direct financial impacts of extreme weather on valuation – for example, Addoum et al. (2019) have shown that extreme temperatures can adversely affect corporate earnings, and Kruttli et al. (2019) document that extreme weather can be reflected in stock and option market prices.
The primary purpose of this paper is to present a protocol and framework that, if applied across
industry sectors, will alleviate the dissatisfaction felt by institutional investors regarding reporting relative to climate risks. The framework prioritizes the top 1-2 means by which each category of extreme weather (e.g., flood, fire, wind, etc.) may negatively impact each industry sector, while simultaneously identifying the action that an investor could expect a company to take to mitigate prioritized risks (including probable risk and tail risk). The framework of risk prioritization is profiled in an easily interpretable industry-specific Climate Risk Matrix. Furthermore, by way of a case study, the translation of extreme weather risk into impact on share price is calculated using standard financial valuation methods.
Although the target audience for the Climate Risk Matrix is institutional investors, the matrix will also be of value to securities commissions calling for material climate risk disclosure by issuers (e.g., CSA Staff Notice 51-358 2019). In Canada, it is within the mandate of corporations to disclose climate risk, as directed by the Canadian Securities Administrators, beginning with CSA Staff Notice 51-333, Environmental Reporting Guidance (2010). Until the release of the Phase I Report of the Task Force on Climate-Related Financial Disclosures (TCFD 2016), this notice did not draw appropriate attention by issuers across Canada.
The Climate Risk Matrix also offers utility to credit rating agencies, under circumstances where extreme weather events might impact the capacity of a borrower to repay a loan. As suggested by Tigue (2019):
“Credit ratings, much like individual credit scores, assess how likely it is that a borrower will repay debt. Those ratings can affect how much governments and companies are able to borrow and how much it will cost them. Just the threat of a lower credit rating can pressure cities and companies to be more proactive in taking steps to mitigate risks, and now those risks are starting to include climate change.”
In sum, a concise encapsulation of industry-specific climate change and extreme weather risks, presented in standardized user-friendly form, would be of primary benefit to aforementioned institutional investors, secondarily to securities commissions and credit rating agencies, and to a growing extent Boards of Directors that need concise guidance on the physical manifestation of climate change risk.
Factoring Climate Risk into Financial Valuation
5
In this study, two industry sectors – Electricity Transmission & Distribution (“T&D”) and Commercial Real Estate (“CRE”) – are profiled to illustrate how climate change and extreme weather risk can be incorporated into portfolio management by institutional investors. T&D and CRE were appropriate to serve as “model sectors”, based on three requisite criteria (TCFD 2019):
• Operational Impacts: T&D and CRE are experiencing substantial impacts due to climate change and extreme weather events (e.g., Bienert 2016, Burillo 2018);
• Mitigation Actions: relative to T&D and CRE, means to mitigate climate change and extreme weather risks are reasonably well understood (e.g., CSA 2019, BOMA 2019); and
• Geographical Range: climate change and extreme weather risks (e.g., flood, fire and wind) can impact T&D and CRE in virtually any populated region of Canada.
Before describing the framework to establish the Climate Risk Matrix, it is necessary to first describe how climate risk will continue to become more severe, and thus of greater relevance to institutional investors and more broadly the capital markets.
> GROWING COST OF CLIMATE CHANGE
The term “new normal” is often used to describe weather that today is more extreme than was commonplace prior to 2010 (Moore 2019) – however, caution should be exercised relative to this terminology, as it can instill a sense of complacency with institutional investors that could unintentionally add risk to their investment decisions. Extreme weather, driven in concert with a changing climate, will continue to evolve and become increasingly severe over time, thus generally rendering greater costs across industry sectors. Otherwise stated, there will be nothing normal about the weather of the future (GCA 2019). Investors must, therefore, be vigilant and cognizant of the increasing potential for severe weather to impact investments over time.
There is no better witness to the financial costs associated with extreme weather than the Property and Casualty (“P&C”) insurance sector, where the impacts of a flood, fire, wind, etc., can be tallied almost instantly (Moudrak et al. 2017). Recognizing that the impact of extreme
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Factoring Climate Risk into Financial Valuation
weather would not be restricted to one area of business (Bloomberg 2014), the P&C sector should be viewed as a proxy for the growing cost of climate change that will impact, to varying degrees, most if not all industry sectors going forward.
In Figure 1, which profiles annual catastrophic insurable loss claims for Canada (i.e., a “cat loss” is any event such as a flood, fire, hail storm, etc., that triggers $25
million or more in insurable losses), there is a discernable upward trend in losses since 1983. Note that the losses presented in the figure are normalized for inflation to $2018, and for per capita wealth accumulation – thus the horizontal axis presents a comparison of “apples to apples”. The trend of increasing costs associated with extreme weather events should concern any investor as a predictor of growth in climate change risk that is pervasive across industry sectors.
Figure 1: Catastrophic Insured Losses in Canada (1983 – 2018)
5.5
5.0
Loss & Loss Adjustment Expenses
4.5 Estimated Trend
Fort McMurray Fire
4.0
Alberta & Toronto
3.5 Floods
Eastern
3.0
Ice Storm
2.5
Slave Lake
2.0
Ontario
Fire
Quebec
Wind & Rain
1.5
Floods
1.0
0.5
0.0
$CAD Billions
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: IBC Facts Book, PCS, CatIQ , Swiss Re, Munich Re & Deloitte. Values in $2018 CAN; total losses are normalized by inflation and per-capita wealth accumulation
As a cautionary note, the upward claims trend in Figure 1 is not solely due to escalations in extreme weather events. For example, compounding factors that can affect flood claims include loss of permeable areas and natural habitats due to development (i.e., the loss of the natural “sponge” capacity of wetlands and green spaces to absorb water/reduce flooding), aging municipal infrastructure and housing construction practices that did not incorporate flood-resilience considerations adequately in the past (Moudrak and Feltmate 2019).
Further evidence of the growing costs associated with extreme weather is evident in escalating Disaster
Factoring Climate Risk into Financial Valuation
Financial Assistance Arrangements (DFAA) payments made by the Federal Government of Canada – these are funds that are transferred from the federal to provincial or territorial governments, principally to provide relief when the costs associated with natural catastrophes are exceptional. According to Public Safety Canada, the number of natural disasters for which provinces and territories were granted assistance under DFAA increased nearly tenfold from 2005 – 2014 as compared to the previous decade. Going forward, the annual costs borne by DFAA will average $902 million, with $673 million attributable to flood relief. The $902 million
7
projection is substantially in excess of the nominal DFAA program budget of $100 million (PBOC 2016).
Escalating insurance claims, combined with substantial increases in DFAA transfer payments, presage the growing risk that climate change and extreme weather will present to institutional investors. The discussion now turns to a practical means to prioritize risks in user-friendly format that managers may factor into portfolio management.
> METHOD: DEVELOPING CLIMATE RISK MATRICES
The method to construct Climate Risk Matrices, for both electricity T&D and CRE, is described below. Where the protocol applied to T&D vs. CRE varies, such differences are described. The protocol applied to establish climate risk for T&D and CRE would be applicable to virtually all industry sectors.
The method to establish a Climate Risk Matrix was based on two axioms. First, that insight to identify and prioritize climate change and extreme weather risk resides within the collective intelligence and consensus of operating officers, or similarly experienced senior persons, who have worked in specific industry sectors for an extended period of time (i.e., which in this study was deemed to be > 20 years of service). Second, that six-to-eight “subject matter experts”, each with at least 20 years of experience, thus representing total “person years of experience” of 120 - 160 years, would have collective insight to identify and prioritize physical climate change risks, if any, relative to their respective industry sectors.
In this paper, there is also an assumption that the manifestation of extreme weather would be in the direction of risk to an issuer, more so than benefit.
Based on the above criteria, subject matter experts, with at least one representative drawn from eastern, central,
western and northern regions of Canada, were engaged in the following generalized protocol to help create a Climate Risk Matrix for each of T&D and CRE:
1) each expert was asked to identify physical climate change risks/hazards they deemed to be most material to their business operation (e.g., flood, fire, wind, etc.);
2) each expert was asked to describe up to 5 ways in which their operations could be impacted by each of the identified hazards (e.g., service disruption, power outage, equipment damage, etc.); and
3) experts were brought together for an in-person meeting to determine the most material hazards and associated operational challenges impacting industry as a whole (accomplished vis-à-vis a voting exercise, where only 2-3 operational challenges were allowed to be kept per hazard).
Once the climate change and extreme weather concerns were established, subject matter experts performed three additional tasks:
1) identify what action, if any, could be reasonably taken to limit the identified risk/hazard;
2) provide a question the portfolio manager could present to a company or issuer to determine if the issuer was aware of the risk; and
3) provide direction as to what would constitute an “excellent response” or “good response” by the issuer in reference to risk mitigation.
Following the generalized protocol profiled above, Climate Risk Matrices were completed for the T&D and CRE sectors.
In addition to subject matter input received from experts in T&D, information was also drawn from NRC – CSA Group Canadian Electrical Code (CE Code), Climate Change Adaptation Project (CSA Group 2019), and additional insight was received from Ernest Wiebe (Innovative Solutions Engineering Inc., personal communication, 2019). Similarly, input into CRE drew upon expert advice from members of the Building Owners Management Association (BOMA Canada), Real Property Association of Canada (REALPAC), and Moudrak and Feltmate (2019).
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Factoring Climate Risk into Financial Valuation
FACTORING CLIMATE RISK INTO FINANCIAL VALUATION
GENEROUSLY SUPPORTED BY:
Dr. Blair Feltmate Natalia Moudrak
Kathryn Bakos Brian Schofield
March 2020
ABOUT THE INTACT CENTRE ON CLIMATE ADAPTATION The Intact Centre on Climate Adaptation (Intact Centre) is an applied research centre at the University of Waterloo. The Intact Centre was founded in 2015 with a gift from Intact Financial Corporation, Canada’s largest property and casualty insurer. The Intact Centre helps homeowners, communities and businesses to reduce risks associated with climate change and extreme weather events. For additional information, visit: www.intactcentreclimateadaptation.ca
ABOUT THE UNIVERSITY OF WATERLOO The University of Waterloo is Canada’s top innovation university. With more than 41,000 full and part-time students (Fall 2019), the university is home to the world’s largest co-operative education system of its kind. The university’s unmatched entrepreneurial culture, combined with an intensive focus on research, powers one of the top innovation hubs in the world. For additional information, visit: www.uwaterloo.ca
ABOUT THE GLOBAL RISK INSTITUTE The Global Risk Institute is the premier organization that defines thought leadership in risk management for the financial industry globally. It brings together leaders from industry, academia, and government to draw actionable insights on emerging risks globally. For more information, visit: https://globalriskinstitute.org/
ABOUT SCOTIABANK Scotiabank is a leading bank in Canada and a leading financial services provider in the Americas. We are here for every future. We help our customers, their families and their communities achieve success through a broad range of advice, products and services, including personal and commercial banking, wealth management and private banking, corporate and investment banking, and capital markets. With a team of more than 100,000 employees and assets of over $1 trillion (as at October 31, 2019), Scotiabank trades on the Toronto Stock Exchange (TSX: BNS) and New York Stock Exchange (NYSE: BNS). For more information, please visit www.scotiabank.com and follow us on Twitter @ScotiabankViews.
ABOUT INTACT FINANCIAL CORPORATION Intact Financial Corporation (TSX:IFC) is the largest provider of property and casualty (P&C) insurance in Canada and a leading provider of specialty insurance in North America, with over $11 billion in total
annual premiums. The Company has approximately 16,000 employees who serve more than five million personal, business and public sector clients through offices in Canada and the U.S. In Canada, Intact distributes insurance under the Intact Insurance brand through a wide network of brokers, including its wholly-owned subsidiary BrokerLink, and directly to consumers through belairdirect. Frank Cowan brings a leading MGA platform to manufacture and distribute public entity insurance products in Canada. In the U.S., OneBeacon Insurance Group, a wholly-owned subsidiary, provides specialty insurance products through independent agencies, brokers, wholesalers and managing general agencies.
ACKNOWLEDGMENTS The Intact Centre thanks GRI, Scotiabank and IFC for their support of the report. We are grateful to Ernest Wiebe who offered substantial insight into producing the list of key T&D climate risk and mitigation measures, and to stakeholders across Canada who provided expert input to development of the T&D and CRE matrices.
CITATION Feltmate, B., Moudrak, N., Bakos, K. and B. Schofield. 2020. Factoring Climate Risk into Financial Valuation. Prepared for the Global Risk Institute and Scotiabank. Intact Centre on Climate Adaptation, University of Waterloo.
For information about this report, contact Kathryn Bakos: [email protected]
DISCLAIMER
The information stated in this report has, to the best of our knowledge, been collected and verified as much as possible. The Intact Centre cannot make any guarantees of any kind, as to the completeness, accuracy, suitability or reliability of the data provided in the report. This report has been prepared for general guidance on matters of interest only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and Intact Centre employees and affiliates do not accept or assume any liability, responsibility or duty of care for any consequences to you or anyone else acting, or refraining to act, in reliance on the information contained in this report or for any decision based upon it.
TABLE OF CONTENTS
Executive Summary
p. 3
Introduction
p. 4
Growing Cost of Climate Change
p. 6
Method: Developing Climate Risk Matrices
p. 8
Results
p. 9
Climate Change, Extreme Weather Risk and Financial Valuation
p. 11
CASE STUDY:
p. 14
Extreme Weather Impacts Applied To Financial Valuation
Role of Subject Matter Experts
p. 18
Beneficiaries of Climate Risk Matrices
p. 19
• Securities Commissions
p. 19
• Credit Rating Agencies
p. 19
• Boards of Directors
p. 19
Next Steps
p. 20
References
p. 21
Appendix
p. 23
Factoring Climate Risk into Financial Valuation
1
2
Factoring Climate Risk into Financial Valuation
“ The framework presented in this report provides a solid and practical way to assess and value physical climate risks, supporting improved disclosure and better pricing of climate risks.”
Tiff Macklem Chair, Expert Panel on Sustainable Finance
EXECUTIVE SUMMARY
The Task Force on Climate-Related Financial Disclosures (TCFD), and the Expert Panel on Sustainable Finance (EPSF), both advised that climate change and extreme weather risk should factor into institutional portfolio management. This paper offers a practical means to execute on that advice, that conforms well with the risk management protocols that have become convention since the financial crisis (2008).
Climate Risk Matrices, presented herein for two industry sectors, identify the top 1-2 physical climate risk impacts that portfolio managers should prioritize as most material to affect performance of companies within a given sector. These 1-2 impacts reflect the expert advice of operations officers or similarly experienced subject matter experts within industry sectors – based on their collective experience, these practitioners are best positioned to identify a short list of material means by which flood, drought, fire, wind, etc., may convey risk to companies within a specific sector. Within this paper, climate risk reflects the magnitude of an impact, juxtaposed to its probability of occurrence (which includes tail risk). Prioritized impacts presented within Climate Risk Matrices provide standardized guidance to portfolio managers, in user-friendly language, which can be used to determine if, and how, issuers are mitigating climate change and extreme weather risk satisfactorily.
Two Climate Risk Matrices – Electricity Transmission & Distribution (T&D), and Commercial Real Estate (CRE) – presented in this paper, illustrate the user-friendly and interpretable information that a portfolio manager would receive. The protocols used to develop both the T&D and CRE Climate Risk Matrices are transferable to any industry sector.
Guidance is presented to help ensure that issuers profile climate risk data, relative to each industry sector, in a manner that is readily predisposed to five common financial valuation methods: (1) Ratio Analysis, (2) Discounted Cash Flow, (3) Rules of Thumb Valuation,
(4) Economic Value Added (EVA®), and (5) Option Pricing Models. Utilizing these methods, a quantitative case study is presented whereby climate risk impact on share price is presented for a publicly traded issuer, thus illustrating that so-called “non-financial” measures of performance are predisposed to valuation.
Relative to next steps, all major industry sectors were reviewed (utilizing publicly available climate risk/ ESG reports) to determine which offer the greatest predisposition to develop additional industry-specific Climate Risk Matrices going forward. Those sectors were determined to include (1) Materials, (2) Energy, (3) Utilities, (4) Industrials, and (5) Real Estate (See Appendix 1).
Although the utility of Climate Risk Matrices discussed herein focuses on institutional investors, the matrices offer value to securities commissions (to guide expectations on climate risk related disclosure), credit rating agencies (to identify a borrower’s key climate risk liabilities) and Boards of Directors (to set a framework for Board members to ask appropriate climate risk related questions of management).
Time is not a luxury in reference to applying climate risk to portfolio management. The development of industryspecific Climate Risk Matrices offers an immediately executable and practical means to incorporate climate risk into portfolio management now, which in turn will drive GLOBAL preparedness to arrest the future impact of irreversible and largely debilitating climate change.
Factoring Climate Risk into Financial Valuation
3
INTRODUCTION
“ Climate change and extreme weather risks can represent challenges for capital markets. This report provides practical guidance that will help the financial sector to better incorporate climate risk into financial valuation.”
Brian Porter President and Chief Executive Officer, Scotiabank
>
A warming climate (IPCC 2019) and associated extreme weather risks (e.g., flood, drought, fire, hail, wind, extreme heat, storm surge/sea level rise, permafrost loss) will be more challenging across Canada, and globally, as described in Canada’s Changing Climate report (ECCC 2019):
“There is overwhelming evidence that the Earth has warmed during the Industrial Era
and that the main cause of this warming is human influence. The observed warming and other climate changes cannot be explained by natural factors, either internal variations within the climate system or natural external factors such as changes in the sun’s brightness or volcanic eruptions. Only when human influences on climate are accounted for… can these observed changes in climate be explained.
This warming is effectively irreversible.” >
4
Factoring Climate Risk into Financial Valuation
In response to irreversible climate change, global warming, and exacerbated extreme weather events, many companies spanning most (if not all) industry sectors will suffer disruptions to the continuity of their operations due to physical climate change induced impacts (Krueger et al. 2019, Roman 2019, Macklem et al. 2019, TCFD 2018). When these disruptions are material – for example, if an extreme weather event resulted in flooding that truncated supply chain, which subsequently impacted a company’s long-term cash flow – fiduciary duty would require that this information be disclosed, as it could affect the decision of an investor to buy/hold/sell stock in the company (Bank of Canada 2019, Giuzio et al. 2019, Tooze 2019).
The fiduciary logic of the above scenario is straightforward – however, there are practical limitations that prohibit corporations, spanning virtually all industry sectors, from disclosing climate-related risk that may be material to an investor. As articulated by Macklem et al. (2019) and CSA (2019), the challenge is this:
“ Institutional investors are dissatisfied
with the state of corporate climate-related
reporting in Canada, noting a general
inability to determine whether non-
disclosure reflects legitimate immateriality
or a lack of internal focus. Investors are
turning to third-party providers that face
the same information barriers, making
assurance difficult.”
Building on this observation, Krueger et al. (2019) highlight that despite growing empirical evidence that investors should consider climate stress, integrating climate risk into investment management can prove to be challenging, as investment tools and best practices are not yet well established. However, a few studies are beginning to record the direct financial impacts of extreme weather on valuation – for example, Addoum et al. (2019) have shown that extreme temperatures can adversely affect corporate earnings, and Kruttli et al. (2019) document that extreme weather can be reflected in stock and option market prices.
The primary purpose of this paper is to present a protocol and framework that, if applied across
industry sectors, will alleviate the dissatisfaction felt by institutional investors regarding reporting relative to climate risks. The framework prioritizes the top 1-2 means by which each category of extreme weather (e.g., flood, fire, wind, etc.) may negatively impact each industry sector, while simultaneously identifying the action that an investor could expect a company to take to mitigate prioritized risks (including probable risk and tail risk). The framework of risk prioritization is profiled in an easily interpretable industry-specific Climate Risk Matrix. Furthermore, by way of a case study, the translation of extreme weather risk into impact on share price is calculated using standard financial valuation methods.
Although the target audience for the Climate Risk Matrix is institutional investors, the matrix will also be of value to securities commissions calling for material climate risk disclosure by issuers (e.g., CSA Staff Notice 51-358 2019). In Canada, it is within the mandate of corporations to disclose climate risk, as directed by the Canadian Securities Administrators, beginning with CSA Staff Notice 51-333, Environmental Reporting Guidance (2010). Until the release of the Phase I Report of the Task Force on Climate-Related Financial Disclosures (TCFD 2016), this notice did not draw appropriate attention by issuers across Canada.
The Climate Risk Matrix also offers utility to credit rating agencies, under circumstances where extreme weather events might impact the capacity of a borrower to repay a loan. As suggested by Tigue (2019):
“Credit ratings, much like individual credit scores, assess how likely it is that a borrower will repay debt. Those ratings can affect how much governments and companies are able to borrow and how much it will cost them. Just the threat of a lower credit rating can pressure cities and companies to be more proactive in taking steps to mitigate risks, and now those risks are starting to include climate change.”
In sum, a concise encapsulation of industry-specific climate change and extreme weather risks, presented in standardized user-friendly form, would be of primary benefit to aforementioned institutional investors, secondarily to securities commissions and credit rating agencies, and to a growing extent Boards of Directors that need concise guidance on the physical manifestation of climate change risk.
Factoring Climate Risk into Financial Valuation
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In this study, two industry sectors – Electricity Transmission & Distribution (“T&D”) and Commercial Real Estate (“CRE”) – are profiled to illustrate how climate change and extreme weather risk can be incorporated into portfolio management by institutional investors. T&D and CRE were appropriate to serve as “model sectors”, based on three requisite criteria (TCFD 2019):
• Operational Impacts: T&D and CRE are experiencing substantial impacts due to climate change and extreme weather events (e.g., Bienert 2016, Burillo 2018);
• Mitigation Actions: relative to T&D and CRE, means to mitigate climate change and extreme weather risks are reasonably well understood (e.g., CSA 2019, BOMA 2019); and
• Geographical Range: climate change and extreme weather risks (e.g., flood, fire and wind) can impact T&D and CRE in virtually any populated region of Canada.
Before describing the framework to establish the Climate Risk Matrix, it is necessary to first describe how climate risk will continue to become more severe, and thus of greater relevance to institutional investors and more broadly the capital markets.
> GROWING COST OF CLIMATE CHANGE
The term “new normal” is often used to describe weather that today is more extreme than was commonplace prior to 2010 (Moore 2019) – however, caution should be exercised relative to this terminology, as it can instill a sense of complacency with institutional investors that could unintentionally add risk to their investment decisions. Extreme weather, driven in concert with a changing climate, will continue to evolve and become increasingly severe over time, thus generally rendering greater costs across industry sectors. Otherwise stated, there will be nothing normal about the weather of the future (GCA 2019). Investors must, therefore, be vigilant and cognizant of the increasing potential for severe weather to impact investments over time.
There is no better witness to the financial costs associated with extreme weather than the Property and Casualty (“P&C”) insurance sector, where the impacts of a flood, fire, wind, etc., can be tallied almost instantly (Moudrak et al. 2017). Recognizing that the impact of extreme
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Factoring Climate Risk into Financial Valuation
weather would not be restricted to one area of business (Bloomberg 2014), the P&C sector should be viewed as a proxy for the growing cost of climate change that will impact, to varying degrees, most if not all industry sectors going forward.
In Figure 1, which profiles annual catastrophic insurable loss claims for Canada (i.e., a “cat loss” is any event such as a flood, fire, hail storm, etc., that triggers $25
million or more in insurable losses), there is a discernable upward trend in losses since 1983. Note that the losses presented in the figure are normalized for inflation to $2018, and for per capita wealth accumulation – thus the horizontal axis presents a comparison of “apples to apples”. The trend of increasing costs associated with extreme weather events should concern any investor as a predictor of growth in climate change risk that is pervasive across industry sectors.
Figure 1: Catastrophic Insured Losses in Canada (1983 – 2018)
5.5
5.0
Loss & Loss Adjustment Expenses
4.5 Estimated Trend
Fort McMurray Fire
4.0
Alberta & Toronto
3.5 Floods
Eastern
3.0
Ice Storm
2.5
Slave Lake
2.0
Ontario
Fire
Quebec
Wind & Rain
1.5
Floods
1.0
0.5
0.0
$CAD Billions
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: IBC Facts Book, PCS, CatIQ , Swiss Re, Munich Re & Deloitte. Values in $2018 CAN; total losses are normalized by inflation and per-capita wealth accumulation
As a cautionary note, the upward claims trend in Figure 1 is not solely due to escalations in extreme weather events. For example, compounding factors that can affect flood claims include loss of permeable areas and natural habitats due to development (i.e., the loss of the natural “sponge” capacity of wetlands and green spaces to absorb water/reduce flooding), aging municipal infrastructure and housing construction practices that did not incorporate flood-resilience considerations adequately in the past (Moudrak and Feltmate 2019).
Further evidence of the growing costs associated with extreme weather is evident in escalating Disaster
Factoring Climate Risk into Financial Valuation
Financial Assistance Arrangements (DFAA) payments made by the Federal Government of Canada – these are funds that are transferred from the federal to provincial or territorial governments, principally to provide relief when the costs associated with natural catastrophes are exceptional. According to Public Safety Canada, the number of natural disasters for which provinces and territories were granted assistance under DFAA increased nearly tenfold from 2005 – 2014 as compared to the previous decade. Going forward, the annual costs borne by DFAA will average $902 million, with $673 million attributable to flood relief. The $902 million
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projection is substantially in excess of the nominal DFAA program budget of $100 million (PBOC 2016).
Escalating insurance claims, combined with substantial increases in DFAA transfer payments, presage the growing risk that climate change and extreme weather will present to institutional investors. The discussion now turns to a practical means to prioritize risks in user-friendly format that managers may factor into portfolio management.
> METHOD: DEVELOPING CLIMATE RISK MATRICES
The method to construct Climate Risk Matrices, for both electricity T&D and CRE, is described below. Where the protocol applied to T&D vs. CRE varies, such differences are described. The protocol applied to establish climate risk for T&D and CRE would be applicable to virtually all industry sectors.
The method to establish a Climate Risk Matrix was based on two axioms. First, that insight to identify and prioritize climate change and extreme weather risk resides within the collective intelligence and consensus of operating officers, or similarly experienced senior persons, who have worked in specific industry sectors for an extended period of time (i.e., which in this study was deemed to be > 20 years of service). Second, that six-to-eight “subject matter experts”, each with at least 20 years of experience, thus representing total “person years of experience” of 120 - 160 years, would have collective insight to identify and prioritize physical climate change risks, if any, relative to their respective industry sectors.
In this paper, there is also an assumption that the manifestation of extreme weather would be in the direction of risk to an issuer, more so than benefit.
Based on the above criteria, subject matter experts, with at least one representative drawn from eastern, central,
western and northern regions of Canada, were engaged in the following generalized protocol to help create a Climate Risk Matrix for each of T&D and CRE:
1) each expert was asked to identify physical climate change risks/hazards they deemed to be most material to their business operation (e.g., flood, fire, wind, etc.);
2) each expert was asked to describe up to 5 ways in which their operations could be impacted by each of the identified hazards (e.g., service disruption, power outage, equipment damage, etc.); and
3) experts were brought together for an in-person meeting to determine the most material hazards and associated operational challenges impacting industry as a whole (accomplished vis-à-vis a voting exercise, where only 2-3 operational challenges were allowed to be kept per hazard).
Once the climate change and extreme weather concerns were established, subject matter experts performed three additional tasks:
1) identify what action, if any, could be reasonably taken to limit the identified risk/hazard;
2) provide a question the portfolio manager could present to a company or issuer to determine if the issuer was aware of the risk; and
3) provide direction as to what would constitute an “excellent response” or “good response” by the issuer in reference to risk mitigation.
Following the generalized protocol profiled above, Climate Risk Matrices were completed for the T&D and CRE sectors.
In addition to subject matter input received from experts in T&D, information was also drawn from NRC – CSA Group Canadian Electrical Code (CE Code), Climate Change Adaptation Project (CSA Group 2019), and additional insight was received from Ernest Wiebe (Innovative Solutions Engineering Inc., personal communication, 2019). Similarly, input into CRE drew upon expert advice from members of the Building Owners Management Association (BOMA Canada), Real Property Association of Canada (REALPAC), and Moudrak and Feltmate (2019).
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Factoring Climate Risk into Financial Valuation