Evaluating physical climate risk for equity funds with quantitative modelling – how exposed are sustainable funds?

Abstract

The climate system is undergoing rapid changes because of anthropogenic emissions of greenhouse gases. The effects from a warmer climate are already noticeable today with more frequent extreme weather events. These extreme weather events have financial consequences and pose risks to the financial system. This study evaluates such physical climate risks for the periods 2021-2025 and 2026-2030 by developing a quantitative model. Physical risks are here limited to heat waves, heavy precipitation events, drought and tropical cyclones. The model applies climate data from CMIP5 to evaluate hazard intensity at the location of a company. Vulnerability of the certain hazard is determined based on the sector. Physical risks from supply chain relations are also considered. The result is then aggregated on portfolio level. The model is applied to compare the exposure of physical climate risks on sustainable equity funds with the exposure on the general market and to determine what characteristics that contribute to low respectively high climate risks.Generally, the total climate risk proves to be lower for the period 2021-2025 compared to 2026-2030 because of the natural variability in the climate system. Europe has the lowest climate risk, and the GICS-sector with the highest risk is Real Estate. No clear conclusion can be drawn in the comparison of physical risk exposure between sustainable funds and the market; however, the result indicates that sustainable funds select securities of lower risk within a specific investment universe. The average sustainable funds select equities with lower risk within regions, sectors and market cap sizes in almost all studied cases. Regional allocation proves to be important for the exposure to physical climate risks. This is also related to market cap size since larger companies are likely to have their assets distributed in several countries which contributes to diversification. On fund level, the strategy of carbon minimising is shown to have no significant impact on physical climate risks, neither positively nor negatively.The awareness among investors on physical climate risks is currently low, and sustainability labels seem to offer no guarantee for minimising physical risk exposure. This study adds to the very small pool of studies on physical climate risks in investment management and provides a market wide overview. Hopefully, development of this research area can contribute to increase the awareness of investors and thereby drive capital towards a more resilient society.

Sustainable Finance and ESG Importance: A Systematic Literature Review and Research Agenda

“…Another important issue covered in the literature was climate-related risks (physical or transition) because they could strand assets in different economic sectors. Additionally, structural models for defaultable bonds should incorporate the uncertainty in corporate earnings due to climate-related risks [89,90]. More specifically, climate-related financial risks (CRFRs) that can produce unexpected crucial reductions in asset values often have no differential effects on "green projects" compared to conventional or "brown projects", although transition risks likely determine different effects.…”

Climate Risk Measures: A Review

“…Weather conditions have also been used as an indicator of climate risk in the literature (see, for example, Bressan & Romagnoli, 2021;Sheng, Gupta, & Cepni, 2022;Wiklund, 2021). This measure tends to focus more on the physical aspect of climate risk including heat waves, heavy precipitation events, drought, and tropical cyclones (Wiklund, 2021). Basically, measures of climate risk based on weather condi-tions are usually defined by temperature and some related factors.…”

“…In their study, Bressan and Romagnoli (2021) explain aggregate temperature indices over a certain period as the composite of Heating Degree Days, Cumulative Average Temperature, and Cooling Degree Days. Wiklund (2021) defines climate risk in terms of the three most commonly identified physical risks, namely extreme weather events, changes to precipitation patterns, and rising temperatures.…”

Dynamic impact of financial inclusion and industrialization on environmental sustainability

“…In this regard, UN Environment Finance Initiative can be a suitable touchstone (UNEP, 2018). Europe is the most proficient region in implementing eco-friendly strategies at a macro level and has the lowest climate risk level (Wiklund, 2020). Other continents can also take the lead from European initiatives to cap on greenhouse gas emissions and carbon trading.…”