female polar bear and cub on polar ice

Two recent research reports underline the need for capital markets participants to prepare for the financial consequences of climate change.

“Financial risk from climate change is here to stay,” states a recent report from New York-based Citigroup Global Markets Ltd. “Prepare now or pay later.”

As well, a recent report from Amsterdam-based research firm Sustainalytics states companies are failing to disclose their climate risks to investors.

Citigroup’s paper divides the financial risks of climate change into two categories: physical risks and transition/mitigation risks.

Physical risks involve the harm to assets wrought by global warming, such as extreme weather events that inflict damage on property, infrastructure and the environment. Mitigation risks reflect the costs of taking action to prevent that damage.

“Mitigation risk is the price of success in the fight against global warming,” Citigroup’s paper states. “Physical risk is the price of failure.”

Citigroup anticipates both types of risks will materialize. The question isn’t whether they will arise, but in what proportion and to what level.

If there is a dramatic shift away from fossil fuels and toward cleaner energy sources, Citigroup’s paper states, “mitigation risk becomes mitigation certainty.” This would undermine the value of readily available energy assets (e.g., coal, oil and gas), leaving these resources “stranded” once consuming them is no longer economical.

Conversely, the longer the delay before action is taken to prevent excessive global warming, the greater the physical costs will be. “Mitigation risk is reduced – there will be fewer stranded assets – but physical risks are bound to be higher and so are the risks of financial losses to those that own physically damaged assets or insure them,” Citigroup’s paper states.

In either scenario, the price to be paid is likely to be substantial.

Action to curb global warming “implies severe emission reductions in the coming decades and net zero CO2 emissions over the medium to long term,” Citigroup’s paper states. This would carry huge mitigation costs.

If these dramatic emission reductions aren’t realized, Citigroup’s paper adds, “the environmental damage and wealth destruction associated with more than 3.0 degrees Celsius global warming is likely to be vast.”

For example, in one of the first efforts to gauge the impact of climate risk to financial assets, researchers at the London School of Economics estimated in 2016 that current warming trends put US$2.5 trillion of global financial assets in peril.

Moreover, the costs associated with such physical risks are already materializing. Citigroup’s paper reports that the average annual number of extreme weather events has more than tripled since the 1980s. And, the report adds, the economic cost of these events has been above the long-term average in seven of the past 10 years.

As a result, Citigroup’s report concludes: “Some realization of physical risk associated with climate change is now unavoidable.”

The effects also are likely to be widespread. Citigroup’s report states that to the extent that physical damage is inflicted on insured assets, much of the cost will be borne by insurance companies, reinsurers and the firms and investors having investments exposed to the insurers.

For uninsured assets, the costs could spread to taxpayers if governments decide to bail out the owners of assets damaged due to climate change.

Governments face other major climate-related risks, such as the physical risk to government-owned assets (including real estate) and reduced tax revenue stemming from the costs incurred through natural disasters.

There are numerous other impacts to consider as well: banks may need to hold more capital as both physical and mitigation risks materialize and other corners of the financial markets also are likely to be affected.

For example, rising physical risk could impact traditional financial instruments, such as mortgages, as the costs of property insurance increases due to rising climate-related risks.

Despite these threats, investors are poorly prepared. While regulators have begun pushing companies to provide investors with greater disclosure about the companies’ climate-related risks, the results to date generally appear to be insufficient.

New research from Sustainalytics found that just 16% of 3,000-plus companies listed in the FTSE all world index provide financial disclosure that enables investors to assess the physical climate risks to their property, plant and equipment (PP&E).

Sustainalytics’ report focuses on PP&E disclosures because that’s the asset category most exposed to physical climate risks. The report notes that lack of geographically specific PP&E disclosure makes evaluating these risks difficult.

Ultimately, Sustainalytics’ report concludes, financial statements don’t offer investors much useful insight into the exposure that companies face from physical climate impacts: “Until and unless disclosure practices include location-specific asset information, many investors could face a blind spot.”

In addition, Sustainalytics’ research found that most companies in industries that are highly exposed to physical climate risks aren’t disclosing their risk-mitigation efforts.

“Climate change may be one of the most important risks facing the global economy,” Sustainalytics’ report concludes, “but corporate disclosure practices and climate risk mitigation programs clearly have room to evolve.”