GPs should prepare for a grilling on physical climate risks

As more investors conduct climate scenario analyses, the severity of physical risks on investment portfolios is becoming clearer.

CPP Investments’ Pamela Thomas is addressing her pension fund peers. “Your fiduciary duty is to preserve value. Make money, yes – but for the love of God, don’t lose any money because you were ignoring obvious risks.”

That is why CPP and a raft of other giant institutional investors have started to conduct climate scenario analyses for their portfolios. The Los Angeles County Employees’ Retirement Association has projected that its current portfolio would experience a 15 percent net asset value drawdown in a global warming scenario of below 2C (the global warming scenario most governments are working towards). “We’re doing this because climate and other scenarios potentially have material economic consequences for the fund,” LACERA chief investment officer Jonathan Grabel told the investment board last month.

CPP Investments reported “a potential negative impact to the fund’s market value by up to 13 percent in a given year during the next 30 years” in its sustainability report released earlier this autumn. It uses scenario analyses to “determine what assets are at risk of stranding”. Either get these assets onto transition plans or sell them off, said Thomas, speaking onstage at PEI Group’s PERE Network conference last month.

CalPERS has started to integrate climate risk assessments into due diligence and scenario analyses for some parts of its portfolio to make asset liability and risk evaluations, it announced last month. And Harvard Management Company has been asking its fund managers for climate scenario analysis data for several years.

Climate scenario analyses typically involve developing projections of total-portfolio valuations, performance or expected returns. Many investors have included both optimistic (1.5-2C) and more severe (2.5-3C) global warming scenarios. Such analyses incorporate transition risks: the effects of regulatory changes and market factors in pursuit of a global transition; and physical risks: the impact of climate change itself, including extreme weather events, rising sea levels and chronic higher temperatures and rainfall.

Transition risks receive more attention than physical risks in private markets, according to a report by sustainability consultancies ERM and Ceres, produced using 27 GP and LP interviews. “This is partly explained by the shorter investment lifecycle of a typical private equity portfolio, where physical risk may not be perceived to play as significant a role in the near term,” the report stated. “Many firms interviewed mentioned that, given typical hold periods of five to seven years, transition risks are given more attention than physical risks, as they are seen to provide more lucrative investment opportunities and to generate potentially higher exit multiples.”

There are easy wins for asset managers to show they are addressing transition risks. By introducing net-zero targets and putting assets on decarbonisation pathways, as more and more managers are doing, they position assets to avoid the potential taxes and regulatory risks that a global transition will bring.

Addressing physical risks may be more challenging and less rewarding for both asset managers and asset owners. There will be unavoidable costs associated with climate resilience and adaptation that investors and managers will need to price in, such as higher energy bills for cooling systems, insurance costs for extreme weather events and higher prices for natural resources. It may entail, for example, excluding and divesting from the geographies most vulnerable to extreme weather events and sectors reliant on natural capital and global supply chains.

But physical risks are perhaps more important than transition risks. In LACERA’s analysis, physical risks account for 11.1 percent of the 15 percent NAV drawdown, while transition risks account for 4.4 percentage points. And that is in a target global warming scenario (below 2C) that we are not on track to achieve. Physical risks will become even more acute as global warming increases – and, according to December 2023 analysis by Climate Action Tracker, the world is currently on a trajectory to 2.7C global warming.

Asset managers should prepare for more questions related to physical climate risks.