At 79 degrees north, the northernmost permanent human settlement and gateway to the North Pole, Ny-Ålesund is a leading centre for international Arctic scientific research and environmental monitoring. It used to be an arctic coal mine. The stunning turnaround from a fossil fuel extraction base to leading climate science research site represents an apt analogy for the type of transition we need to make globally to manage the risks associated with climate change.

This autumn, Affirmative Investment Management (AIM) participated in the annual Ny-Ålesund Symposium, which focused on climate risks. It was timed just ahead of the release of the 2018 UN Intergovernmental Panel on Climate Change (IPCC) report on the impacts of global warming of 1.5°C above pre-industrial levels. The 53 delegates at this high-level convention in the High Arctic comprised climate researchers, investors, green bond issuers and policy-makers, coming together to discuss how the financial system can collectively navigate climate risks.

All investments have an impact, whether positive or negative, socially and/or environmentally. Similarly, climate events, such as floods and droughts, have a financial impact. The Symposium posed the question: how prepared is the financial system for assessing and managing climate risks? One emerging solution gaining traction is the fast growing green bond market. It originated in 2008 and has grown to approximately $400 billion outstanding today, but it’s still well below the $1 trillion of green finance required annually.

What is climate risk and why should the financial system be worried about it?

According to the 2018 IPCC report, which includes research from more than 6,000 scientists across the globe, “limiting global warming to 1.5 degrees Celsius would require rapid, far-reaching and unprecedented changes in all aspects of society [my emphasis]”. And we must act quickly, cutting CO2 emissions by 45% (against 2010 levels) by 2030, and reaching net zero around 2050. It is not an impossible task, but it is a very difficult one.

Is the financial system prepared for the risks of meeting this target, such as valuations affected by transition risks and the creation of stranded assets, defined as "fossil fuel supply and generation resources which, at some time prior to the end of their economic life, are no longer able to earn an economic return"? Is it also prepared for the risks of not meeting this target, such as the impact of higher levels of global warming on society and investments?

Building upon the G20 Financial Stability Task Force on Climate Related Financial Disclosures (TCFD) definitions, climate risks can be understood in two primary categories.

Physical risks

Climate models predict that, with continued global warming, weather patterns will become more extreme. The 2018 IPCC report confirms that we are on a 3 degrees pathway by 2100, having already warmed by approximately 1 degree against pre-industrial levels.

It has a strong conviction that warming over 1.5 degrees will bring significantly higher climate risks. For those wondering if the half-degree really matters, it does. The IPCC reports tells us that all ocean coral may be irreversibly wiped out by 2 degrees warming, but 10-30% may survive if we remain within 1.5 degrees. Arctic summers could be ice-free once a decade in a 2 degrees scenario, but once a century in a 1.5 degree world.

Sea levels may rise an extra 10cm with a 2 degrees increase, washing away the terrain and livelihoods of millions of people. Approximately 1 in 10 people in the world live in a low-elevation coastal zone. The 10 countries with the most people in low coastal areas are China, India, Bangladesh, Vietnam, Indonesia, Japan, Egypt, the US, Thailand and the Philippines.

Climate events can also have a severe impact on food security, destroying crops and disrupting food storage and transport. Furthermore, agriculture is a leading employer of the world’s poorest, and such disruption threatens the livelihoods of some of the most vulnerable people in the world.

Climate change exacerbates extreme weather events, such as the hurricanes, storms, high temperatures and wildfires seen in summer 2018. These damage buildings and infrastructure (lowering asset values), severely disrupt supply chains due to power outages and reduce agricultural yields. In addition to their devastating impact on people and society, they bring negative economic shocks.

Transition risks

To meet the Paris Agreement and limit global warming to within 1.5-2 degrees by the end of this century, a broad-based transition to a low-carbon economy is required. This includes technological shifts (from fossil fuel energy to renewables, increased energy efficiency and green infrastructure) and advances (developing large-scale negative emissions technology), as well as the implementation of government climate policies (carbon taxes, green growth policies). Such changes are likely to impact corporate valuations and profitability severely.

For context, Carbon Tracker estimates that, in a 2 degrees scenario, $104 billion worth of fossil fuel assets are at risk of being “stranded” in order to meet the required carbon emission reductions. Furthermore, the economics of energy technologies are changing. There are estimates indicating that, by 2021, new wind energy will be cheaper than existing coal. By 2023, new solar PV is also expected to be cheaper than existing coal.

Not only are global policy efforts underway to support a low-carbon transition, but a technological revolution has begun. It is an economic force with increasing clout. The International Renewable Energy Agency estimates that there are now 10.3 million renewable energy jobs globally, a 5.3% increase from 2017. A recent US Department of Energy report reveals that solar energy accounts for the largest proportion of employers in the electric power generation sector, with wind energy the third largest, while coal industries have been declining over the past 10 years. During 2016, the US solar workforce increased by 25% and the number of employees in the US wind energy industry increased by 32%.

How is the financial system responding?

In 2015, as Bank of England Governor Mark Carney gave his now landmark speech on the tragedy of the horizon on climate change and financial stability, the Financial Stability Board launched the Task Force on Climate Related Financial Disclosure (TCFD), which released voluntary recommendations urging companies and investors to stress test their portfolios against aforementioned climate risks and different global warming scenarios. The movement has subsequently grown, and the development of TCFD and climate risk analysis tools is well underway, albeit far from complete. Climate risk and reporting is still at the nascent stage and not well understood among stakeholders.

Climate researchers also highlight that, although some principles are generally accepted - for example, the need for decarbonization to limit global warming and that global warming exacerbates extreme events - there remains considerable uncertainty in modelling climate risks: how to understand different scenarios and how to compare them. It was clear from the Symposium that improved dialogue is necessary, between climate researchers, investors and the broader financial system, to address the challenge of measuring and managing climate risks. The financial sector makes a business out of pricing risk, but it also requires better data and tools to help translate climate risks into financial risks.

However, AIM cautions that there are dangers and potential unintended consequences in focusing on climate change solely from a financial risk perspective. There are also risks in failing to fund a low-carbon transition meaningfully, and in not diverting funding to areas that are vulnerable to climate threats. For example, if large parts of Southeast Asia are deemed high-risk and theoretically ‘uninvestable’ and ‘uninsurable’ against rising sea levels, are we missing an opportunity to invest in the area to improve its resilience?

Are green bonds an effective tool for managing climate risk?

Green bonds - self-labelled bonds with a defined use of proceeds towards low-carbon and/or environmental activities and sectors - are one of the major success stories in terms of financial innovation supporting green finance flows in recent years. There are many reasons why this fast-growing, emerging asset class can be an effective tool in helping manage climate risks.

First, green bond frameworks tend to finance low-carbon assets. Approximately 40% of total green bond issuance went towards energy projects, such as renewable energy generation, and 87% of the LO-Funds Global Climate Bond fund (winner of Environmental Finance magazine’s Green Bond Fund of the Year) was in mitigation-focused activities in 2017. In AIM’s analysis, we do find that there are fewer proceeds in the green bond market dedicated to addressing physical risk through funding adaptation-focused activities than mitigation-focused activities.

Second, the choice of an issuer to issue a green bond can also be a signal that it is seeking to address transition risk. This signal only holds if the green bond framework is aligned with the broader entity-wide transition, i.e. it is not used as a tool to grant the issuer social licence to continue counterproductive strategies. This is one of the reasons why AIM verifies green bonds on a combined framework and issuer basis.

Third, enhanced disclosure relating to green bond issuance promotes greater transparency and engagement between issuers and investors on climate-related matters. Within the green bond market, disclosure remains heavily focused on carbon-related data, where it is relevant. Increasingly, AIM seeks to encourage greater disclosure relating to physical risks.

AIM has been working with leading climate experts South Pole to develop a tool to understand green bond exposure to physical risks. This can be applied at both issuer level and asset level. The green bond market has, so far, been largely focused on expected impacts associated with financed activities (eg tonnes of CO2 emissions avoided in financing a wind farm versus business as usual).

However, in order to address climate risks effectively, we also need to ask: what is the risk that the wind farm will not generate the expected impact, given changing climate conditions and the risk of extreme weather events? For example, recent storm and hurricane events debilitated a number of solar parks in the US and Caribbean.

Phrased differently, how resilient are our transition efforts? In an attempt to address that question, the tool assesses the adaptive measures in place, in light of different physical risks expected in different warming scenarios (2 degrees versus 4, for example). For instance, does the solar park or wind farm have a storm or flood prevention management plan? Are they located in strategic areas? Can they withstand and continue operating in changing and/or extreme weather conditions?

Green bonds can be an effective tool to manage climate risks, but they are not a panacea

In summary, our view is that green bonds can be an effective tool to manage climate risks, providing that issuers and investors focus on both climate change mitigation and adaptation, and show alignment of green bonds with issuer low-carbon transition plans. The failure to assess issuer responsibility leaves green bonds vulnerable to climate risks - i.e. green bonds issued by an issuer unable to carry out their expected strategies or meet their forecasts in a 2 degree scenario, as global policy and consumer demands shift, may render their ‘business as usual’ less profitable or assets vulnerable to event risks.

AIM’s in-house sustainability verification and impact analysis includes both aspects: assessing both issuer and frameworks from a transition perspective, while seeking to support activities promoting climate resilience. We also require and encourage transparency and reporting on these elements, which helps investors understand and communicate climate risks and impacts to their stakeholders.

However, significant further work is required to develop tools and harmonization in disclosure to enable comparability and application of data for navigating climate risks. As a dedicated impact bond asset manager, all of our investments must support the Paris Agreement and Sustainable Development Goals. Assessing climate risks is core to our business.

The urgency of climate change cannot be ignored. As the 2018 IPCC report highlights, we have a brief window of time to limit global warming and its potentially devastating consequences. If we miss our extremely ambitious decarbonization targets, we need to increase substantially our efforts in adapting to its effects. Either way, what is clear is that we cannot continue with business as usual.