Wildfires - Burning More Than Just Landscapes
Climate change and the risks that go with it have been front of mind for investors and regulators alike for several years. Time and again, we are told that climate change is a tangible investment risk that markets will have to grapple with over the coming years and decades, and investors should be taking this risk into consideration in portfolio construction decisions. This is reinforced by guidance from global financial regulators, who are increasingly considering climate change risks as relevant to their supervisory mandates.
But what does climate change risk actually mean to investors? Climate risk is broadly categorised as two distinct risks. The first is physical risk, which involves the damage to land, buildings and infrastructure caused by climate change, through the more frequent and severe weather events such as flooding, droughts and storms as well as the chronic impacts of shifting temperature patterns. The second is transition risk, namely the risks to businesses or assets of the global transition to a lower-carbon economy.
Climate risks have significant negative implications for economic growth, inflation and investment returns. It is possible that direct central bank intervention may be required in buying up heavily devalued and stranded assets to protect the financial system in a worst-case climate scenario. Climate change has a direct and already visible implication on the financial stability of insurance companies and banks for example.
However, much of the conversation around how climate risk will affect investors is forward-looking. Investors need to ‘future proof’ their portfolios against the risk of climate change. While we agree that this is true, it is important to note that climate change is happening around us now and is already starting to impact investors’ portfolios. Investors not only need to assess the risk of climate change in the future, but also the current reality of it.
In this month’s article, we provide a specific, but very relevant example of how climate change is impacting investors’ portfolios today. Wildfire activity in the state of California has increased dramatically over the past several decades, with 2020 marking the worst year on record. Over the course of the year, ferocious wildfires burned through more than four million acres, more than quadrupling the annual average from the preceding five years. California gets most of its annual rainfall throughout its fall and winter. Then, throughout most of the spring and summer months, the vegetation dries out, essentially turning the landscape into a tinder box. This is not a new phenomenon. What is changing is the climate, and the hotter and drier weather conditions are leading to more plentiful and ripe fuel sources.
In California, utilities are liable for wildfire damages caused by their equipment, even if not found negligent. In this article, we focus on two Californian utilities that were deemed responsible for causing deadly and destructive wildfires in 2017 and 2018. The financial and reputation impacts were severe, sending their share prices plummeting and one into bankruptcy. Even with a significant regulatory response following the fires, climate change has changed the investment case for this sector of the market. We consider this is just one example of many of how the changing climate is impacting investments – but investors need to be prepared for this to become the norm.
Download the PDF below to read the full article.