Climate change is an emergency that requires all hands on deck. What should be the role of investors when it is governments that have the most power to effect change?
I spoke to Roger Urwin, global head of investment content at WTW whose Thinking Ahead Institute published a report, ‘Pay now or pay later’, that tries to address this question.
The scientific evidence is unequivocal that if humanity continues along its current path, it is likely that, by 2100, global average temperatures will rise by between 2.7°C and 3.6°C. A rise of 4°C could lead to a cost of as much as $31trn (€29trn) per year in 2100, according to WTW estimates, apart from the costs of loss of life and destruction of habitats.
The firm predicts it would entail a 50-60% downside to existing financial assets. By contrast, taking action immediately to effect a transition to contain temperature rises to well below 2°C might lead to a loss of 15% of assets, which could be partly offset by the positive benefits from new primary investment.
WTW’s report argues that the “investment industry is not acting swiftly and definitely enough on its net-zero commitments”. Perhaps that is not surprising when there is more need for a closer dialogue between climate scientists and the financial world, while economics as a discipline is ill-equipped to cope with the multi-generational issues at stake, giving politicians an escape route to avoid taking the necessary measures.
Danger of discount rates
An example of the potential failure of classical economics is in the role of discount rates in the calculation of the social cost of carbon emissions. Financial economics is predicated on the idea that gains and losses in the future are worth less today by an amount determined by a discount rate. Over multi-generational time periods, the present value of future damage will vary by orders of magnitude dependent on the discount rate chosen.
“Investing in the next decade has got a positive payoff if we have an intergenerational discount rate which actually respects the future”
Roger Urwin
WTW’s Urwin argues that it is, in reality, a question of a value system and a morality call. London School of Economics economist Nicholas Stern in his 2006 review ‘The Economics of Climate Change’ suggested a social welfare discount rate of 1.4% per year. US President Donald Trump’s administration used 7%. Urwin says: “The difference between the two is really quite eloquent and reflects a difference in value systems.” The Trump administration did not seem to put much value on intergenerational equity. “And intergenerational equity is at the heart of anyone’s values essentially: how much do you lay down for your children and your children’s children?”
Sustainability has become an integral component of investment thinking for the likes of pension funds, sovereign wealth funds and endowments that have long-term horizons. It aligns with the concept of a universal owner with a responsibility beyond short-term returns to try to influence the behaviour of corporate managers to have positive and sustainable impacts on the world. As Urwin argues, climate is the biggest piece of sustainability, which is what motivated the production of the WTW report, written and edited by a team of six and based on work undertaken by the Thinking Ahead group over several years.
Connecting economics and climate risk
Climate change is a systematic risk to investors that has been known about for a long time, but the physical and transition risks have become much greater. Where WTW’s work breaks new ground is in relation to the thinking about systemic risk and the interconnectedness of climate and the economy, explains Urwin. Investment professionals tend to see risks as following the normal bell-shaped (Gaussian) distribution rather than having an asymmetric character.
There are large uncertainties associated with the magnitude of the risks and their often nonlinear, asynchronous and concentrated nature. That can lead to cascades of negative events and tipping points where risks can increase dramatically through, for example, temperature rises and associated water scarcity leading to the Amazon rainforests becoming savannah. Discontinuities in risks can lead to a phase change of a risk where it goes from being manageable to off the scale.
Given that climate change is the principal systemic risk for investors, the challenge for investment organisations is to interact more closely with developments in climate science. The creation of integrated assessment models combining economic analysis with climate science has been, so far, mainly led by traditional economics rather than ecosystem-led thinking, argues Urwin. “As a result, it understates what are the economic consequences of the progression of climate change and the integrated assessment models seem to be underestimating the materiality of economic damage that is likely to ensue.”
Invest in the transition now
WTW argues that there is a much better pathway for the financial industry to take, which is to invest more upfront in the costly transition to diminish the physical damage that will otherwise likely ensue. It is analogous to the wager by the French mathematician and philosopher Blaise Pascal relating to how a rational person should live their life without the certainty that an afterlife with God exists. Replacing God with the idea of climate change, it becomes clear that a rational person should act as though climate change exists and seek to minimise the damage. If it turns out that climate change does not exist, the world will only have a finite loss associated with misplaced spending, whereas if it turns out that climate change would definitely happen in the absence of preventative investment, then the world risks existential losses.
Investment institutions could connect economics and climate science by adding internal climate expertise, but Urwin admits that it is not easy to do. The more practical alternative would be more collaboration with academics, which is what happened with the rapid creations of COVID vaccines. The challenge for academic institutions and the financial and corporate sectors is to be able to emulate that co-operation in the pursuit of solutions to a risk that dwarfs that of a pandemic.
For investors, dealing with climate change is not all negative. Urwin declares: “Investing in the next decade has got a positive payoff if we have an intergenerational discount rate which actually respects the future.” But he adds: “If it’s all about the next year, then this paper shouldn’t be read!”
Joseph Mariathasan is a contributing editor to IPE and a director of GIST Advisory
