Climate change generates risk that will affect the portfolios of sovereign funds and SIFs. Although vulnerability to climate change varies considerably between geographies and sectors, climate change generates increased risk across sectors and asset classes. The risks take three main forms:
1. Physical risk is the risk of physical damage to real assets, caused by changing precipitation patterns and increased frequency of extreme weather events such as floods, draughts, storms and heat waves. Weather-related damage to real assets could cause portfolio companies to cease or modify operations, affecting their valuation.
2. Transition risk refers to the likelihood of significant changes in asset valuations during the transition to a low-carbon economy. This includes the risk of stranded assets in high-emissions sectors such as coal, oil and gas. The low-carbon transition could shift the competitive advantage of entire regions and sectors, affecting investor portfolios and broad financial stability (Carney, 2015[12]) (Caldecott and Harnett, n.d.[13])
3. Liability risk could arise from failures to disclose and manage climate risk, and liabilities for companies that have contributed significantly to carbon emissions.
The impact of physical risks and transition risks depends on the magnitude of future temperature increase. In a “business as usual” scenario, with limited efforts to combat climate change and a global average temperature increase of 2.6-4.8 degrees Celsius, physical impacts are likely to be catastrophic. Physical risks will then dominate. In a scenario of ambitious climate policies, and a below 1.5 degrees Celsius global average temperature increase, transition risk is likely to dominate, with less physical risk. Either way, sovereign funds’ portfolios are likely to be profoundly affected by climate change (Caldecott and Harnett, n.d.[13]) (Caldecott, 2018[14]).
According to (BNP Paribas, 2019[15]), the effect of carbon pricing on firm profits and equity value could be material as soon as 2020-25. In an aggressive carbon-pricing scenario, companies in the utilities, basic materials, energy and industrial sectors may cease to be viable operating entities. In these cases, the portfolio impact is therefore potentially 100% loss of the exposure.
Climate change will create winners as well as losers, as the low-carbon transition generates investment opportunities across geographies, sectors and asset classes. This is likely to increase global demand for capital (Carney, 2016[16]) (Caldecott and Harnett, n.d.[13]). Companies that contribute to the low-carbon transition, or are otherwise able to position themselves in the context of a changing climate, are likely to see their valuations rise – in turn having an impact on the portfolios of sovereign funds and SIFs.
Investment opportunities are likely to continue arising in low-carbon infrastructure, and in low-carbon technology. In the infrastructure sectors, global needs compatible with low-carbon and climate resilient development amount to USD 7 trillion per year for the next 15 years, of which USD 3.9 trillion in developing countries (OECD, 2018[17]). The investment gap for developing countries, or difference with the current level of around USD 1.4 trillion, is estimated at USD 2.5 trillion per year (UNCTAD, 2014[18]). This is broadly consistent with the findings of the 2018 special report of the Intergovernmental Panel on Climate Change (IPCC), which estimates investment needs for the global energy system at 2.5% of world GDP between 2016 and 2035. By comparison, total official overseas development assistance in 2018 amounted to USD 153 billion (OECD, 2019[19]), or about 6% of the investment gap for developing countries. A significant share of the infrastructure will need to be built on commercial terms, and sovereign funds and SIFs that manage to position themselves as infrastructure investors will be well placed to invest in commercial infrastructure projects.