Preparing for the future today

CLIMATE CRISIS Drought hits rice fields in Negros Occidental. Global equity portfolios could lose up to 45 percent in value should climate-related fears dent investor sentiments. —FILE PHOTO

Climate change is creating uncertainties for companies around the world. With the right policies, governments can help them to navigate tumultuous times and support green transformation.

Growing evidence of climate change suggests companies need to brace for severe negative impacts on their bottom lines. While climate change is real and it could instigate significant chaos and incur economic and financial costs, specifics about when, where, and how it will affect businesses remain uncertain.

Companies are already starting to feel the pinch.

According to a report by the Carbon Disclosure Project, companies estimate the costs related to climate change to be roughly $1 trillion over the next few decades unless actions are taken now to prepare for the impact.

Investors are not immune to climate risks. Global equity portfolios could lose up to 45 percent in value should climate-related fears dent investor sentiments, according to a recent report by Cambridge University.

Despite increasing awareness of climate change and international efforts to curb global warming, oil and gas prices have soared in recent years. High energy prices have also led to underperformance of a majority of “sustainable” funds.

The rise in fossil fuel prices stems from the private sector’s response to high uncertainties associated with climate risks, as firms and their shareholders should prepare for the risks of early and unexpected termination of their businesses, known as termination risks, in their investment strategies. This internalization of termination risks is a key factor influencing their financial decisions.

Uncertain future

Our research examined the strategies companies and investors are adopting when they operate in industries that might be shut down at an uncertain future date due to climate risks.

When these companies, particularly those at risk from climate change, factor in the possibility of being forced to close, they often invest less in their operations.

This lower investment can lead to a decrease in the supply of their products while they are still in business, which can cause the prices of these products to rise before the businesses actually shut down.

Contrary to the common perception of high energy prices as a failure of sustainability, an increase in fossil fuel prices could be a natural consequence of the inevitability of policies to mitigate climate change. Accordingly, it can be also interpreted as evidence that the private market does indeed recognize that climate change is real and must be addressed.

In fact, the consequences of private sector decarbonization are quite similar to the consequences to be expected from implementation of an optimal carbon tax. For example, when fossil energy prices are high, it will encourage conservation and induce fossil energy firms to prepare for termination.

Of course, there is a key difference between private sector decarbonization measures and carbon taxes, in that the profits from the private process would be channeled to investors bearing the risk of climate change rather than governments who could use the proceeds to reduce other regressive taxes or accelerate decarbonization.

Sustainable investors

Sustainable portfolios should still have climate hedge characteristics, even though they temporarily underperformed conventional diversified portfolios. If climate risk continues to increase, results for sustainable investors should improve relative to unhedged investors.

A substantial rise in fossil fuel energy prices is inevitable to prompt a shift to renewable energy. However, better policies implemented now can considerably reduce the cost of climate mitigation.

For example, governments can adopt and implement a carbon tax. Research shows putting a price tag on carbon emissions can be effective in cutting emissions.

Implemented well, a carbon tax can boost investments in low-carbon energy, raise government revenues, and support green growth, rather than private sector decarbonization simply leading to higher equity values for fossil energy investors.

Increased government revenues could be also directed to support transition to a greener economy or limit expected physical risks.

Private sector investors can play an important role in advancing climate actions and supporting the transition to a lower-carbon economy. A natural investment strategy is to put a portion of investors’ portfolio into a climate hedge, which should increase in value if climate risk increases and decrease when climate risk declines.

Multiple challenges

Yet, multiple challenges exist in identifying potential climate-related risks in investment portfolios as well as new investment opportunities, leading to less than desirable private sector climate finance.

Multilateral development banks such as ADB can help scale up private sector investment to bridge the gap in climate finance by providing policy advice, quality projects and capacity building.

As the financial impacts of climate change on businesses and investors are felt immediately through profit losses and drops in shareholders’ value arising from inaction, it’s time to act decisively to mitigate risks and harness opportunities.

Proactive strategies and policies are needed to substantially increase investment in low carbon transition for Asia and the Pacific’s evolving economies. —Contributed INQ

Park is director of ADB Regional Cooperation and Integration and Trade Division, Economic Research and Development Impact Department, while Engle is professor emeritus of Finance at New York University Stern School of Business. This ADB blog was published in November 2023.