Should Your Investment Strategy Incorporate a Climate Risk Discount?

Mar 6, 2018 8:05 AM ET

Should Your Investment Strategy Incorporate a Climate Risk Discount?

by Cyrus Lotfipour, CFA, Vice President at MSCI and MSCI ESG Research 

Consider these three recent developments: California emerged from drought in April 2017, fewer companies reported impacts associated with water scarcity, and the average freshwater intensity of companies in the MSCI ACWI Index dropped by 15 percent between 2015 and 2016. While these are positive short term signals for investors concerned with water scarcity, 2017 was also the most costly in U.S. history for natural disasters. This underscored the thinking behind a key trend that MSCI ESG Research identified in the beginning of 2017: institutional investors are shifting their portfolio analysis from the measurement of regulatory risks, such as the U.S. withdrawal from the Paris Agreement, to physical risks, such as exposure to coastal flooding along the U.S. Gulf Coast.

Measuring Water Risk at the Company and Fund Level

MSCI ESG Research assesses risk from water scarcity based on two key variables: how much water a company needs, and how secure is the supply. By way of example, consider two U.S. utilities: Ameren Corporation and Xcel Energy. In 2016, both companies required more than 200,000 cubic meters of freshwater for every USD $1 million in revenue (as of June 30, 2017 based on MSCI ESG Research analysis). While both Ameren and Xcel need large volumes of water to produce power, they face different physical limitations based on the location of their operations. Ameren mostly draws water from states with a relatively high level of water security, such as Missouri and Illinois. Xcel, on the other hand, has most of its operations located in Texas and Colorado, where water resources are already stressed and competition for water is likely to intensify between industrial and agricultural users.

A similar level of scrutiny can be applied at the portfolio level. Consider two U.S. funds with similar investment objectives: the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) and the WisdomTree US Dividend ex-Financials Fund (DTN). On average, holdings in these funds require more than 65,000 cubic meters of water per dollar of sales to operate, ranking in the top 10 percent of all funds in our coverage of over 26,000 mutual funds and ETFs (as of June 30, 2017 based on MSCI analysis). However, based on the geographic distribution of each fund’s underlying holdings, DTN has approximately 60 percent of its asset value invested in high risk regions, while for PEY, the allocation to high risk geographies is 45 percent. Without measuring the potential water risk of an income-focused strategy, investors may run the risk of higher than anticipated exposure to an event such as a severe drought across a portfolio.

Shifting the Analysis From Scarcity to Flood Risk

While the costs associated with drought in the U.S. declined from USD $4.7 billion to USD $2.5 billion over the last two years, 2017 was one of the most tumultuous years for climate events. According to the National Oceanic and Atmospheric Administration (NOAA), 2017 was the most costly for natural disasters in U.S. history and exceeded the previous record set in 2005 by 42 percent. Approximately 86 percent of the total economic cost was attributed to three hurricanes that exceeded USD $50 billion in costs, all of which made landfall within a one month timespan. The severity of these events served as a wake-up call for investors: not all water-related risk revolves around scarcity. Some investors may question the possible impact of climate change on their portfolios, but the 2017 U.S. hurricane season likely left little doubt about the financial costs that can result from events such as flooding and severe storms.

In one example, Hurricane Harvey resulted in USD $300 million in lost sales and related storm costs for the petrochemical producer, LyondellBasell. The company has four large crackers, four polyethylene plants, and more than 2,000 miles of pipeline concentrated in a region that is prone to tropical storms. The impact of severe weather and flooding has also extended beyond operating assets. In Lake Charles, Louisiana, the South African chemical producer, Sasol, is building a USD $11 billion chemical complex that overlaps with a high risk flood zone. The project, already well over the initial USD $8 billion budget, in part due to weather delays and poorer-than-anticipated subsurface conditions, incurred an additional USD $130 million in costs related to the same storm. As the frequency of severe weather events increases, investors may want to consider whether the projected return on investment adequately considers a discount for future climate risk. 

Read the complete article from Cyrus, that includes several graphs and numerous footnotes, here -