Financial History 142 Summer 2022 - Page 22

Investing in the Era of Climate Change

By Bruce Usher
Climate scientists have been sounding the alarm about the need for investment to reduce greenhouse gas emissions , but investors have been slow to commit capital because mitigation of climate change requires collective action . Fortunately for the planet , recent trends are prompting financial leaders to finally act . Understanding those trends and the implications for investors is the first step toward investing in the era of climate change .
Aerial view of the Power County wind farm in Idaho . Renewable energies , such as wind power , are undercutting fossil fuels using advanced technologies to drive down the cost of energy to the point where competitors are becoming insolvent .
Trend No . 1 : Physical Risks
Investors commit capital on the assumption of a stable climate and a predictable future . Now , financial returns are at risk from a rapid warming of the planet that raises the probability of uncertain outcomes . The physical impacts of a changing climate are already cropping up across America . In just one year , 2021 , the country experienced devastating wildfires in California , multiple hurricanes in Texas , frequent flooding in Florida and extreme heat waves in Oregon , destroying homes , businesses and even entire communities . Investors are becoming aware that the physical impacts of climate change are putting financial assets at great risk .
The first risk for investors is in the nonlinearity of impact — as the climate changes , the value of assets is initially unaffected , but then a critical point is reached where the value of assets can quickly collapse . For example , buildings are designed to withstand floods up to a certain depth , below which little damage is done , above which the damage is immense . Similarly , crop yields decline marginally with a modest change in temperature until a threshold is reached , after which crops fail entirely .
The second risk for investors is timing . Physical risks from climate change , such as rising seas , storms , drought and severe heat , will mostly occur decades in the future . But that does not mean asset values are unaffected today . Investments are valued by predicting cash flows over the life of an asset and applying a discount rate . Physical changes that might affect future cash flows increase the discount rate , which is a measure of uncertainty . In the era of climate change , investors must increasingly factor in the risks posed by physical changes and discount future cash flows accordingly .
The physical risk of climate change is the most obvious trend to affect asset
20 FINANCIAL HISTORY | Summer 2022 | www . MoAF . org