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A revolution in data mapping the effects of climate change has created opportunities for investors to develop a more granular picture of the risks involved, while it is also likely to lead to a gradual repricing of assets, PGIM says.
In 2017, the United Nations issued a challenge to researchers: find the best way to harness data science and big data in fighting climate change.
The challenge, called Data for Climate Action, was met by 450 teams of data scientists and researchers from 67 countries.
The competition’s grand prize was ultimately won by a team of researchers who studied the interaction between pollution and Mexico City’s traffic patterns. They analysed data from Waze, a global positioning system (GPS) navigation software app owned by Google, to evaluate different transportation electrification policies in order to reduce air pollution and greenhouse gas emissions.
What this competition showed was how recent advances in cloud computing, remote sensing and artificial intelligence could be applied to the field of climate change and it contributed to a quiet revolution that was already underway: a quickly growing body of climate risk related data.
In a report released earlier this year, titled “Weathering Climate Change: Opportunities and risks in an altered investment landscape”, PGIM delves into the consequences of this data revolution for investors and their portfolios.
“There is a data revolution that has been going on for the last five to six years and what that means is climate analytics and climate data have never been better. They are more accessible, more granular and easier for investors to utilise,” Shehriyar Antia, Head of Thematic Research at PGIM, says in an interview with [i3] Insights
the trend is very clear: climate data and analytics have never been better for investors and investors who embrace this can be more granular in how they assess risk.
Antia admits we are coming off a low base, but the advances made should not be underestimated.
“I don’t want to overstate things here, because the truth is that climate analytics still remains imperfect. There is much room for improvement; the data is incomplete,” he says.
“But the trend is very clear: climate data and analytics have never been better for investors and investors who embrace this data revolution can be more granular in how they assess risk.”
PGIM conducted a survey of over 100 global institutional investors to better understand their current investment actions and future aspirations around climate change. And it showed a shift was taking place in the thinking of these institutions on climate risks.
“One interesting conclusion from our survey is that investors are just now starting to become aware of the opportunities to do good and to do well,” Antia says. “I think one of the aha moments for them was that the data revolution enabled them to better differentiate between firms within green industries and brown industries.
“Many of these opportunities come from the fact that markets incompletely or inconsistently price climate risk and as the understanding of that risk by investors becomes more granular then opportunities start to reveal themselves,” he says.
This combined with the fact that the effects of climate change are already playing out today in many parts of the world is creating a certain urgency to address the issue, Antia says
“The second catalyst is that climate change may feel like a distant risk if you are a CIO with a certain investment horizon in mind, but the truth is that it is already impacting our world, it is already disrupting economic activity.
“That makes it harder for markets to ignore extreme climate events that are now happening more frequently everywhere,” he says.
As more investors embrace climate risk data, markets will start pricing in this risk. But Antia warns that this will be a gradual process and will take multiple decades to play out.
“We don’t think climate gets priced in all at once,” he says. “There won’t be a big Minsky moment of repricing. It will be more gradual, as more reliable data becomes available,” he says.
Some of the data that is now available is simply a more detailed version of existing information. A well-known example in this space is the application of flooding data to real estate assets.
For many years, investors have been looking at flooding data at a regional level or even by postcode. But advances in geospatial technology and cloud computing have made it possible to get a more granular view of individual assets.
“Increasingly with GPS and geolocation, the sort of flooding risk data is at a street level or even a building-by-building level, rather than at a postal code level,” Antia says.
“You can tell from the way that different properties are oriented whether it is on a slight slope or not, and this can vastly change the risk.
“That level of granularity can help an investor find a hidden gem, where the broader market doesn’t necessarily differentiate the risk,” he says.
Another example is the pharmaceutical industry. The coronavirus pandemic has made it clear how easily and devastatingly supply chains can be disrupted. Pharmaceutical companies are heavily reliant on water and modelling the risk of water stress in different parts of the world can lead to some interesting data on fragility of pharmaceutical supply chains.
We don't often think of Japanese and Swiss pharmaceutical companies as being broadly exposed to climate risk, but they are
“We don’t often think of Japanese and Swiss pharmaceutical companies as being broadly exposed to climate risk, but they are,” Antia says. “Their supply chains run through places like Israel and India and these are two places that happen to be vulnerable to water stress.
“When it comes to pharmaceuticals, it is a water-intensive industry. They need special purified water and they need a lot of it. Using alternative data and geolocation, you can identify which firms are more exposed to water risk.
“You plot prominent factories, prominent plants in, say, India on a map and you overlay that with metrics for water risk and, ta-da!, you can come up with the plants that are most at risk of water stress.
“As an investor, you then can take this information and make decisions around tilting your portfolio slightly away from those companies that are more at risk from water stress and more to those with lower water risk,” Antia says.
Passive investing has achieved great popularity over the years and this popularity seems to have only increased more rapidly since the global financial crisis.
It took over 20 years for Vanguard’s first retail index mutual fund to reach US$100 billion after it was launched in 1976. Another 20 years later and the fund stands at more than US$ 4 trillion.
The pitch for passive investing is simple: guaranteed market returns at low fees. But the issue with passive investing is that it doesn’t allow you to sell out of problematic companies.
This characteristic makes passive investing particularly vulnerable to climate risks, Antia says.
“Climate change is non-linear; the impact of climate can grow exponentially and there is a good body of scientific research that shows that our minds are not wired to fully anticipate exponential growth,” Antia says.
“A really good recent example of this was the very early days of COVID. It all seemed like it was a manageable risk. ‘Oh, there are a few isolated cases,’ people said. Until, boom, the virus exploded. Humans and markets have a hard time anticipating growth that’s not linear and we’re often caught by surprise by these kinds of events.”
Climate change is exactly like one of these events and markets will have a hard time anticipating the new risks it throws up, he says.
“The second aspect of climate change, and a real thorn in the side of passive index approaches, is that its impact is highly uneven,” Antia says.
“Of course, climate change will have a wide impact; there is not going to be any region that will be unaffected. For example, we already know that emerging markets are going to be hit harder than developed markets in general.
“But even within the emerging markets, there is significant variability in impact. Large emerging markets like India and Brazil are going to be impacted much more than places like Russia and China, for example.
“The physical risk from climate change alone is estimated to shave off about two per cent per year from equity returns in Brazil and India over the next 30 years,” he says.
Emerging markets in South America, Asia and Africa have higher average temperatures and are more likely to see significant declines in productivity and growth due to climate change., PGIM says in the report.
While at the other extreme, remote parts of Russia may see an economic boom as previously uninhabitable polar regions become more hospitable to farming and other economic activity.
Investors can then use this data on susceptibility to climate change to make investment decisions, for example, which sovereign bonds to invest in, especially if two countries have a similar creditworthiness rating.
Another example is United States municipal bonds. More than half of the market for these bonds is made up of retail investors, who tend to hold these instruments for tax purposes and mostly overlook any climate related risk.
Yet, with states such as California facing water scarcity and significant wildfires the indifference of retail investors could provide an opportunity for institutional investors.
“This uneven distribution will be especially problematic for passive index approaches, whose whole premise is based on the idea that risk is normally distributed and perhaps even reverts to mean,” Antia says.
Perhaps surprisingly, Antia views the fossil fuel industry as a potential area for opportunity in relation to climate change, at least in the near term.
Although it is clear there is a trend towards more green energy, with US renewable energy generation having doubled since 2000, fossil fuels won’t disappear overnight, he argues.
”In 2019, there was more new solar and wind power that came online than new incremental fossil fuel power. That is the first time that that has ever happened, so clearly we’re reaching some of these tipping points,” Antia says.
Renewable energy consumption is expected to double again between now and the next 20 years, but the total demand for energy is also going to increase.
“And it is also true that fossil fuels will not be rendered extinct soon and this is supported by simple maths. Today fossil fuels, such as oil, natural gas and coal, account for roughly 80 per cent of global energy consumption.
“Yes, renewable energy consumption is expected to double again between now and the next 20 years, but the total demand for energy is also going to increase, especially in emerging markets. Consequently, fossil fuels are still projected to make up more than 70 per cent of global energy consumed in 2050.
“So fossil fuels are going to have a really long sunset,” he says.
Asked whether the commitment of an increasingly greater number of institutional investors to become carbon net zero in 2050 will not speed up the transition, Antia says a shift has taken place in the mindset of these investors as to how to engage fossil fuel companies.
“Investors, who are really ardently ESG (environment, social and corporate governance)-minded…, more of them are reconsidering their exclusionary approach,” he says.
“In fact, some are considering what the best way is to influence these companies. What is the best way to shape outcomes for the future and how can they contribute to reducing carbon emissions globally by 2050?
“More and more investors are recognising that the way to bring down carbon emissions by 2050 is not by divesting, but by investing and influencing the behaviour of these firms. They want to engage with fossil fuel firms in a collective manner,” he says.
Collective engagement with companies is proving to be quite effective, even in countries where there isn’t much push from governments to reduce carbon emissions, Antia says.
“In the US, Amazon, Delta Airlines and a whole raft of companies have voluntarily committed to data disclosures and carbon neutrality pledges, because they have been under pressure from their customers and their shareholders.
“Investors realise this and are looking to find collective ways to encourage better disclosures, greener practices.
“So this more active investor approach is leading to some investments in fossil fuels, where previously they were divested from,” he says.
Another sector that is widely expected to bear the brunt of climate change is the insurance sector. The increased occurrence of extreme weather events, including storms, flooding and wildfires, has lifted claim levels, thereby putting pressure on insurers’ bottom lines.
But Antia says many insurance companies are at the forefront of understanding climate risk and, once again, helped by better data and sophisticated weather modelling, have gained a better view on the risks involved.
“Artificial intelligence and big data have enabled better modelling and better forecasting,” he says. “So top-tier P&C (property & casualty) insurers in the United States, I’m talking about companies like Chubb and Liberty Mutual, have benefited tremendously from advances in cloud computing and climate analytics.
“The data revolution has seen them developing some of the most sophisticated climate models out there. The combination of enhanced modelling – which is more much predictive than backwards-looking, regression-based modelling – and big data means they have a more nuanced understanding of potential climate tail risks.
“This combination has created some differentiation within the marketplace, because they had a data advantage. They were able to stay away from the most heavily impacted and risky areas.
“So climate change may have made it a little bit easier to discern between winners and losers within the industry,” he says.
The other driver behind the success of insurance companies has been innovation in financing and capital raising. Many insurers today offer so-called ‘sidecars’, a vehicle where insurers invite private investors to share in the premiums and losses from the underwritten policies, which helps insurers diversify risk.
“These risk sharing structures have really expanded the loss absorbing capacity in the industry,” he says. “US insurers have used these sidecars as ways to disperse risk by syndicating it to global institutional investors who are looking for uncorrelated returns.
“A good example of this elevated loss-absorbing capacity was the 2017 hurricane season in the US, where there were three major hurricanes that hit Florida, Texas and North Carolina within the span of a few weeks.
“They all happened to hit major metropolitan areas and the level of insured losses hit record highs, over US$ 250 billion. But this record amount of loss was largely absorbed by the P&C insurers and there was not a whole lot of capital raising,” he says.
This article is paid for by the PGIM. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.