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Physical climate risk in climate adaptation investing

In 2023, we published a series of research papers on the case for climate adaptation investing. Since then, investors’ understanding of the climate adaptation space has become more sophisticated, while the ability to measure physical risks and integrate this data into investment decision-making has continued to evolve. Chief Global Sustainable Investing Strategist Jennifer Wu joined a panel at the 7th Annual Sustainable Investment Forum to discuss our efforts to assess physical climate risk and identify areas where better information could enhance investment decisions.

How we think about physical climate risk

As an asset manager, our fiduciary duty to our clients is always top of mind. Our priority is to understand the risks that climate change poses to our clients’ investments, including both physical and transition risks. It’s from this perspective that we approach climate adaptation and climate resilience. We aim to evaluate how our business and client portfolios might be impacted by physical climate risk and what opportunities there may be to build resilience through integrating adaptation.

We manage money for a wide range of clients across the world. The materiality of climate-related risks depends on several variables, including investment style, guidelines and objectives, region, and asset class. As a result, we need to take a tailored view of physical risks and adaptation opportunities. Even within a given sector and region, the importance of climate-related risks can vary significantly. The information that is relevant also changes depending on the asset class in question – for example, fixed income investors will want to understand the impact of physical risks on credit spreads, while equity investors are interested in the potential share price impact. Meanwhile, alternatives investors across infrastructure, real estate and transport are concerned with the resilience of the real assets that they manage for clients.

Time horizon is also a particular consideration for us as an asset manager. Physical risks are increasingly important over longer time horizons – which is why, as a long-term, active manager generally looking to hold investments for five years or more, we consider climate change to be an important investment topic. But it can be challenging to reconcile the long time horizon of physical risks with the shorter-term risk management and investment decision-making that portfolio managers also need to carry out. To address this challenge, we are continuing to improve our understanding of physical risks across relevant sectors and asset classes, to determine how physical risk could impact our client portfolios and forward-looking strategic asset allocation.

Physical risk is relevant for long-term resilience

It is increasingly clear that more comprehensive and quantifiable oversight of physical climate risks can help to enhance the long-term resilience of investments. Subsequently, proactive investment in adaptation solutions and climate-resilient companies or assets can help to minimise investors’ exposure to these types of risks. As we have begun to appreciate the need for a more in-depth understanding of climate resilience and adaptation-related risks and opportunities, we have dedicated greater research resources to this topic. In our 2023 climate adaptation series, we focused on the potential physical risks and impacts as they relate to cities and urban infrastructure, nature and ecosystems, and the healthcare sector. We discussed frameworks for assessing risks in these different areas and identified opportunities for investing in more resilient businesses and assets, as well as highlighting specific adaptation products and solutions. Since then, we have continued to monitor the development of various industry frameworks and taxonomies around adaptation solutions as well as the increase in quality and availability of physical risk data.

As an asset manager we also have the option of one-on-one engagement with our investee companies. Engagement is one of the tools we can use to gain a deeper understanding of how companies are approaching resilience and adaptation. We can then look to incorporate these insights into our own decision-making. Increasingly, we are having dialogues with companies about how they monitor their exposure to physical climate risks and what plans they have put in place for mitigating these potential risks.

Potential data challenges

One challenge for asset managers is that physical risks are not yet consistently and broadly priced across markets. Analysis by the International Monetary Fund in 2020 found that the impact of large disasters on equity markets, bank stocks and non-life insurance stocks has been modest over the last 50 years and that, as of 2019, aggregate equity valuations did not reflect predicted changes in physical risks under various climate change scenarios. While we know that climate change has the potential to cause significant damages on a macroeconomic scale, with one recent study going so far as to suggest that climate change could cost the world 12% in GDP for each 1°C of global temperature rise, it’s hard to translate these high-level estimates into a markets context and into potential valuations impacts for individual companies and client portfolios. 

In this context, measuring the scope and full impact of physical risks to individual holdings can present challenges. One example is the challenge of combining different types of data – namely, combining data from high-level physical risk models with data on asset location and financial valuation. While we have relatively good data on current and forward-looking global exposure to physical climate risks, it is still difficult to translate this to the level of individual assets and impact on their market value. The evolution of data, reporting and measurement will therefore be important to help us further understand how risk is overlayed onto the specific assets to which our investee companies are directly and indirectly exposed.

Since we know that physical risk will pose increasing risks to client portfolios over longer time horizons, we are working to fill certain information gaps in portfolio-level risk assessment. As the industry develops, we are continuing to identify solutions, which may include specialist data providers that are working to provide access to more granular data that can help inform investment decisions.

Looking to the future

We believe investors will benefit from better quantification of both the potential financial impacts of physical climate risks, and the financial benefit from implementing climate adaptation measures.

Estimates of these financial impacts remain somewhat subjective: since physical risk data still requires an overlay of human interpretation to try to understand the impact on individual assets or portfolios, there can be discrepancies between different risk assessments that make it more difficult to compare investment opportunities. Increasing the accuracy and convergence of physical risk measurements, for example through the use of artificial intelligence (AI) weather forecasting and asset mapping or more granular geospatial data, will play an important role in increasing the reliability and comparability of risk assessments.

More broadly, we need to continue the dialogue across the industry in order to increase the understanding of physical climate risk, climate adaptation investing and the identification of climate adaptation-related opportunities. At J.P. Morgan Asset Management, we are continuing to educate ourselves and our clients – where relevant for their investment objectives – on this evolving but important area.