The catastrophic bushfires and extreme weather events last summer highlighted the physical and economic risks of climate change, and galvanised the urgent need to not only reduce greenhouse gas (GHG) emissions but begin to think about how we make the transition globally to a low carbon world.

In Australia, APRA has outlined plans that, from 2021, will require super funds to perform balance sheet vulnerability assessments of the potential physical impacts of changing climate, including extreme weather events and the risks arising from the global transition to a low carbon economy.

To that end, it is clear that addressing the risks associated with climate change is a global theme, and one that will only gain momentum over the coming years.

Global warming the greatest challenge of the modern world

Under current global emissions trajectories, the planet is on track for approximately 3°C of warming by 2100 – a path expected to result in temperatures not seen in three million years.

This degree of warming is forecast to exact a staggering toll on global economic output. McKinsey forecasts that 2°C of warming by 2050 would trigger lethal heatwaves in Asia, impacting labour and costing the region between seven and 13 per cent of GDP.

The 2015 Paris Agreement was supposed to mark a historic turning point for combating climate change, setting forth ambitious limits on global temperature increases. But to stay within these limits, countries must set equally ambitious GHG emissions targets and aligning with these pathways requires unprecedented and urgent change.

Global shift to renewables results in decarbonisation risks

The key to achieving these emissions goals is decarbonising the global energy system with a significant shift in the energy mix towards renewable sources. As it currently stands, the use and combustion of fossil fuels contribute to around 75 per cent of GHG emissions, with the remaining 25 per cent coming from agriculture and land use change.

The required shift introduces significant asset stranding risks. In essence, existing fossil fuel reserves cannot all be burned if emission targets are to be met. When determining the extent to which fossil fuels should remain buried, it is important to note the three main types of fossil fuels—coal, oil, and gas—have varying carbon intensities. Coal has the highest by a wide margin, with coal-fired power stations emitting around double the carbon per unit of electricity that natural gas plants do.

Positively, the global shift to renewable energy sources is already well underway. The US Energy Information Administration recently reported that energy consumption from renewables in 2019 surpassed coal consumption for the first time since 1885. And, in some instances, renewables are now a cheaper form of electricity than traditional fossil fuel sources.

Further progress in the global shift to green energy will require sizable government investment and accommodative policies. The European Union’s Green Deal, developed by the European Commission, aims for climate neutrality by 2050: it proposes using 25 per cent of the long-term EU budget for related initiatives.

In addition, US president-elect Joe Biden’s victory marks renewed US commitment to green initiatives. Whilst the US has already begun its shift to renewables, the pace is expected to accelerate under Biden’s presidency. Biden has pledged that the US will re-join the Paris Agreement and spend at least $2 trillion on climate-related actions. He has also unveiled plans to decarbonise US power by 2035.

As the shift to green energy becomes more widespread, so too will decarbonisation risks.

But importantly, we believe that the magnitude and scope of these risks have not been efficiently priced into markets.

Risks impact every company – including less obvious ones

It is difficult for markets to efficiently price in risks where they are not obviously apparent.

There are some areas of the market—such as fossil fuel companies and the necessary shift to renewables—where the impacts of the transition to a low-carbon world are clear. In reality, the shares of oil companies are not the only assets influenced by climate change – the effects can be felt across a broad range of equities, bonds and real assets.

For example, when massive flooding devasted Thailand in 2011 due to an unusually rainy monsoon season, the impact reached far beyond local companies. Thailand is home to several large semiconductor manufacturing facilities, many of which sustained substantial damage during the flooding. The resulting loss in manufacturing productivity caused significant disruption in global supply chains, ultimately impacting the bottom line for an extensive list of electronics companies and their customers (such as Japanese auto makers), as well as the performance of their securities.

As the planet continues on its warming trajectory, weather anomalies such as these are expected to become even more prevalent. With interconnected supply chains that span the globe, the ripple effect of these events can be felt across countless companies, securities and assets.

Being active in the face of climate change

The global transformation required to align with emissions targets will be monumental in its scope and complexity, necessitating an urgent need to reallocate investments to reduce global warming and in turn address climate change risks.

Being an active investor means thinking beyond fossil fuel exclusion or optimising a portfolio to focus solely on companies with low GHG emissions. Climate change will impact every factor in the global economy, and so a holistic approach is needed to understand both the risks and opportunities arising from the physical and policy impacts. We believe this is best achieved through a forward-looking, fundamental investment approach, one that assesses risks and opportunities across corporate value chains while also incorporating environmental, social and governance (ESG) considerations.

The risks to fossil fuel companies and the opportunities in areas such as electrification, renewable energy and energy efficiency are evident. However, risks and opportunities in other areas of the market might be less clear. For example, carbon pricing can have a knock-on effect to the raw material input costs of many industries. Similarly, the physical effects of climate change, such as water scarcity, temperature rises, flooding to agricultural land, and the need to reduce our meat consumption will be felt throughout the food chain.

Taking an active approach to climate change also involves company engagement. We believe changing the behaviours of companies on climate change means reducing climate risk in our investments. Our philosophy is to be direct and visible in representing our views on ESG issues across all of our investments, spanning every asset class.

Opportunities for Australian super funds

The change needed to transition to a low-carbon and climate-resilient world will impact every company around the globe. While for some companies the impact is clear, for others it is less apparent. As such, we believe that financial markets are not efficiently pricing the move towards decarbonisation, nor are they reflecting the physical risks of climate change.

This underscores the importance of Australian super funds taking an active approach to identifying those companies that are best orientating their business models for a lower carbon, warmer world – and mitigating the associated risks.