AIQ - The risk edition

The era of ecological disasters

Part 5 of our series exploring the potential source of the next global crisis

As the frequency and ferocity of natural hazards increase, in part five of our mini-series on the source of the next crisis AIQ considers the economic and investment implications and what we can learn from past mistakes.

While COVID-19 is claiming the headlines, it is by no means an isolated example of our increasingly fragile relationship with the natural world. This year has also seen severe wildfires in Australia, floods in the UK and Uganda, as well as droughts in the American west and New Zealand; hurricane season will add to the final tally.

Climate change and environmental degradation are increasing the frequency and severity of natural disasters. According to the World Economic Forum’s (WEF) Global Risk Report 2020, these now average one a week across categories. The top five risks are all environment-related, with three linked to environmental disasters and extreme weather (Figure 1).1

Natural hazards are taking a heavy toll on human health and wealth, as some communities barely have time to recover from one disaster before another hits.

“The planet is not in danger – it’s we who are in trouble, in that we are endangering the ecosystem that supports us. If we disappear, after a period of destruction the planet will thrive again: just look at the area around Chernobyl, which is now a paradise for animals,” explains Didier Sornette, professor on the Chair of Entrepreneurial Risks at the Swiss Federal Institute of Technology Zurich (ETH Zurich).

Figure 1: The global risks landscape 2020
The global risks landscape 2020
Source: The Global Risks Report 2020, World Economic Forum

Perhaps we have been too quick to dismiss environmental risks as the stuff of big budget disaster movies. But in light of recent events, when something that started as a localised health issue rapidly morphed into a global health and economic crisis, it seems reasonable to ask whether a natural disaster could be humanity’s biggest threat.

Ecological threats abound

According to Dr Robert Glasser, former head of the UN Office for Disaster Risk Reduction and visiting fellow at the Australian Strategic Policy Institute, two main factors are increasing the risk of natural disasters.

First, he argues investments in infrastructure and economic development are being made without due consideration of the disaster risk. “With such poorly risk-informed investments, it is not surprising that more infrastructure is being destroyed and the financial costs of disaster risk are going up,” explains Glasser.

Infrastructure investments need to take account not only of historical risk of hazards but also of how climate change is altering the risk

The second is climate change, whose impacts are only just becoming visible. “Climate change is increasing the frequency and severity of many hazards. “Infrastructure investments need to take account not only of historical risk of hazards but also of how climate change is altering the risks. In the US, if you look at Hurricane Harvey, something like half of the homes destroyed by that were situated outside the one-in-500-year threat area.”

Ed Dixon, head of environmental, social and governance (ESG) for real assets at Aviva Investors, agrees that whereas physical climate risk used to feel like a distant problem, it is now on top of us. On balance, he says the industry is realising the need to assess climate risk for legacy business and assets, as well as new investments.

Biodiversity loss and excessive use of natural resources are further weakening ecosystems’ resilience and capacity to recover from shocks. As the UK’s Dasgupta Review on the Economics of Biodiversity explained: “Just as diversity within a portfolio of financial assets reduces risk and uncertainty, diversity within a portfolio of natural assets – biodiversity – directly and indirectly increases Nature’s resilience to shocks, reducing risks to the services on which we rely. But Nature’s resilience is being severely eroded, with biodiversity declining faster than at any time in human history. Current extinction rates are around 100 to 1,000 times higher than the average over the past several million years – and they are accelerating.”2

Tales of the unexpected

Perhaps the most dangerous dimension of increasing hazards is that, as human interference grows and disasters become more frequent, they begin to compound to cause unpredictable and unmanageable knock-on effects. Rick Stathers, climate change specialist and senior ESG analyst at Aviva Investors, gives the example of chemicals in the environment interacting with each other, creating chemical ‘cocktails’ that can amplify their effect on plants, animals and humans.

A recent post by Simon Clark of the University of Liverpool’s Institute for Risk and Uncertainty also linked the frequency and magnitude of flood events throughout the last century to the impact of human activity on rivers and floodplains. Clark explains that, with only 14 per cent of rivers considered to be in a good ecological state, “the natural functions that regulate flooding have been lost to centuries of human interference”.3

In the most serious cases, simultaneous and consecutive disasters create a chain reaction with global consequences. Take the food security crisis in 2010-2011. Droughts and fires in Russia, Ukraine and parts of China, as well as floods in Canada and Australia, combined to destroy the wheat crop. That led to countries hoarding wheat and hiking the price of food, which resulted in food riots in parts of North Africa. That was a contributory factor behind the Arab Spring.

Figure 2: Links between the top global risks in 2020
Links between the top global risks in 2020
Source: The Global Risks Report 2020, World Economic Forum

The European Union’s Joint Research Centre is also looking into possible cascade effects; specifically the damage caused by natural disasters to chemical plants or oil and gas pipelines, including the release of hazardous materials into the environment.4

Frederique Nakache, equity fund manager at Aviva Investors, thinks it is already part of the higher risk premium for oil and gas companies, as is the political risk stemming from geographic exposure, and risks borne of companies’ plans.

Oil and gas companies have to integrate harsh environments in their development plans

“Oil and gas companies are used to working in extreme conditions, including hurricanes and storms in the Gulf of Mexico or the North Sea for example. They have to integrate these harsh environments in their development plans. It also explains why they don’t choose oil services companies purely on price, but factor in their reliability in terms of product quality and execution as well,” she says.

These risks – of natural disasters, cascading effects and impacts on individuals and communities – are predicted to get worse (Figure 3). In a January 2020 report, consultancy McKinsey stated: “According to climate science, further warming will continue to increase the frequency and/or severity of acute climate hazards across the world, such as lethal heat waves, extreme precipitation, and hurricanes, and will further intensify chronic hazards such as drought, heat stress, and rising sea levels.”5

In addition to rising frequency and severity, the patterns of hazards are changing, presenting risks to areas that have been unaffected previously. “In Australia, in a warming world, recent scientific research suggests that cyclones will begin tracking further south to parts of the country including the Gold Coast, a big tourist area with high-rise buildings that have not been designed for extreme cyclones,” says Glasser.

Figure 3: Extreme precipitation and increasing temperatures, 2020-2050
Extreme precipitation and increasing temperatures, 2020-2050
*Note: Based on RCP 8.5 (RCP = representative concentration pathway, a greenhouse gas concentration trajectory). Source: McKinsey Global Institute, as of January 2020

Tipping point

The overuse of resources is not only contributing to the higher frequency of natural disasters, but also the potential for one to turn into a genuine global catastrophe. Moreover, these risks are linked. Pandemics become more likely as humans overshoot their natural boundaries. Rapid deforestation accelerates global warming and degrades wildlife habitats.6

Climate change, for example, could bring the planet to several tipping points, each occurring at different levels of warming, where a system goes from one state of equilibrium to another and is permanently changed. According to WEF, passing one of these tipping points may increase the risk of crossing others, and they are all under growing threat of abrupt and irreversible changes.7

Figure 4: The nine tipping points
The nine tipping points
Source: Timothy M. Lenton et al., Nature, April 9, 2020

“Ocean and atmospheric circulation, and feedback between these shifts, could accelerate global warming, triggering a cascade of tipping points or even a global tipping point – and a less habitable, “hothouse” Earth,” it warned.

Scientists currently estimate this could happen at three degrees Celsius of warming, at which point humans would no longer be able to stop runaway climate change from occurring, according to Stathers. “If you go to three degrees, you are very likely to go to six degrees or more, hence the urgency to keep warming to within 1.5 degrees,” he says.

One example of such a feedback loop causing runaway change is the Amazon. “If we lose 20 per cent of the Amazon – and we are at 17 per cent now – it could change from rainforest to savannah. That would have huge implications because it is a massive carbon sink: it would release that carbon, causing more warming, which would cause other systems to change,” says Stathers (Figure 5).

Figure 5: The Amazon rainforest tipping point
The Amazon rainforest tipping point
Note: Graphic showing the conception of tipping points. Source: Dasgupta Review on the Economics of Biodiversity, April 2020

Glasser notes a similar example of a negative feedback loop: at 1.5 degrees of warming most coral reefs – which are fish nurseries for perhaps ten per cent of the world’s species – will have died, depleting tropical food supplies. Scientists have also determined that fish species are already moving towards the poles to escape warming waters. At two degrees Celsius of warming, this will result in a decrease of up to 60 per cent in fisheries yield in the tropics. And, as coral reefs disappear, so will the protection they offer coastal areas against storm surges, exposing millions of people to more extreme weather. Combine these factors with the impact warming will have on agriculture, and the food security risks become enormous.

“If you put all those things together, it is extremely likely we will see these cascading impacts happening relatively quickly. They will happen in a given year, like bushfires in Australia, but they will also happen in consecutive years, and the individual events will, in effect, become one big event as the interval of time between them shortens,” says Glasser.

The human and economic impact

Natural disasters are leading to increased health spillovers, loss of life and the displacement of populations, though potentially unequally. According to WEF’s Global Risks Report 2020, women and children are 14 times more likely than men to die during natural disasters. The elderly and infirm are also at higher risk, and health systems in the poorest countries and communities may not be able to cope as well as those in the rich world. Over 20 million people a year were displaced between 2008 and 2016, and worsening climate change could trigger conflicts in the future.

The Cambridge Global Risk Index 2019 identified natural catastrophes as the biggest threat to gross domestic product (GDP), with $174 billion at risk - 30 per cent of the overall total. Tropical windstorms are the third highest individual risk, at $66 billion or 11 per cent of total risk (Figure 6).8

Figure 6: 2019 GDP at risk by city
2019 GDP at risk by city
Source: Source: Cambridge Global Risk Index 2019

This is projected to rise significantly, from direct damage – which could reach ten per cent of GDP by the end of the century in the US alone – but also productivity losses, which could be equal to 80 million full-time jobs by 2030 as a result of heat stress.9

According to McKinsey, agricultural production could be impacted in similar ways. Though some regions may benefit from a warmer climate, others will see crop yields drop (Figure 7).

Figure 7: Temperature impact on corn crop yields
Temperature impact on corn crop yields
Source: McKinsey Global Institute, January 2020

Although these estimates do not account for the occurrence of tipping points, the impacts of which are difficult to model, they are enough to underscore the urgent need for action. Unfortunately, the increasing economic cost posed by the disasters themselves, coupled with current geopolitical strains,10 could compromise efforts to mitigate and adapt to what Glasser calls “the era of disasters”.

Risks and opportunities

To adapt to this situation, the first step, says Glasser, is to understand the risks, both from a historical perspective and the current and future impacts of climate change. “That is really tricky because you can get some useful information from climate scientists on, for instance, the risk of extreme weather in a particular part of the country, but we would need much better information to provide climate risk information at levels and with degrees of certainty that are useful for planning in regional and local communities,” he says.

The second step is to incorporate this understanding of risks into new investments and also previous investments to make them less exposed and vulnerable to the hazards climate change is amplifying. Policymakers and business leaders will need to take adaptation and mitigation measures to assess climate risk, adapt to risks already locked in, and transition to a low-carbon economy. Pressure is growing on companies, although only a small number seem to be taking decisive action.

“Companies have begun to up their rhetoric, but at the moment only 850 companies are committed to align their emission pathways with a 1.5 or two-degree future as per the science-based targets initiative,” says Stathers. “There aren’t enough companies fully analysing the potential ramifications of what a four-degree environment might imply versus a 1.5-degree environment – through the value chain, in terms of cost of goods sold, suppliers, and how it will impact customers and their disposable income.”

Stathers attributes this to the obsession with short-term profitability, which constrains companies’ ability to invest in research and development, resilience and adaptation – collectively undermining their risk management capability. “In the aviation sector, 90 per cent of the free cash flow in the last decade has gone into share buyback schemes; nothing was spent on building resilience.”

The other challenge is an inability to model and value externalities, which remain unaccounted for in company balance sheets and economic forecasts. “They call them externalities because they don’t know how to model them – and an externality is climate change, water scarcity, biodiversity loss,” says Stathers.

“The way we can measure the ability of companies to face climate change is to use CDP data. CDP provides data on sustainability metrics and scores companies and their climate-change strategies according to the risk they are exposed to through their operations. These are all the actions companies must take, either to decrease their emissions or to offset them by investing elsewhere, for instance in reforestation, and to tackle the physical impact climate change may have on their day-to-day operations,” adds Francoise Cespedes, equities portfolio manager at Aviva Investors.

“For example, in the winter of 2018-2019, German chemical companies operating on the Rhine, such as BASF, couldn’t use the river to transport and deliver their products to clients because the level of the Rhine was too low. These companies have to adapt and find new ways to transport their goods in order not to be dependent on the level of the Rhine,” she says.

She also argues that, as climate change is under way and temperatures will rise for some time to come, some niches or markets should benefit, notably those that help companies and individuals face the impacts of warming. “There are companies like Boskalis, which provides coastal defence equipment to face rising sea levels, but also air-conditioning providers. Segments such as these are a few niches where we expect to see value creation in the next few years.”

Much remains to be done in terms of incorporating disaster risks into valuations. But progress is critical if capital is to be redeployed

Much remains to be done in terms of incorporating disaster risks into valuations. But progress is critical if capital is to be redeployed away from companies that are not adapting or are contributing to the risks towards firms that are adopting best practices, including those leading decarbonisation efforts.

“To date, this type of analysis is typically conducted as a qualitative risk overlay related to businesses at the high end of exposure risk. I have not seen it included in a formal way to impact pro-forma models or leverage metrics, thereby directly impacting companies’ credit rating. Doing this properly would require analysts to model the related forward probabilities in a precise way, but I don’t think we are there yet in terms of market practice,” says Paul Lacoursiere, Aviva Investors’ global head of ESG research.

In addition to short-termism, Stathers believes one of the issues is that disruption rarely comes from incumbents. It is much harder to entirely redefine an industry from within, particularly for firms with a fiduciary duty to their investors.

“You get a lot of warnings from science, and it takes at least a decade before these signs start moving into policy and investment. But now we recognise that climate change is a fiduciary issue we are taking steps to address that. We are also seeing greater demand from clients and regulators on what investors are doing on climate change, so that is creating changes in how we respond,” he says.

Glasser thinks the business community, particularly the financial sector, is moving faster than governments. “I suspect, as these disasters happen more often, and as the impacts become bigger, business regulators will begin requiring corporations to disclose their exposure to climate risks and how they are addressing the risks.” he says. “Ultimately this will accelerate the movement of hundreds of billions of dollars towards more resilient infrastructure. It will change the whole system because asset owners will want to make sure they have something to offer investors that is resilient to climate and disaster risk”.

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