A Framework for Global Warming Induced Extreme Weather and Water Investment Risks

Climate risks, including those which arise from global warming induced extreme weather and hydrological events, need to be considered by both institutional and underlying investors in their portfolios (Porritt, J. (2001). The world in context: beyond the business case for sustainable development. Cambridge: HRH The Prince of Wales’ Business and the Environment Programme, Cambridge Programme for Industry.; Stern, N. (2006). Stern Review executive summary. New Economics Foundation.). Emissions from carbon-intensive sectors can be linked to potential liabilities caused by extreme weather and hydrological events, such as extreme rainfall and flooding. The risks these events present may not be reflected in current equity or bond prices (Krosinsky et al., Evolutions in sustainable investing: strategies, funds and thought leadership, John Wiley & Sons, 2012). Consequently, financiers and investors need tools to assess the climate risks of portfolio holdings. Financial supervisors and regulators also need to identify downside risks. We propose a framework which may be helpful for estimating investment losses based on firms’ historical carbon emissions. Our framework would also allow the sensitivity of losses to uncertain inputs to be explored for climate risk stress-testing. We further develop and refine Rayer et al. (2021b), with “hypothetical climate liabilities” now, in principle, being applicable to any company for which the relevant data is available. It also includes scope for a financial and economic focus to encompass moral responsibility. The principal idea is that a company’s knowledge of the climate damage its emissions have caused, together with its subsequent willingness to accept responsibility to address the harms caused is incorporated, which is likely to reflect a societal judgment. Our framework enables financial market practitioners and policymakers to estimate, for individual listed companies, potential equity or bond price falls arising from a company’s historical emissions following climate change induced extreme weather or climate events.