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Devastating wildfires in Canada, Europe and California. Lingering droughts parching much of the globe. 1,000-year rainstorms occurring several times in a single month. Last year was hottest North American summer on record, and 2024 is shaping up to be even hotter. These extreme weather events have been persistent front-page stories in recent years. And meteorologists are warning that the increasing frequency and magnitude of severe weather will likely become the new normal for much of the world.
The most immediate and devastating effects of extreme weather have upended the daily lives of people who have lost loved ones, homes and livelihoods to storms and wildfires. Millions more are facing challenges from enduring triple-digit temperatures for weeks on end, from toxic wildfire smoke and from frequent and unpredictable storm patterns. With each new disaster, our hearts go out to the people enduring the unbearable consequences of these events.
Weather events and the impacts from natural disasters pose risks to individuals, businesses and financial markets. Strong company management teams anticipate such events as potential business risks and have established robust plans to address them and mitigate their impacts. There will be both leaders and laggards in how companies withstand, respond to and adapt to a changing and more volatile climate. We are working with our portfolio companies to evaluate their plans for climate resilience, to share best practices in navigating climate risks and to collaborate with them to improve in these areas through our engagements as well as through proxy voting.
As the increase in extreme weather incidents is unlikely to abate, we are building portfolios of leading companies that are more likely to be resilient in a changing climate through quality management, foresight and long-term strategic planning. We believe these leaders are not only working toward a low-carbon world but are best positioned to address extreme weather events in the meantime.
Risk Assessment in an Era of Climate Change
When we evaluate potential investments for climate risks, we consider each company relative to its industry. Certain industries inherently have more risk than others. For example, companies with a lot of real estate and/or manufacturing facilities will have more risk than companies offering business services that don’t produce physical goods. The “footprint” in terms of where the offices and manufacturing plants are located is an important consideration as well as how that affects the entire supply chain.
In assessing a company’s climate resilience, we look at how well they can handle the risk of a climate event and can shift operations to other locations, considering both the impact to operations and their employees. Worker safety is paramount for the companies we consider for our portfolios. Evaluating impacts on the supply chain is also critical, as is understanding the potential effects on all contributors to the company’s operations.
The close partnership between our investment team and our stewardship team puts us in a position to identify and communicate with companies their potential risks from climate change, drawing on accepted disclosure frameworks. In our view, companies face two main types of climate risk that can be financially material—physical risks and transition risks:
Physical Risks
These include the impacts of a changing climate on a company’s assets, employee base and operations. These impacts can be acute or can emerge as chronic threats over time—for example, rising sea levels, prolonged and frequent heat waves or limited water availability. Exposure to climate events could affect a company’s geographic footprint when facilities are located near areas prone to floods, droughts or wildfires. Climate events can also disrupt company operations and reduce revenue through decreased production or interruptions in supply chains and transport. Employees can face health and safety risks that could be fatal or limit their ability to get to their jobs or complete a full workday, contributing to increases in absenteeism or furloughs and leading to lower productivity.
Companies can also face higher insurance premiums, increased capital costs to repair damaged facilities, shortages of water or other natural resources, and even the need to write off or relocate assets in locations with high exposure to severe weather. A recent example of this type of risk occurred last summer, when a tornado hit a Pfizer manufacturing plant that produced 8% of U.S. sterile injectables such as anesthesia and anti-infectives, shutting down production for more than two months. According to the FDA, the company lost inventory ready for shipment and restricted deliveries of some products with high medical needs.
Transition Risks
These include the impacts from adapting a business to reduce its use of fossil fuels and support a low-carbon economy. Every company in every industry is potentially exposed to transition risk. Such risks can slow or hinder a company’s ability to transition away from fossil fuels, especially in industries such as oil and gas and those with limited access to renewable energy: Airlines, transportation, steel, cement and fertilizers. Risks can include increased costs from regulation or lawsuits, policy changes and shifts in consumer demand toward climate-friendly practices. Failing to address transition risks can also lead to obsolete assets.
Manufacturing facilities and other physical assets are most vulnerable to extreme weather events. They can incur both physical risks if they endure a climate event and transition risks through renovation costs during the transition to a low-carbon economy. Where appropriate, we evaluate how well companies are managing these risks, for example, in diversifying manufacturing and physical assets.
With both types of climate risk, companies can be especially vulnerable if they lack the necessary technology or strategic planning. In general, best practices to mitigate these risks include setting emission reduction targets below 1.5°C, incorporating climate change into strategic planning and business decisions and increasing transparency through materiality assessments and regular climate disclosures.
We welcome a broader adoption of climate-disclosure practices and have already started to engage companies on climate risks. We typically target companies with the following three opportunities for climate-related engagements:
- Companies with limited climate actions or disclosures;
- Companies with stronger climate protections but some remaining areas of potential improvement; and
- Companies with a higher vulnerability to physical risks.
Engagement as a Risk Assessment Tool
Company engagement efforts are a core part of our approach. One helpful tool we employ is a materiality assessment, a process to identify and prioritize sustainability issues that are most material to a company’s business. A materiality assessment can uncover a variety of sustainability-related risks and lead to increased disclosure and productive conversations that help to identify strategies to reduce climate and other risks.
While there are many areas of physical risk we can explore, we are focusing on companies in several industries with high climate-risk exposure:
- Semiconductor fabrication plants can use millions of gallons of water a day. According to Stanford University, each manufactured chip can require 10 gallons of fresh water. In regions where water is scarce, chipmakers need to collaborate with local communities on water usage and develop solutions to conserve water. Intel, for example, has emerged as a leader in water conservation: The company is recycling more water than its fabrication plants use in the U.S., India and Costa Rica.
- Homebuilders and real estate companies are vulnerable to several kinds of extreme weather, such as wildfires, hurricanes, inland floods and droughts. They can also emit carbon emissions from construction. Climate-related risks can include lawsuits in the wake of a natural disaster. A shift to climate-resilient building materials could also lead to higher construction costs. Banks with considerable exposure to real-estate loans could also see credit officers incorporate climate risks into their underwriting.
- Utilities face risk from an increased frequency and magnitude of heat waves and wildfires, especially in California and the southeastern U.S. Regulators may push back if utilities try to recover capital spending while raising customer rates. Political, legal and further regulatory risks can also follow from perceptions of poor responses to extreme weather.
Global trends can have a significant impact on a company’s financial performance. That’s why our investment team pursues industries and companies that are positioned to remain resilient to physical climate risks. Extreme weather is occurring in different forms, posing risks to company operations, assets, workforces and long-term stock performance. While individual risks can be hard to predict, many industries are likely to be affected by extreme weather in multiple ways.
Article by Marian Macindoe, Head of ESG Stewardship; Robert Klaber, Director of ESG Research; and Lori Keith, Director of Research at Parnassus Investments.
Disclosures
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