This article is a part of our ESG Special Report week
Climate change is not just a social issue, it also transforms economies. Investors and business will need to adapt to the ‘new normal’, while navigating the new industries, infrastructures and opportunities – both domestic and international – that come up. And along the way, deal with the very real risks.
“Climate change has been recognized as a systemic financial risk,” says Sarah Keyes, Principal at ESG Global Advisors, noting that the Bank of Canada has identified climate change as a top vulnerability to Canada’s financial system as part of the 2019 Financial System review.
What’s the risk?
“Not sure we want to get into worst case scenarios,” says Jamie Bonham, Corporate Engagement Manager at NEI Investments. “It will be bad – and there will be nowhere to hide.”
How bad? Drastically, Keyes warns. “Canada experiences double the average global warming compared to the rest of the world. Globally we are experiencing the effects of an average 1 degree Celsius of warming, Canada is experiencing 2 degrees on average, with up to 3-4 degrees of warming in the North,” she says.
She further explains the worst-case scenario, where Canada will experience catastrophic consequences in the form of extreme weather (flooding, droughts, wildfires) across the country and significant warming in the North will drastically impact Indigenous communities and businesses with operations in these regions. “Permafrost will melt rapidly, impacting infrastructure (homes, roads, businesses, hospitals, schools) that is built on it,” she says.
"Climate change is a global problem, so it’s Canada’s problem too," says Morningstar's Director of Sustainable Stewardship Research, Jackie Cook. "We are one of the highest per-capita consumers of oil and gas; much of our national wealth is in oil reserves and our economy is heavily skewed towards extraction. According to Morningstar’s 2018 Sustainability Atlas, Carbon Edition, Canada has one of the most carbon intensive equity markets in the world, leaving the Canadian economy significantly exposed to a transition to a low-carbon economy.
"Carbon is embedded in almost every economic transaction," says Cook.
All these negative effects on companies aggregate in individual portfolios, which in turn take a collective toll on Canada’s financial system, says Michelle de Cordova, Principal at ESG Global Advisors.
“This has real economic consequences,” says Keyes.
The best-case scenario isn’t immune either. “In a best-case scenario (i.e. meeting goals of Paris Agreement to limit global warming to no more than 2 degrees), we can manage the physical climate impacts and build resilience through adapting to climate change,” says Keyes, noting that we will still be impacted but the impacts will be more manageable.
Climate change is inevitable. The only question is how ready is our economy? And what can we do about it as investors?
How ready are we?
Keys notes that the federal government’s Expert Panel on Sustainable Finance acknowledged that Canada has work to do in order to position its economy to meet global demand for low-carbon, climate-resilient products, services and solutions.
That being said, "Canada has made more progress than most governments," says Cook. "With the Pan-Canadian Framework on Clean Growth plan and Climate Change enabling policy developments, including Canada’s Carbon Tax, intended to tackle emissions and accelerate investment in zero carbon technologies. A large number of municipalities have declared a climate emergency, signaling political appetite for decisive action on climate change."
Bonham believes we are in a much better place than we were just five years ago. “We are seeing fairly broad mobilization by Canadian investors on the topic of climate risk, something that could not be said previously.” It’s not all good news, though. Bonham says we’re coming from behind compared to European investors and Canada has a much bigger exposure to climate risk as a result of our extractives-heavy economy.
Canada does have a few advantages that will help us get to the right place, says Keyes. “A strong diversified and resource-rich economy; a world-leading financial sector; and excellent capacity for innovation” are strengths that “can be harnessed to transition Canada’s economy to thrive in a low carbon future.”
So where are the weaknesses? And what sectors are relatively safe?
Strengths and weaknesses
“I think it is important to note that no one is really safe if we don’t head off the very worst impacts of climate change,” says Bonham.
That said, there are some sectors that have far more exposure and are arguably already facing the impacts of climate change, adds Bonham. “This includes energy (and oil and gas in particular) and agriculture but also sectors such as insurance and even real estate where exposure to low lying areas and/or increasingly harsh weather will have material impacts.”
Keys agrees, noting that Canada is in a unique position when it comes to effects on – and political pressure around - our energy sector, as well as challenges that come with the privilege of living on such a big piece of land.
“Firstly, we have a natural resource-based economy – many of these sectors are high-emitting and they will face increasing pressure from global investors to reduce emissions in order to access capital,” says Keyes. “Secondly, we have a large and diverse land mass. The predicted impacts of climate change vary significantly by region, which means Canadian businesses will have to navigate adapting to increasing frequency and severity of extreme weather with a nuanced approach.”
"The fossil fuel industry is of course particularly vulnerable to a low carbon economy – increasing competition from renewables and the withdrawal of government fossil fuel subsidies are just two of a growing number of existential risks the industry faces," says Cook.
In terms of sectors best suited to tackling climate change risks, it’s actually those involved in the transition to a low carbon economy.
“The sectors most resilient are those that will be providing the solutions and services that will be needed to either mitigate further warming or address the physical risks of increased warming,” says Bonham. “This includes companies providing solutions in energy efficiency, renewables and energy distribution, but also water treatment and conservation, sustainable agriculture and waste and recycling solutions. There will only be a growing market for these solutions and companies that are focused on these solutions will likely be resilient.”
But the success of these new sectors and the resiliency of existing sectors depends highly on where we go from here.
Steps to sustainability
First and foremost, a critical policy piece to look out for, Keyes says, is developing a “transition” taxonomy for Canada to enable our natural resources sectors (e.g. energy, forestry, mining, agriculture) to access new financial instruments (e.g. green and transition bonds) intended to encourage low-carbon, climate-resilient innovations and investment.
Canada’s energy sector, for all its negative ESG publicity, has been making some moves in the right direction, says Morningstar sector analyst Joe Gemino. And he notes that some progress has been made, “our oil sands coverage lowered its carbon intensity by 13% - [but] despite the improvements, more can be done to improve the environmental impact of oil sands production.”
Gemino also notes that, paradoxically, some of the improvements – such as ‘solvent assisted technology’ which he expects to lower greenhouse gas emissions by 25% from today’s levels – can only be showcased on expanded pipelines. In a bit of a catch-22, “even though we expect the major pipeline projects (Enbridge Line 3, TC Energy Keystone XL, and the Trans Mountain Expansion), we expect continued opposition due to the current environmental stigma associated with the oil sands that can lead to continued delays. Once the pipelines are built, then oil sands producers can work to improve their environmental footprint.”
For all the uncertainties, individual investors might consider diversifying away from high risk sectors, however the effects of climate change are wide-reaching, warns Bonham. You can’t sell your way out of exposure.
What can investors do?
“Simply divesting of energy stocks for example is not going to mitigate the risks of climate change. It is important to remember that since the oil and gas sector is going to be around for some time, and since most people believe the energy transition is already underway, these companies are by definition part of the transition. So, we need to be engaging these critical actors to affect the greatest change, and thus hopefully avoid the greatest impacts,” says Bonham.
"Investors have a leading role to play in the low-carbon transition," says Cook. "This has been explicitly acknowledged at the signing of the Paris Climate Agreement, the setting up of the Task Force on Climate Related Financial Disclosures by the G20, and with new investor initiatives growing out of the One Planet Climate Summits – the Climate Finance Partnership, the One Planet Sovereign Wealth Funds Initiative and the One Planet Asset Managers Initiative. That climate change is a material investment risk is underscored by the fact that over a third of all managed assets globally have joined forces to engage the world’s most systemically important emitters in finding alternative business plans."
“Investors and financial institutions can identify the material climate-related risks and opportunities across time horizons and integrate them into capital allocation decisions,” says Keyes, “Investors in high-emitting sectors can actively seek opportunities to fund low-carbon innovations and solutions that can be exported to other high-emitting economies globally."
Cook encourages investors to "challenge investment fiduciaries to use their votes and their influence over corporate management to champion sustainable business practices and greater transparency." She says to ask key questions: "Are the existing approaches to active ownership bringing about change at the pace required? How can investment fiduciaries work together to amplify the voice of the investor in advocating for more sustainable business practices and pressuring governments to envision and activate policy roadmaps for decarbonizing economies?"
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