It’s Not All Bad News
Finance professionals can adapt, thrive, and help mitigate the harmful impacts of physical climate risk
Climate change is alarming. It is indeed a climate crisis. Regardless of the actions we take to decarbonize, changes are coming. The seas will rise, storms will strengthen, the planet will warm, crops will die. The future we face is uncertain and challenging. But humans are intelligent. We have tools to adapt and reduce the damage. Forward-thinking finance professionals can adapt, thrive, and help mitigate the harm of these coming changes. It is not all bad news.
Early thinking about the financial risks of climate change dubbed them “unhedgeable.” In finance, hedging is a strategy to limit risk exposure. Projections of future physical climate risk from Jupiter Intelligence can provide insight into which areas are riskier than others.
A risk that can be defined is a risk that can (usually) be hedged.
Consider Florida; after years of “sunny day flooding,” Florida is the iconic example of sea-level rise risk. However, we have no reason to expect that the entire state of Florida will ever be entirely underwater. As John Englander notes in his book Moving to Higher Ground, “Florida is neither flat nor about to ‘slide beneath the waves’…the tourism mecca of Orlando is a solid 80 feet above sea level and not in any direct jeopardy” even in a world with ten feet of sea-level rise. Some areas are always safer than others.
If the entire distribution of risks is understood, then the market can price them.
When prices reflect risks, markets will naturally drive resources to safer areas. If the risks are known, newly informed migrants to Florida will “vote with their feet” and target safer regions at higher elevations.¹ This migration will drive up home prices in safer areas, and builders will shift their attention to these new higher profit zones. Companies interested in locating in Florida will go where the highly skilled population is and look to the safer, higher elevation cities. New capital will naturally shift to safer areas, builders will profit, homeowners will enjoy safer homes. These natural shifts in the market landscape will reduce the overall social damage from the climate crisis. This mechanism driving us to better outcomes is the “invisible hand” economics talks about so often.
The Importance of Adaptation
In a departure from previous international agreements, the Paris Agreement codified adaptation and flexibility into international cooperation on climate change. Two key features of the Paris Agreement, differentiating it from its predecessors, are local autonomy and the importance of supporting adaptation efforts. Each country must set its own goals for emissions reductions and how it will reach those goals in the agreement.
This flexibility to local conditions is great for financial markets and local communities already planning for resilience. It means capital can flow where it is likely to generate the highest returns. The era of significant infrastructure investments will return. The focus of the Paris Agreement on adaptation will direct resources to massive engineering projects — like the Maeslantkering in Holland or the MOSE barrier in Venice — that will inspire future generations and provide jobs and investment opportunities for years to come.
The climate crisis is an existential threat, but there is an irrational level of pessimism about our ability to adapt to future challenges. Not only have we as a species explored the moon and Mars, but recall that, well before the age of modern computing, human engineering changed the direction of the Chicago River. While there are some issues with that particular bit of geoengineering today, it successfully adapted Chicago to a physical peril for more than a century. Extending the life of our greatest cities by more than a century is certainly an excellent investment.
With modern technology and a minimum of $100B committed annually in the Paris Agreement to help developing countries reduce their emissions and adapt to climate change,² some very innovative projects are likely on the horizon.³ To accomplish them, substantial amounts of money will need to be directed towards its best uses. Financial markets are the vehicle in which these funds will travel, and reasonable climate risk projections are the signposts they will follow.
Quantifying the Financial Impacts of Physical Risks
Climate risks are typically split into two categories: transition risk and physical risk. The former are those associated with the transition away from a fossil fuel-based economy. A primary example of transition risk is that many companies count as assets oil reserves that are still underground, even though, in a low carbon economy, these reserves may be worthless. Physical risks are those associated with emerging climate perils. The rising sea levels that threaten our coastal cities are a primary example of physical risks. Both transition and physical risks are global in scope and potentially devastating in scale, but the financial system must adapt to each in different ways.
Transition risks depend on political action and their occurrence is uncertain. They are relatively more straightforward to model as financial impacts.⁴ In contrast, some degree of physical risk is nearly certain to occur. No amount of mitigation today will prevent our climate from changing for decades to come. But physical risks are tough to model as financial impacts.
Jupiter Intelligence provides the data to help close this gap, yet Jupiter’s models do not remove uncertainty; they quantify it. Physical risks can be thought of as increasing the variance, or volatility, of the value of any asset. Luckily, finance is good at dealing with uncertainty and volatility; one might say financial markets exist because of them. The game played in markets is to capture new information that reduces uncertainty and quantifies volatility. Quantified volatility can be hedged, and a hedge reduces risk. Reducing — not removing — uncertainty and understanding volatility are all that is needed to hedge risk and increase returns.
Consider the investment mechanisms such as credit derivatives and default swaps that proliferated during the 2003–2007 period that preceded the housing market crisis of 2008–2012. Instruments like these are essential to keeping liquidity in financial markets when tail risk is large. Given good data on where climate risks are and are not, these same instruments can be adapted to hedge climate risks. Ironically the very financial innovations that once brought the worldwide economy to its knees may save us from a climate-related economic meltdown.
A Case Study: Mortgage Loan Fulfillment
There is no way to relocate real estate assets to safer ground quickly. Investments in real estate assets are also long-term investments. A typical home, once built, can last for a century. The average home buyer in the United States will remain in their home for a decade or more⁵ and loans on residential real estate amortize over 30-year horizons. Any investor lending money towards the purchase of real estate is assuming that the risks faced by that region will be somewhat stable into the future. Knowing where to invest requires validated, transparent, and granular information about which places are safe, and which are not. Jupiter Intelligence is well-positioned to help investors make these investment decisions about real estate location.
Research has shown that climate change matters most for home prices when the risk of weather-related damage is “new news” to the homeowner. Today the only information a buyer receives about this risk comes in the required insurance policies for flood or fire. Yet neither of these are perfect signals of risk. Flood insurance, in particular, is based on an outdated and imperfect system.⁶ With better information about risks, rational home buyers would ask for a discount on riskier properties. Without this information, climate events will shock both homeowners and lenders, and thus negatively impact the housing market. If climate disclosures become a part of mortgage loan transactions, the risk will be priced in at the beginning. The resulting changes will be expected, gradual, and properly hedged. Jupiter can provide exactly this information to the loan fulfillment process.
Mirror Images: Opportunity and Risk
We at Jupiter believe it is important to highlight these opportunities alongside the risks.
As President Biden noted in the Executive Order on Climate Related Financial Risk, “this global shift presents generational opportunities to enhance U.S. competitiveness and economic growth, while also creating well-paying job opportunities for workers.”⁷ The promise of future possibilities is more motivating than the risk of doom and gloom. As a motivating example, note that in his presentations on climate change, Al Gore always devotes at least a third of his slide deck to a hopeful message. He calls this allocation the “hope budget.”
To move forward, we need a hope budget. The financial system should prepare for the worst. Yet our mindset should remain hopeful, focused on the coming opportunities. The financial system exists to move resources as quickly and efficiently as possible to their location of best use. The promise of opportunity and good information about risks will move resources towards a smooth and just transition.
Ryan Vaughn, PhD is a Technical Product Manager at Jupiter Intelligence. Learn more about Jupiter at jupiterintel.com.
Footnotes
¹ Barth, Molly, and Rollins, John. Climate Gentrification and the Role of Flood Insurance. Milliman, Inc. (September 2019)
² International Affairs 92, №5. (September 2016)
³ See, for example, blue carbon and nature based coastal resilience initiatives in the Ocean Based Climate Solutions Act
⁴ As Robert Pindyck of MIT has often pointed out, there are still complications in modeling macro-economic transition scenarios.
⁵ Katz, Lily. One in Four U.S. Homeowners Have Lived in Their Homes for Over 40 Years — The Highest Share on Record. Redfin (21 January 2021)
⁶ Jupiter Intelligence Special Report. The Danger in Relying on FEMA Flood Maps For Risk Management.(29 April 2020)
⁷ The White House. Executive Order on Climate-Related Financial Risk. (20 May 2021)
