Real assets are particularly exposed to climate risk.

Canadian pension funds rely heavily on investments in real assets, particularly in real estate and infrastructure, to diversify their portfolios and reduce their level of risk. However, climate change is undermining this strategy.

Some real assets are very exposed to the risks of floods, hurricanes, fires, ice and even extreme heat. According to the Insurance Bureau of Canada, insurable financial losses linked to catastrophic weather events in the country represented between $250 and $450 million per year between 1983 and 2008. Since then, they have increased to approximately $2 billion per year.

“Added to this are uninsurable losses, which are three or four times higher and which generally concern damage to infrastructure such as buildings, roads and bridges,” adds Kathryn Bakos, general manager, finance and resilience. from the Intact Center on Climate Adaptation, at the University of Waterloo.

A lack of long-term vision

Climate risks that threaten real assets fall into two categories. The first includes physical risks, such as floods or forest fires. “Climate transition risks are another major category,” says Shiva Mitra, senior analyst, ESG research at Morningstar Sustainalytics. New regulations on energy consumption or greenhouse gas (GHG) emissions may, among other things, affect operations or the value of an asset.

Pension funds have been trying to measure these threats for several years. “However, their managers focus a lot on physical and short-term risks, such as a port's exposure to rising sea levels, but less on the long-term systemic danger of accumulating risks climate change,” says Adam Scott, executive director of Shift Action, a Canadian organisation that tries to get pension funds to make a positive contribution to the fight against the climate crisis.

For example, there is a danger that some commercial properties will become very expensive or impossible to insure. This is already the case in certain cities in Florida and Texas, among others. “Pension plans invest for the long term and need to be concerned about the value of their assets more than ten years from now, not just short-term physical risks,” says Adam Scott.

According to him, the Caisse de dépôt et placement du Québec (CDPQ) and the Ontario Teachers' Pension Plan (OTPP) are a step ahead of other large institutional investors in terms of understanding these long-term risks and their willingness to talk about them openly. Both pension funds have their portfolios assessed by external experts to measure their exposure to climate risks and then try to reduce it.

But Adam Scott notes several shortcomings if we look at all pension plans, notably the lack of expertise on climate risks in boards of directors, investment committees, management and teams. Some even seem to have a direct conflict of interest. Shift Action, for example, denounced the appointment in December 2022 of Deborah Stein to the board of Teachers', while she also sits on that of four oil and gas companies whose objectives run counter to the pension fund's climate strategy.

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Managers focus a lot on physical and short-term risks, such as a port's exposure to rising sea levels, but less on the long-term systemic danger of accumulating climate risks.

– Adam Scott, Shift Action

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A filter for all investments

About a quarter of CDPQ's investments, more than $102 billion, are in real assets. “We take climate risks in this investment category very seriously,” says the Caisse’s head of sustainable investment, Bertrand Millot. Four years ago, CDPQ, Investissements PSP and the British Columbia Investment Management Corporation (BCI) enlisted the services of the firm The Climate Service (since acquired by S&P Global) in order to develop a tool for evaluating these risks.

“This provided us with a fairly sophisticated instrument, which allows us to assess physical climate risks over different time horizons, based on the geographic location of our assets,” explains Bertrand Millot. This is crucial because real assets stay in our portfolios for a very long time. » All of the Caisse's potential investments went through this filter, and a large part of the assets already in the portfolio were also reviewed.

More recently, the CDPQ added another, even finer, tool to precisely evaluate infrastructure investments. “There is a lot of uncertainty at the moment regarding models, particularly weather models, because due to climate change the past is no longer a guarantee of the future,” he continues. It is therefore better to use two tools than just one.

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There is a lot of uncertainty at the moment in terms of models, particularly weather models, because due to climate change the past is no longer a guarantee of the future.

– Bertrand Millot, Caisse de dépôt et placement du Québec

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Above all, the Caisse attempts to identify the most relevant risks for an asset. For example, if an office tower is exposed to rising temperatures, perhaps the only impact will be an increase in the use of air conditioning. But a highway susceptible to flooding or a factory that could find itself cut off from its suppliers in the event of wildfires present much greater dangers.

Until now, the Caisse's evaluations have not led it to divest itself of assets, but have made it shy away from potential new investments. Mr. Millot cites a dam that threatened to become less profitable over the next twenty years given a drop in precipitation.

Bertrand Millot points out that real assets are very geographically concentrated and that they are often “single assets”, such as a highway or a specific building. These assets are therefore more vulnerable to climate risks than large companies listed on the stock exchange, which have establishments in several countries or regions.

Risks difficult to quantify

The climate risks to which real assets are exposed can arise from a very large number of factors, such as location, the composition of a building's occupants or even the carbon footprint. This makes them more difficult to value than traditional stocks or fixed income securities. It is also very difficult to obtain reliable data on a specific asset.

“Organisations and standards for voluntary disclosure of climate risks have multiplied, which creates confusion and a lack of standardisation of data,” explains Kathryn Bakos. Additionally, these organisations and standards place a lot of emphasis on reducing GHG emissions and less on physical climate risks. » As a result, many companies fail to disclose physical risks that could affect their operations.

Kathryn Bakos believes governments need to establish mandatory climate risk disclosure standards, including physical risks, to simplify it and standardise data. In Canada, the Office of the Superintendent of Financial Institutions now imposes a disclosure procedure aligned with the framework of the Task Force on Climate-Related Financial Disclosures (TCFD). The creation of the International Sustainability Standards Board (ISSB) also aims to harmonise these disclosures.

The Intact Center on Climate Adaptation itself developed risk matrices for six industry sectors, including electricity transmission and distribution, commercial real estate, hydropower generation, and wind power generation. “For each one, we identify the most critical risks, but also the main measures to reduce them,” explains Kathryn Bakos. It is important for investors to know whether the managers of an asset in which they want to invest strive to mitigate this type of risk.

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Disclosure standards place a lot of emphasis on reducing GHG emissions and less on physical climate risks.

– Kathryn Bakos, University of Waterloo

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For its part, Sustainalytics offers a tool to better inform investors about physical climate risks. The Physical Climate Risk Metrics covers 12 million assets across 135 sectors and 235 countries. It analyses direct and indirect risks and incorporates the probability of eight types of disasters affecting the asset: coastal flooding, extreme heat, extreme winds, wildfires, freeze-thaw, land subsidence and cyclones. “We use data from XDI Systems, a firm specialising in this type of prediction,” explains Shiva Mitra.

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Contribute to the transition

The need for adaptation and resilience in the face of climate change also generates investment opportunities. “In our view, climate change presents opportunities for companies that promote decarbonisation, but also for those that help us adapt to its unfortunately inevitable physical impacts,” says Mike Harut, partner and director of responsible investment at Munro Partners. This Australian firm manages three funds offered in Canada by CI Global Asset Management.‍

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Climate change presents opportunities for businesses that drive decarbonisation, but also for those that help us adapt to its unfortunately unavoidable physical impacts.

– Mike Harut, Munro Partners

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He gives several examples. In the United States, a third of investments in electricity transmission and distribution are for adaptation and resilience. However, one of CI's funds owns Quanta Services, a company specializing in electrical networks. Another company in their portfolio, Core & Main, specializes in the adaptation of water infrastructure, a priority for several Canadian and American municipalities. Finally, extreme temperatures require building managers to acquire better heating, air conditioning and ventilation systems, fueling the growth of companies like Comfort Systems.

Pension plans themselves can participate in adapting infrastructure to climate change. “Pension funds invest in the long term on behalf of different stakeholders, including young workers, who will experience the effects of climate change,” recalls Adam Scott. They have the responsibility to protect the investments of these participants. »
To achieve this, pension funds cannot simply assess climate risks to choose more prudent investments. According to Adam Scott, their investments must also actively participate in the fight against climate change and adaptation to the new environment. “The capital allocation decisions made today will determine our ability to confront this crisis and escape its negative consequences.