Episode 20: Physical Climate Risks
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Today’s guest, Dr. Mekala Krishnan, Senior Fellow, McKinsey Global Institute, is one of the authors of the McKinsey Global Institute’s ground-breaking report, “Climate risk and response - Physical hazards and socioeconomic impacts”. Dr. Krishnan’s research focuses on various topics related to inclusive growth and economic development, including climate risk, globalization, productivity growth in advanced economies, and women’s role in labor markets. Her most recent research focuses on the near-term impact of physical climate risk across sectors and geographies, including its implications for companies and countries.
In this episode, Michael Torrance talks with Dr. Krishnan about how physical climate risks can impact economies and financial and social systems and about the physical climate risks that could influence investors, businesses and governments in the next 10-30 years.
In this episode:
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The 7 types of physical climate risk
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How physical climate risks influence social systems
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The role of financial markets in managing physical climate risks
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How climate risks can influence financial systems, investors, and insurance
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TRANSCRIPT:
Mekala Krishnan: We need to find ways to embed and integrate and understanding of climate risk into all decision making. It can't be something that is separate or from the day-to-day work that institutions undertake.
Michael Torrance: Welcome to Sustainability Leaders. I'm Michael Torrance, chief sustainability officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.
Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.
Michael Torrance: In today's podcast, we're going to do a deep-dive on physical climate risk and explore how it may affect economies' financial and social systems. Our guest, Dr. Mekala Krishnan, is one of the authors of the McKinsey Global Institute's ground-breaking report released earlier this year entitled "Climate Risk and Response: Physical Hazards and Socioeconomic Impacts." The McKinsey Global Institute is a think tank within McKinsey that researches a broad range of topics, including natural resources and climate, and how they influence economics. Dr. Krishnan's research focuses on various topics related to inclusive growth and economic development, including climate risk, globalization, productivity growth in advanced economies and women's role in labor markets. In today's podcast, we will discuss with Dr. Krishnan what her research tells us about how physical climate risks will occur and what it may mean for people and economies around the world. Thanks for speaking with me, Mekala.
Mekala Krishnan: Thanks, Michael. Great to be speaking with you.
Michael Torrance: BMO has been focused on climate-related financial risk with our adoption and support for the task force on climate-related financial disclosures, and we've been looking at scenario analysis, including with respect to transition and physical risk. And we've been consuming as much as we can to try to understand the emerging methodologies and understandings of those areas of risk. There's been a lot of work done around transition risk, but really there hasn't been a lot of good material on physical risk, so it was really exciting to see your report and how McKinsey is looking at that issue. Can you now turn to that report, and for our audience, give a little recap of what was the genesis of the research that led to the report and why did you focus on analyzing physical climate risk?
Mekala Krishnan: Yeah, that's a great question. So this research that we've undertaken on physical risk was really a coming together of different parts of McKinsey. It was the McKinsey Global Institute, which is where I work, as well as our risk and sustainability practices, and as we did the work, we also drew upon expertise across McKinsey, across different sectors, across our offices and different geographies. And as we were thinking about doing the work, there were a few framing slash methodological choices that we made that really underpinned the research. The first was to say, "We are not, as McKinsey, while we employ climate scientists, we are not a climate science institution," and so we really sought to work with the best climate scientists out there to draw from the best thinking in the climate science literature as an import into the work. The second was to say, "Really the contribution that this research can make is to help stakeholders, whether that's individuals, companies or countries, think about how they can translate climate hazards," and by climate hazards, I mean things like hurricanes or flooding or temperature increase, "how they can translate climate hazards to direct socioeconomic impacts, as well as indirect socioeconomic impacts." We also wanted to look at the near term. So a lot of the climate reports that are out there look out to 2100, the second half of the century, but we wanted to examine much nearer time frames because we wanted to look at decisions that were being made today by stakeholders around the world and how those could be impacted by a changing climate. And so, to that end, what we've done is look at two different time periods. We've looked at impacts that could occur by 2030, and then impacts that could occur by 2050. So our entire frame of analysis is what I would call a near to mid-term frame, given the fact that we wanted to look at these near-term decision-making horizons that are relevant for stakeholders today. Rather than doing top-down analysis, which is what a lot of other economic models have done in this space, we really wanted to understand through a set of nine case studies how climate hazards could manifest in different geographies around the world and how they might impact different sectors and different assets. Using the learnings from those case studies, we also extended the analysis to 105 different countries. So we've done a geospatial analysis of six different risk indicators across 105 different countries in the world using the learnings from these case studies. And then the last thing I will say as a framing point for the research was what we wanted to try and do was to understand what we call the inherent risk, and by that I mean the risk absent any adaptation and mitigation response. A lot of people looking at this may say, you know, "Did you want to try and be alarmist with the work?" And that was not the intent at all. What we wanted to do was to try and understand what's the magnitude of the challenge that we need to solve and really create a case for change as a result of understanding the magnitude. So we've looked at the inherent risk absent adaptation, absent mitigation, which is, I would say, quite a standard approach in the risk literature and in risk management, and then after doing that, we looked at what could potential adaptation responses look like. And, again, we did that across our nine case studies and then rolled that up into broader learnings for stakeholders.
Michael Torrance: That's really helpful to frame the background to the report, and just to dig a little bit into the weeds more about the climate-related data piece, it's really always a challenge in doing this kind of analysis to get reliable data in light of the very forward-looking characteristics of climate risk. How did you deal with these kinds of challenges and, in particular, translating them into economic impacts as you've done?
Mekala Krishnan: Yeah, so this question about reliability of climate data is one that we often get asked, and I will answer that, Michael, in a minute, but I think first to say that when you think about uncertainties in modeling the impacts of climate change, certainly there are uncertainties related to the climate models themselves. And those, I would say, are primarily too full, the first to do with what pathway of emissions we think we're on, and then the second to do with across the spectrum of climate models, which model do you look to choose. But I would say that the bigger uncertainties almost are a few other forms of uncertainty, which have more to do with our socioeconomic systems. So uncertainties to do with how socioeconomic systems might respond to those climate hazards, and then what stakeholders might look to do to manage those hazards, those, to me, are almost the bigger uncertainties, the bigger question marks. The systems that we're looking at, whether they're physical assets, food systems, natural systems, as well as economic, financial and social systems, all have implicit in them an assumption of a stable climate, and as those assumptions are tested as the climate changes, that could lead to significant, often nonlinear responses, and really identifying the thresholds of such systems and understanding how they might respond, that's almost more challenging than the climate modeling itself. Now, on the climate models themselves, what we did was to leverage the best thinking, external thinking, on climate science, and so we partnered with a set of external climate science institutions. Most of our analysis was done by the Woods Hole Research Center, and in using these external climate models, the approach we followed was to not just look at one climate model. So different climate models have different assumptions embedded in them, but what the climate literature has found is that rather than sampling one model, if you look at a spectrum of models, look at mean outcomes across these models or median outcomes, depending on the type of variable you're interrogating, that process, essentially, helps you most robustly model the world around us because different models pick up different aspects of natural phenomenon. I think the other thing I would say is the whole frame of analysis, really, for us was to look at risk, right? So it's important to recognize that the climate is not weather and the climate is not deterministic, so the entire frame of analysis needs to be a risk-based frame of analysis. You need to think about what is a 1 percent likelihood of an event occurring or an event with what is commonly called one in hundred year likelihood, how does that change going forward, so on and so forth, right? So what we're looking at is not deterministic forecast but rather probabilistic perspectives on how the future will evolve.
Michael Torrance: Okay, so then turning to the actual substance of the report and your findings, which are also fascinating, how did you define physical risk of climate change, and what did you find in terms of its, you know, major characteristics and the basis for your ultimate findings in the report?
Mekala Krishnan: We focused, as I said, on the report on physical climate risk, and by physical climate risk, we mean risks arising from the physical effects of climate change. So as temperatures increase, we see a variety of physical effects, both acute and chronic. So for example, acute events, like flooding, may become more frequent or more severe. We could also see chronic events, like overall increases in temperature in parts of the world. And what we looked at was the risks that could arise from these physical effects, and by doing that, we looked at impacts that could occur on people, on communities, on natural and physical capital, on economic activity, and through that, the implications for companies, government, financial institutions, individuals. So what our analysis finds is that physical climate risk has seven key characteristics. We look across our different case studies, and what we find across the nine different case studies we looked at in different sectors, assets and geographies is that we could see anywhere from a two to 20X increase in potential impacts between now and 2050. We also did a geospatial analysis of 105 different countries in the world, and we looked at indicators like how much capital stock could be damaged as a result of flooding or how much could the effective working hours in a specific geography be impacted because conditions become too hot and humid to work outdoors. And as we looked at the 105 country analysis as well, we found that all countries could see an increase in at least one, oftentimes more, indicators of risk between now and 2050. So it's an increasing form of risk. What that also means it that it's a nonstationary form of risk. That was the second characteristic we identified. And what that nonstationarity means is, as we think about designing systems to be tolerant to risk, we need to factor in the fact that these risk thresholds, are not static. So take, for example, a building. A building is typically designed to withstand a 100-year flood, or a 200-year flood, but now, as the climate changes, what constitutes the 100-year flood could actually look quite different. In the past, a 100-year flood might have been a 2-meter flood, but in the future, even out to 2030, that 2 meters might now be 2.5 meters, might be 3 meters, and that has profound implications for things like infrastructure. If we're making infrastructure decisions today, these are capital assets that are going to live for the next 20 years, 30 years, maybe even longer, and so we need to factor in this nonstationarity into our design decisions as we look to plan for the future. And the same is true for a variety of systems around; as it's true for how we think about growing crops, where we, as individuals, choose to buy homes, so on and so forth. We also find that it is a spatial form of risk, and by that I mean climate hazards manifest locally, so it could look very different across countries. It could also look very different within countries. This may sound kind of obvious, right? We know that climate is very different at different parts of the world, but actually it is quite profound when you think about how we make decisions today. So when we make investment decisions today, when we make capital allocation and planning decisions today, when companies choose suppliers across the world, we don't typically think about space in those decisions. Our financial models, for example, don't have a notion of space built into them, but with the changing climate, it's very important to understand location because location will influence your exposure to risk. The fourth characteristic we identified was that this is a nonlinear form of risk, and by that I mean, if you look at the systems around us, whether it's buildings or how we grow our crops and where we grow them to where we choose to live, all our systems have either been designed or have evolved with a stable climate in mind, and once that stability is tested, you could start to see significant and often nonlinear impacts. If you look at how these systems respond to these different climatic variables, many of them, beyond a certain threshold, whether that is beyond a certain air temperature for agricultural yields or flood depth for a form of capital, you could start to see significant increases in the potential damages, or you could start to see significant increases in how much yields fall. And so all that means is that, assuming that our systems are linear and assuming that our systems would only change by small amounts, when we start to see increases in temperature or different climatic shifts around the world, that's an incorrect assumption. And by the way, that's not just true for physical systems, so it's not just true for the human body or crops or buildings, but it's also true when we think about, for instance, financial systems. So at what point will, if you imagine a real estate ecosystem, which relies on homeowners taking out long-term mortgages, relies on banks continuing to finance those mortgages, relies on homeowners holding flood insurance, if you think about that entire ecosystem, it's been designed for a certain amount of risk transfer across all the individuals and entities in that ecosystem. But now you throw in an external variable into that, which is climate change. At what point will that system still function, right? The fifth characteristic we identify is that it's a systemic form of risk. So on the one hand, the immediate impacts about changing climate are local because climate hazards manifest locally, but they could have large-scale systematic impacts. The direct impacts that you experience in one part of the world could have knock-on effects as you look at interconnected sectors and countries. One example that we call out in the work is supply chains and the risk that supply chains experience. This is obviously top-of-mind in our current COVID situation, but what we find is that if you look at many global supply chains, they've essentially been optimized for efficiency rather than resiliency, and if there are parts of the supply chain that are particularly exposed to climate hazards, that could have significant knock-on impacts on downstream companies, as well as the entire supply chain as a whole. What that could do is for downstream players that are unprepared, so an unprepared player being someone that can't easily switch suppliers or doesn't have enough safety stock buffer or has not worked closely with the supplier to build resilience, and so the upstream supplier can't come up and running very quickly. What that means is that the unprepared downstream player could see as much as 35 percent of their revenue hit in a given year as a result of the climate hazard manifesting. Compare that to a prepared player where they may have high safety stock levels, or they may have worked with their supplier to build additional resiliency. They may have ensured that their suppliers have insurance coverage, so on and so forth. The prepared player may only see 5 percent of their annual revenue affected. So all to say this is a systemic form of risk even though it manifests directly.. Everyone that is connected to that direct impacted location, directly impacted location could be affected. It is a regressive form of risk, and what we find is that parts of the world that have lower per capita incomes could, in many cases, be more significantly affected, and this is for a few different reasons. The first is that oftentimes these parts of the world are already close to these climatic thresholds that I've talked about before, and so even small increases in certain climate variables could mean large impacts for these parts of the world, and then finally, of course, adaptation finance becomes harder for these parts of the world. So it's important to recognize these regressive characteristics of climate risk as we think about managing a response for, as we think, as a global community of how to manage the response, and then finally we find that this is a risk that we may be underprepared for. Across our case studies, we find that, while people have started to think about adaptation action, the pace and scale of adaptation will need to be significantly increased, and perhaps more importantly, it will involve tough choices and trade-offs, questions like what to protect now versus what to protect later, where to invest versus where to retreat. These are all questions that people are going to have to grapple with, and we need to start having that conversation today.
Michael Torrance: One of the conclusions that you just discussed about nonlinearity and systems' thresholds being breached and that having knock-on effects, I saw that reflected in the letter to CEOs of BlackRock's Larry Fink this year. I was wondering if you could maybe unpack sort of what this means, then, from investors and, you know, those in particular that are exposed to these system-wide risks, and one of the implications from that letter was a push for better disclosure, better risk analysis by companies. But what are your thoughts on that implication for investors and financial markets as a whole?
Mekala Krishnan: So, yes, as we look at the different systems around us, whether that's physical systems, economic or financial systems, even social systems, they all have embedded in them an assumption of a stable climate. And so as an investor that is looking to make decisions, it's firstly important to understand the assumptions that you have in-built into all of your modeling and decision making, and I think the first thing that needs to happen across stakeholders is a bit of a mindset shift, right? So things like going from models of the past to thinking about ... things like going from backward-looking models to forward-looking projections. I think we also tee up in the research a set of questions that it's important for investors to be asking themselves and to be considering as they embark on this journey of incorporating climate risk. The first is thinking about what they do in terms of processes, tools and capabilities to integrate an understanding of climate risk, and that is everything from finding ways to incorporate geospatial analysis into their modeling to thinking about enhanced disclosures, you know, working with their counterparties to understand exposure to risk, so on and so forth. The second thing that they need to think about is, do they need to incorporate climate risk into their portfolio analytics and their stress testing capabilities to better understand how much they may be at risk? The third thing is not just thinking about their existing portfolio, but also as they think about future investment decisions, how do they embed an understanding of climate into those decisions and make sure climate risk is a factor in those investment decisions? I think for the global community, a part of that is to think about new mechanisms of financing, new approaches to financing, new avenues or new areas to finance. For example, we think a lot about sustainable finance. We should also be thinking about adaptation finance. Remember I said that climate risk is regressive, so how do we think about ensuring that capital continues to flow to parts of the world where it's most needed, which may be most at risk? How do we find ways to effectively derisk such investments? And then finally I think investors have to think about what they can do and what they should do to work with their own counterparties or work with the entities they invest in to find ways to reduce risk.
Michael Torrance: And some of that seems to dovetail nicely with the goals, the sustainable development goals of the UN and the push towards moving capital needed to achieve those goals. So there is a real, I think, nexus with sustainable finance, as you mentioned. Just turning back, though, to the socioeconomic impacts of physical climate risk, I mean, some of the things that you've talked about from impacts on food systems to the actual ability of the human body to withstand temperature changes that will likely emerge, I mean, it really speaks to human well-being and will undoubtedly have an impact on human behavior, where people can live, how people live. I mean, it could have impacts on migration patterns, for example. Can you just unpack a little bit about what this research you've done, the implications that it will have for the socioeconomic systems and for people, and therefore what even policy makers and those who are interested in developing social systems to address these types of issues should be thinking about?
Mekala Krishnan: So one of the things we wanted to do with this work was to help people understand the characteristics of physical climate risk, and as a part of that, we wanted to build a taxonomy, a framework by which we could think about the types of impacts you could see as the climate changed across the world. And so we examined a set of impacts that climate scientists tell us we've already experienced to date. So there is a field of climate science called attribution studies that has linked different events around the world to climate change, either saying these events have become more severe or more frequent as a result of a changing climate. So we looked at a whole set of them. What we found was that the direct impacts of a changing climate essentially impact five socioeconomic systems. The first thing they do is impact what we call livability and workability. This is essentially impact to human beings. We find that today there are no parts of the world really that are too hot for people to live, but, for example, rising between now and 2030 and further between 2030 and 2050, there are parts of the world that could experience such severe heat waves that a healthy human being sitting in the shade after 4 or 5 hours of exposure may no longer be able to live. We find that there are parts of the world where heat and humidity conditions rise so much that outdoor working becomes hard. People get more tired working outdoors. They may need to take more frequent breaks. And then, of course, all the kinds of impacts that one experiences with things like flooding, where travel to work may be disrupted, where people may even lose their lives from very severe floods. So there are a whole set of things that could impact human livability and workability. The second type of effect we found was things that could impact physical capital and infrastructure services. So as we see different climate events manifest, we could both see damage to physical capital. So this is things like a home being damaged as a result of flooding. We could also see capital productivity get affected. So, for example, power systems may start to function less efficiently if you experience very hot days. So both physical capital could be damaged, but you could also see capital productivity get affected, which of course has particular implications for the economy if infrastructure was affected. One of the things we saw with Hurricane Sandy was things like the metro system getting flooded for long durations of time, and so all of that could have knock-on effects on economic activity. And then we also found that natural capital could get affected. We found, when we looked at food systems in particular that we could start to see impacts on agricultural yield. Between now and 2030, we found that the likelihood of a global bread basket failure could double. Fast forward between 2030 and 2050, that likelihood could quadruple. That has implications, of course, for our ability to feed ourselves. We have food storage across the world so that in the event of grain shortages, we are able to draw down on stocks of grain that have been stored, but the implication of that could be that food prices rise, and that could, again, impact the most vulnerable parts of the world the most going back to the regressive nature of climate risk. And then the other form of impact on natural capital that we identified was there are, of course, many parts of the natural world around us that they could be affected as a result of climate change. We know of examples of glaciers melting or oceans becoming less oxygenated, more acidic as a result of climate change. So across the board, we find impacts on human beings, labor. We find impacts on physical capital and infrastructure services, which is essentially stocks of physical capital, and then natural capital, both food systems as well as natural capital more broadly, and if you stop and think about that for a moment from an economic activity standpoint, what that basically means is that the factors of production in an economy are affected by the fact that the production in an economy are labor, physical capital, natural capital. And climate change could directly impact all of these. Now, those are the direct impacts. What we also found was that there could be a multitude of knock-on impacts as a result of those direct effects, and this is because systems are connected and actors in an economy are connected to each other and there could be, therefore, all kinds of second-order, third-order effects after the immediate climate event. One particularly stark example from our research was, we looked at the example of real estate in Florida, and of course Florida real estate could be damaged as a result of climate change. We examined the impacts of storm surge on Florida real estate. As sea levels rise, storm surge events could become more severe, and all of that could mean that damage from a 100-year storm surge event today in Florida would be about $35 billion, but if we fast forward to 2050, those damages could be anywhere from $50 billion to $75 billion. And so certainly there are direct damages, but what we also find is that there could be knock-on effects on home prices, and in some sense you can insure against damages, but it's a bigger question mark what you do to protect yourself against price devaluations, right? So we looked at the potential impacts in Florida of home prices being affected as homeowners start to experience flooding events and they start to price that into their buying decisions, and what we found was that estimates based on past trends suggest that losses from flooding could devalue exposed homes by $30 billion to $80 billion, or about 15 to 35 percent of the value of the home by 2050, all else being equal. Now this is just looking at historical relationships between tidal flooding and home prices, but you could ask yourself the question of what happens if homeowners more aggressively start to factor this into their buying decisions? What happens if schools or infrastructure are affected? What happens if business activity in a particular part of the state is affected? So all to say that certainly the direct impacts from a changing climate are important, but knock-on effects could be as or more significant. And specifically when you look at financial markets, what they do is that they pull forward future risk. So once financial markets start to recognize future risk, they may start to factor that into decisions today and that may have implications for asset prices. It may have implications for capital allocation. It may also have implications for insurance prices and availability.
Michael Torrance: Unpacking that a little bit further. I mean, it seems like it's almost a tipping point type of issue that, you know, these could be not factored in for a while and then suddenly factored in, and that could have financial implications. Can you describe what rule you see financial markets playing in managing this type of risk? You've alluded to insurance and sustainable finance. Can you just describe what role is there for those markets to play in, and how would that role be taken up?
Mekala Krishnan: Yeah, absolutely. So insurance is very important when we think about managing risk and serves many functions, right? So firstly, it ensures that people don't face financial hardship when loss events occur. Oftentimes they create liquidity after events and help accelerate rebuilding efforts, but insurance also has other very important roles to play. Properly priced insurance sends a signal, an appropriate signal, of risk, which is very important because as you've said, we may be under recognizing this risk in parts of the world today. Insurance can also serve to incentivize adaptation investments, and we saw this, for example, in the case of building fire codes where the insurance industry played a strong role in ensuring robust building standards that helped reduce the incidents of fires in parts of the world. So insurance has many, many different roles to play and all very important. I think as we look forward, when we think about the role of insurance, there are many questions that we need to ask ourselves as we imagine the role that insurance can play in managing this risk. I think the first is around how we think about reducing insurance gaps around the world, that many parts of the world where insurance penetration still remains low, how do we ensure increased uptake of insurance where it's needed? How do we think about appropriately pricing insurance premiums so that they reflect risk, but at the same time manage the affordability of insurance? Today in many parts of the United States, for example, research has shown that flood insurance premiums may need to be repriced to appropriately reflect the risk in those geographies, but then doing so, of course, is a financial hardship for homeowners. So how do you appropriately balance both? So allow insurance to appropriately reflect risk, and allow homeowners to factor these risks into their buying decisions but at the same time not make insurance unaffordable. I think questions around how we can better use insurance to drive adaptation, the role that insurance agents themselves or the insurance industry itself can play in risk advisory services. The role that the insurance industry can play in continuing to improve forward-looking models of risk, right? So the insurance industry, of course, has a whole set of actuarial data that they rely on to make pricing decisions, but is now starting to incorporate more and more forward-looking climate models and climate analysis into their pricing. So what more can the insurance industry do to move us towards that? And then finally this question of a duration mismatch, so if you're a company or a homeowner, you're taking on long-term debt, for example, when you're financing your home. So you're taking on a mortgage, say, of 30 years, but your insurance premium gets repriced every year. And that, of course, creates this mismatch of expectations where the homeowner may be seeing that insurance premium as a signal of future risk, whereas really what it is, is a signal of risk over the next year. So lots of very important roles for the insurance industry, lots of questions about how we think about the future and the role that insurance can play in managing the stress going forward.
Michael Torrance: What are the key takeaway points, you would say, for companies, investors and even governments to be thinking about and asking themselves when they're analyzing their own thinking around climate-related physical risk and maybe what some new strategies they should be taking should look like?
Mekala Krishnan: Yeah, that's a great question. The research, essentially, identifies three imperatives for stakeholders. The first is, we need to find ways to embed and integrate an understanding of climate risk into all decision making. It can't be something that is separate from the day-to-day work that institutions undertake. So for cities, for example, it is integrating climate risk into their open-planning decisions. For a company, it is integrating climate risk into their capital allocation decisions or their supply chain decisions so on and so forth. That will require, of course, building new tools, capabilities, building a new muscle, but it's important that this is not an issue that sits within a sustainability function or sits within a risk function but is really part of the day-to-day of the business or the day-to-day of the institution. The second is identifying ways to adapt to the climate risk that is locked in. We identify a range of measures that you could take to manage risk. It's everything from finding ways to physically harden and protect assets or buildings or people to finding ways to build additional resiliency, whether that's having backup suppliers or holding additional inventory levels. In some instances, adaptation may also require reducing your exposure, and that's both being thoughtful about new investment decisions that you're making so that you aren't making them in harm's way, but also in some instances may require relocating buildings or relocating factories. And then finally the role of insurance and finance, really recognizing that insurance is crucial to be able to manage your risk, and adaptation finance will become more important in the years to come. The physical risk that we experience is as a result of warming, and the only way to stop further warming is to reduce emissions, and so in the long run, the only way to prevent further build-up of risk is through decarbonization. This research hasn't focused on decarbonization, but that's of course an important imperative for stakeholders to consider.
Michael Torrance: So just to wrap up then, we're looking, right now, at a very unprecedented situation with the COVID pandemic, and, you know, in some respects, there is parallels that you could draw, and many have, between this disruption that we're facing and the disruption that could be caused by climate risk. What's your take, just on what we've seen so far, in terms of those potential linkages and what we can both learn from with respect to emerging from the COVID pandemic, from research that's been done around climate risk, and vice versa? What lessons does this pandemic have for managing climate risk disruption in the future?
Mekala Krishnan: Yeah, that's a fantastic question. I think what we have found is that on the one hand; there is many similarities between climate change and what we're currently experiencing with the pandemic. These are both systemic forms of risk. They don't just impact one geography or one sector, but entire systems. They both could have nonlinear impacts. They both, in some sense, are risks that come from outside the economic system, outside the social system, but impact it. And then they both, of course, have implicit in them the importance of resiliency in managing risk, and resiliency, I'm defining very broadly. It's everything from being able to appropriately assess your risk to identifying a set of measures to manage the risk and to implementing that effectively. I think, of course, the big difference is that the time scales on which they operate are quite different, right, so climate risk manifesting over the coming decades, so much longer time horizon in the case of climate change than what we've experienced with COVID. Having said that, I think there are both headwinds and tailwinds as we think about the post-COVID world. What we identify is that on the one hand, that could mean many tailwinds, I think, from the COVID experience and the recovery that could be synergistic with the climate agenda. I think at the highest level what this experience has taught us is that change can happen very rapidly, in ways that we may not have thought were possible. So we all now are teleworking. We're using digital channels much more than we did in the past, and that, of course, could have climate benefits. This experience has also emphasized resiliency, and so some of the resiliency measures that I anticipate we will put in place post-COVID could also support climate resiliency, whether that is finding ways to assess risk, better price risk, monitor risk, so on and so forth. So I think this emphasis on resiliency is going to be very important in the post-COVID world that could be beneficial for the climate agenda. Of course it's also an environment where in the recovery we will be thinking about investment. We will be thinking about stimulus. We will be thinking about a low-interest-rate world, and so the question is, how can we find investments that are synergistic both with climate action and a COVID recovery and put those in place? I do think that it's important to recognize that there could also be some headwinds to the climate agenda in this post-COVID world. We're of course going to be focusing in the recovery on job creation and economic recovery and not on climate, and so again it's important to think about where there are synergies between the two and what ways that we can drive both agendas forward are. There is also, of course, a risk that there could be delays in investment as people experience economic uncertainty. So I think important to recognize that there could be real headwinds, but given the similarities between COVID and climate change as risks, also potential synergies and potential learnings.
Michael Torrance: Fantastic. Well, thank you so much for your time today to talk about your fascinating report.
Mekala Krishnan: Thank you for your great questions.
Michael Torrance: You can learn more about the McKinsey Global Institute at mckinsey.com/mgi. This link can also be found on the show notes on our website. Thank you very much to Dr. Krishnan for taking the time to share her research on physical climate risk. Thanks for listening to "Sustainability Leaders." This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at bmo.com/sustainabilityleaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider, and we'll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.
Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax and/or legal professional about their personal situation. Past performance is not indicative of future results.
Episode 20: Physical Climate Risks
Chief Sustainability Officer
Michael Torrance is Chief Sustainability Officer of BMO Financial Group and is passionate about sustainability, especially as it pertains to corporate governance an…
Michael Torrance is Chief Sustainability Officer of BMO Financial Group and is passionate about sustainability, especially as it pertains to corporate governance an…
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Today’s guest, Dr. Mekala Krishnan, Senior Fellow, McKinsey Global Institute, is one of the authors of the McKinsey Global Institute’s ground-breaking report, “Climate risk and response - Physical hazards and socioeconomic impacts”. Dr. Krishnan’s research focuses on various topics related to inclusive growth and economic development, including climate risk, globalization, productivity growth in advanced economies, and women’s role in labor markets. Her most recent research focuses on the near-term impact of physical climate risk across sectors and geographies, including its implications for companies and countries.
In this episode, Michael Torrance talks with Dr. Krishnan about how physical climate risks can impact economies and financial and social systems and about the physical climate risks that could influence investors, businesses and governments in the next 10-30 years.
In this episode:
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The 7 types of physical climate risk
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How physical climate risks influence social systems
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The role of financial markets in managing physical climate risks
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How climate risks can influence financial systems, investors, and insurance
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Visit bmo.com/sustainabilityleaders-podcast for more information about the podcast
TRANSCRIPT:
Mekala Krishnan: We need to find ways to embed and integrate and understanding of climate risk into all decision making. It can't be something that is separate or from the day-to-day work that institutions undertake.
Michael Torrance: Welcome to Sustainability Leaders. I'm Michael Torrance, chief sustainability officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.
Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.
Michael Torrance: In today's podcast, we're going to do a deep-dive on physical climate risk and explore how it may affect economies' financial and social systems. Our guest, Dr. Mekala Krishnan, is one of the authors of the McKinsey Global Institute's ground-breaking report released earlier this year entitled "Climate Risk and Response: Physical Hazards and Socioeconomic Impacts." The McKinsey Global Institute is a think tank within McKinsey that researches a broad range of topics, including natural resources and climate, and how they influence economics. Dr. Krishnan's research focuses on various topics related to inclusive growth and economic development, including climate risk, globalization, productivity growth in advanced economies and women's role in labor markets. In today's podcast, we will discuss with Dr. Krishnan what her research tells us about how physical climate risks will occur and what it may mean for people and economies around the world. Thanks for speaking with me, Mekala.
Mekala Krishnan: Thanks, Michael. Great to be speaking with you.
Michael Torrance: BMO has been focused on climate-related financial risk with our adoption and support for the task force on climate-related financial disclosures, and we've been looking at scenario analysis, including with respect to transition and physical risk. And we've been consuming as much as we can to try to understand the emerging methodologies and understandings of those areas of risk. There's been a lot of work done around transition risk, but really there hasn't been a lot of good material on physical risk, so it was really exciting to see your report and how McKinsey is looking at that issue. Can you now turn to that report, and for our audience, give a little recap of what was the genesis of the research that led to the report and why did you focus on analyzing physical climate risk?
Mekala Krishnan: Yeah, that's a great question. So this research that we've undertaken on physical risk was really a coming together of different parts of McKinsey. It was the McKinsey Global Institute, which is where I work, as well as our risk and sustainability practices, and as we did the work, we also drew upon expertise across McKinsey, across different sectors, across our offices and different geographies. And as we were thinking about doing the work, there were a few framing slash methodological choices that we made that really underpinned the research. The first was to say, "We are not, as McKinsey, while we employ climate scientists, we are not a climate science institution," and so we really sought to work with the best climate scientists out there to draw from the best thinking in the climate science literature as an import into the work. The second was to say, "Really the contribution that this research can make is to help stakeholders, whether that's individuals, companies or countries, think about how they can translate climate hazards," and by climate hazards, I mean things like hurricanes or flooding or temperature increase, "how they can translate climate hazards to direct socioeconomic impacts, as well as indirect socioeconomic impacts." We also wanted to look at the near term. So a lot of the climate reports that are out there look out to 2100, the second half of the century, but we wanted to examine much nearer time frames because we wanted to look at decisions that were being made today by stakeholders around the world and how those could be impacted by a changing climate. And so, to that end, what we've done is look at two different time periods. We've looked at impacts that could occur by 2030, and then impacts that could occur by 2050. So our entire frame of analysis is what I would call a near to mid-term frame, given the fact that we wanted to look at these near-term decision-making horizons that are relevant for stakeholders today. Rather than doing top-down analysis, which is what a lot of other economic models have done in this space, we really wanted to understand through a set of nine case studies how climate hazards could manifest in different geographies around the world and how they might impact different sectors and different assets. Using the learnings from those case studies, we also extended the analysis to 105 different countries. So we've done a geospatial analysis of six different risk indicators across 105 different countries in the world using the learnings from these case studies. And then the last thing I will say as a framing point for the research was what we wanted to try and do was to understand what we call the inherent risk, and by that I mean the risk absent any adaptation and mitigation response. A lot of people looking at this may say, you know, "Did you want to try and be alarmist with the work?" And that was not the intent at all. What we wanted to do was to try and understand what's the magnitude of the challenge that we need to solve and really create a case for change as a result of understanding the magnitude. So we've looked at the inherent risk absent adaptation, absent mitigation, which is, I would say, quite a standard approach in the risk literature and in risk management, and then after doing that, we looked at what could potential adaptation responses look like. And, again, we did that across our nine case studies and then rolled that up into broader learnings for stakeholders.
Michael Torrance: That's really helpful to frame the background to the report, and just to dig a little bit into the weeds more about the climate-related data piece, it's really always a challenge in doing this kind of analysis to get reliable data in light of the very forward-looking characteristics of climate risk. How did you deal with these kinds of challenges and, in particular, translating them into economic impacts as you've done?
Mekala Krishnan: Yeah, so this question about reliability of climate data is one that we often get asked, and I will answer that, Michael, in a minute, but I think first to say that when you think about uncertainties in modeling the impacts of climate change, certainly there are uncertainties related to the climate models themselves. And those, I would say, are primarily too full, the first to do with what pathway of emissions we think we're on, and then the second to do with across the spectrum of climate models, which model do you look to choose. But I would say that the bigger uncertainties almost are a few other forms of uncertainty, which have more to do with our socioeconomic systems. So uncertainties to do with how socioeconomic systems might respond to those climate hazards, and then what stakeholders might look to do to manage those hazards, those, to me, are almost the bigger uncertainties, the bigger question marks. The systems that we're looking at, whether they're physical assets, food systems, natural systems, as well as economic, financial and social systems, all have implicit in them an assumption of a stable climate, and as those assumptions are tested as the climate changes, that could lead to significant, often nonlinear responses, and really identifying the thresholds of such systems and understanding how they might respond, that's almost more challenging than the climate modeling itself. Now, on the climate models themselves, what we did was to leverage the best thinking, external thinking, on climate science, and so we partnered with a set of external climate science institutions. Most of our analysis was done by the Woods Hole Research Center, and in using these external climate models, the approach we followed was to not just look at one climate model. So different climate models have different assumptions embedded in them, but what the climate literature has found is that rather than sampling one model, if you look at a spectrum of models, look at mean outcomes across these models or median outcomes, depending on the type of variable you're interrogating, that process, essentially, helps you most robustly model the world around us because different models pick up different aspects of natural phenomenon. I think the other thing I would say is the whole frame of analysis, really, for us was to look at risk, right? So it's important to recognize that the climate is not weather and the climate is not deterministic, so the entire frame of analysis needs to be a risk-based frame of analysis. You need to think about what is a 1 percent likelihood of an event occurring or an event with what is commonly called one in hundred year likelihood, how does that change going forward, so on and so forth, right? So what we're looking at is not deterministic forecast but rather probabilistic perspectives on how the future will evolve.
Michael Torrance: Okay, so then turning to the actual substance of the report and your findings, which are also fascinating, how did you define physical risk of climate change, and what did you find in terms of its, you know, major characteristics and the basis for your ultimate findings in the report?
Mekala Krishnan: We focused, as I said, on the report on physical climate risk, and by physical climate risk, we mean risks arising from the physical effects of climate change. So as temperatures increase, we see a variety of physical effects, both acute and chronic. So for example, acute events, like flooding, may become more frequent or more severe. We could also see chronic events, like overall increases in temperature in parts of the world. And what we looked at was the risks that could arise from these physical effects, and by doing that, we looked at impacts that could occur on people, on communities, on natural and physical capital, on economic activity, and through that, the implications for companies, government, financial institutions, individuals. So what our analysis finds is that physical climate risk has seven key characteristics. We look across our different case studies, and what we find across the nine different case studies we looked at in different sectors, assets and geographies is that we could see anywhere from a two to 20X increase in potential impacts between now and 2050. We also did a geospatial analysis of 105 different countries in the world, and we looked at indicators like how much capital stock could be damaged as a result of flooding or how much could the effective working hours in a specific geography be impacted because conditions become too hot and humid to work outdoors. And as we looked at the 105 country analysis as well, we found that all countries could see an increase in at least one, oftentimes more, indicators of risk between now and 2050. So it's an increasing form of risk. What that also means it that it's a nonstationary form of risk. That was the second characteristic we identified. And what that nonstationarity means is, as we think about designing systems to be tolerant to risk, we need to factor in the fact that these risk thresholds, are not static. So take, for example, a building. A building is typically designed to withstand a 100-year flood, or a 200-year flood, but now, as the climate changes, what constitutes the 100-year flood could actually look quite different. In the past, a 100-year flood might have been a 2-meter flood, but in the future, even out to 2030, that 2 meters might now be 2.5 meters, might be 3 meters, and that has profound implications for things like infrastructure. If we're making infrastructure decisions today, these are capital assets that are going to live for the next 20 years, 30 years, maybe even longer, and so we need to factor in this nonstationarity into our design decisions as we look to plan for the future. And the same is true for a variety of systems around; as it's true for how we think about growing crops, where we, as individuals, choose to buy homes, so on and so forth. We also find that it is a spatial form of risk, and by that I mean climate hazards manifest locally, so it could look very different across countries. It could also look very different within countries. This may sound kind of obvious, right? We know that climate is very different at different parts of the world, but actually it is quite profound when you think about how we make decisions today. So when we make investment decisions today, when we make capital allocation and planning decisions today, when companies choose suppliers across the world, we don't typically think about space in those decisions. Our financial models, for example, don't have a notion of space built into them, but with the changing climate, it's very important to understand location because location will influence your exposure to risk. The fourth characteristic we identified was that this is a nonlinear form of risk, and by that I mean, if you look at the systems around us, whether it's buildings or how we grow our crops and where we grow them to where we choose to live, all our systems have either been designed or have evolved with a stable climate in mind, and once that stability is tested, you could start to see significant and often nonlinear impacts. If you look at how these systems respond to these different climatic variables, many of them, beyond a certain threshold, whether that is beyond a certain air temperature for agricultural yields or flood depth for a form of capital, you could start to see significant increases in the potential damages, or you could start to see significant increases in how much yields fall. And so all that means is that, assuming that our systems are linear and assuming that our systems would only change by small amounts, when we start to see increases in temperature or different climatic shifts around the world, that's an incorrect assumption. And by the way, that's not just true for physical systems, so it's not just true for the human body or crops or buildings, but it's also true when we think about, for instance, financial systems. So at what point will, if you imagine a real estate ecosystem, which relies on homeowners taking out long-term mortgages, relies on banks continuing to finance those mortgages, relies on homeowners holding flood insurance, if you think about that entire ecosystem, it's been designed for a certain amount of risk transfer across all the individuals and entities in that ecosystem. But now you throw in an external variable into that, which is climate change. At what point will that system still function, right? The fifth characteristic we identify is that it's a systemic form of risk. So on the one hand, the immediate impacts about changing climate are local because climate hazards manifest locally, but they could have large-scale systematic impacts. The direct impacts that you experience in one part of the world could have knock-on effects as you look at interconnected sectors and countries. One example that we call out in the work is supply chains and the risk that supply chains experience. This is obviously top-of-mind in our current COVID situation, but what we find is that if you look at many global supply chains, they've essentially been optimized for efficiency rather than resiliency, and if there are parts of the supply chain that are particularly exposed to climate hazards, that could have significant knock-on impacts on downstream companies, as well as the entire supply chain as a whole. What that could do is for downstream players that are unprepared, so an unprepared player being someone that can't easily switch suppliers or doesn't have enough safety stock buffer or has not worked closely with the supplier to build resilience, and so the upstream supplier can't come up and running very quickly. What that means is that the unprepared downstream player could see as much as 35 percent of their revenue hit in a given year as a result of the climate hazard manifesting. Compare that to a prepared player where they may have high safety stock levels, or they may have worked with their supplier to build additional resiliency. They may have ensured that their suppliers have insurance coverage, so on and so forth. The prepared player may only see 5 percent of their annual revenue affected. So all to say this is a systemic form of risk even though it manifests directly.. Everyone that is connected to that direct impacted location, directly impacted location could be affected. It is a regressive form of risk, and what we find is that parts of the world that have lower per capita incomes could, in many cases, be more significantly affected, and this is for a few different reasons. The first is that oftentimes these parts of the world are already close to these climatic thresholds that I've talked about before, and so even small increases in certain climate variables could mean large impacts for these parts of the world, and then finally, of course, adaptation finance becomes harder for these parts of the world. So it's important to recognize these regressive characteristics of climate risk as we think about managing a response for, as we think, as a global community of how to manage the response, and then finally we find that this is a risk that we may be underprepared for. Across our case studies, we find that, while people have started to think about adaptation action, the pace and scale of adaptation will need to be significantly increased, and perhaps more importantly, it will involve tough choices and trade-offs, questions like what to protect now versus what to protect later, where to invest versus where to retreat. These are all questions that people are going to have to grapple with, and we need to start having that conversation today.
Michael Torrance: One of the conclusions that you just discussed about nonlinearity and systems' thresholds being breached and that having knock-on effects, I saw that reflected in the letter to CEOs of BlackRock's Larry Fink this year. I was wondering if you could maybe unpack sort of what this means, then, from investors and, you know, those in particular that are exposed to these system-wide risks, and one of the implications from that letter was a push for better disclosure, better risk analysis by companies. But what are your thoughts on that implication for investors and financial markets as a whole?
Mekala Krishnan: So, yes, as we look at the different systems around us, whether that's physical systems, economic or financial systems, even social systems, they all have embedded in them an assumption of a stable climate. And so as an investor that is looking to make decisions, it's firstly important to understand the assumptions that you have in-built into all of your modeling and decision making, and I think the first thing that needs to happen across stakeholders is a bit of a mindset shift, right? So things like going from models of the past to thinking about ... things like going from backward-looking models to forward-looking projections. I think we also tee up in the research a set of questions that it's important for investors to be asking themselves and to be considering as they embark on this journey of incorporating climate risk. The first is thinking about what they do in terms of processes, tools and capabilities to integrate an understanding of climate risk, and that is everything from finding ways to incorporate geospatial analysis into their modeling to thinking about enhanced disclosures, you know, working with their counterparties to understand exposure to risk, so on and so forth. The second thing that they need to think about is, do they need to incorporate climate risk into their portfolio analytics and their stress testing capabilities to better understand how much they may be at risk? The third thing is not just thinking about their existing portfolio, but also as they think about future investment decisions, how do they embed an understanding of climate into those decisions and make sure climate risk is a factor in those investment decisions? I think for the global community, a part of that is to think about new mechanisms of financing, new approaches to financing, new avenues or new areas to finance. For example, we think a lot about sustainable finance. We should also be thinking about adaptation finance. Remember I said that climate risk is regressive, so how do we think about ensuring that capital continues to flow to parts of the world where it's most needed, which may be most at risk? How do we find ways to effectively derisk such investments? And then finally I think investors have to think about what they can do and what they should do to work with their own counterparties or work with the entities they invest in to find ways to reduce risk.
Michael Torrance: And some of that seems to dovetail nicely with the goals, the sustainable development goals of the UN and the push towards moving capital needed to achieve those goals. So there is a real, I think, nexus with sustainable finance, as you mentioned. Just turning back, though, to the socioeconomic impacts of physical climate risk, I mean, some of the things that you've talked about from impacts on food systems to the actual ability of the human body to withstand temperature changes that will likely emerge, I mean, it really speaks to human well-being and will undoubtedly have an impact on human behavior, where people can live, how people live. I mean, it could have impacts on migration patterns, for example. Can you just unpack a little bit about what this research you've done, the implications that it will have for the socioeconomic systems and for people, and therefore what even policy makers and those who are interested in developing social systems to address these types of issues should be thinking about?
Mekala Krishnan: So one of the things we wanted to do with this work was to help people understand the characteristics of physical climate risk, and as a part of that, we wanted to build a taxonomy, a framework by which we could think about the types of impacts you could see as the climate changed across the world. And so we examined a set of impacts that climate scientists tell us we've already experienced to date. So there is a field of climate science called attribution studies that has linked different events around the world to climate change, either saying these events have become more severe or more frequent as a result of a changing climate. So we looked at a whole set of them. What we found was that the direct impacts of a changing climate essentially impact five socioeconomic systems. The first thing they do is impact what we call livability and workability. This is essentially impact to human beings. We find that today there are no parts of the world really that are too hot for people to live, but, for example, rising between now and 2030 and further between 2030 and 2050, there are parts of the world that could experience such severe heat waves that a healthy human being sitting in the shade after 4 or 5 hours of exposure may no longer be able to live. We find that there are parts of the world where heat and humidity conditions rise so much that outdoor working becomes hard. People get more tired working outdoors. They may need to take more frequent breaks. And then, of course, all the kinds of impacts that one experiences with things like flooding, where travel to work may be disrupted, where people may even lose their lives from very severe floods. So there are a whole set of things that could impact human livability and workability. The second type of effect we found was things that could impact physical capital and infrastructure services. So as we see different climate events manifest, we could both see damage to physical capital. So this is things like a home being damaged as a result of flooding. We could also see capital productivity get affected. So, for example, power systems may start to function less efficiently if you experience very hot days. So both physical capital could be damaged, but you could also see capital productivity get affected, which of course has particular implications for the economy if infrastructure was affected. One of the things we saw with Hurricane Sandy was things like the metro system getting flooded for long durations of time, and so all of that could have knock-on effects on economic activity. And then we also found that natural capital could get affected. We found, when we looked at food systems in particular that we could start to see impacts on agricultural yield. Between now and 2030, we found that the likelihood of a global bread basket failure could double. Fast forward between 2030 and 2050, that likelihood could quadruple. That has implications, of course, for our ability to feed ourselves. We have food storage across the world so that in the event of grain shortages, we are able to draw down on stocks of grain that have been stored, but the implication of that could be that food prices rise, and that could, again, impact the most vulnerable parts of the world the most going back to the regressive nature of climate risk. And then the other form of impact on natural capital that we identified was there are, of course, many parts of the natural world around us that they could be affected as a result of climate change. We know of examples of glaciers melting or oceans becoming less oxygenated, more acidic as a result of climate change. So across the board, we find impacts on human beings, labor. We find impacts on physical capital and infrastructure services, which is essentially stocks of physical capital, and then natural capital, both food systems as well as natural capital more broadly, and if you stop and think about that for a moment from an economic activity standpoint, what that basically means is that the factors of production in an economy are affected by the fact that the production in an economy are labor, physical capital, natural capital. And climate change could directly impact all of these. Now, those are the direct impacts. What we also found was that there could be a multitude of knock-on impacts as a result of those direct effects, and this is because systems are connected and actors in an economy are connected to each other and there could be, therefore, all kinds of second-order, third-order effects after the immediate climate event. One particularly stark example from our research was, we looked at the example of real estate in Florida, and of course Florida real estate could be damaged as a result of climate change. We examined the impacts of storm surge on Florida real estate. As sea levels rise, storm surge events could become more severe, and all of that could mean that damage from a 100-year storm surge event today in Florida would be about $35 billion, but if we fast forward to 2050, those damages could be anywhere from $50 billion to $75 billion. And so certainly there are direct damages, but what we also find is that there could be knock-on effects on home prices, and in some sense you can insure against damages, but it's a bigger question mark what you do to protect yourself against price devaluations, right? So we looked at the potential impacts in Florida of home prices being affected as homeowners start to experience flooding events and they start to price that into their buying decisions, and what we found was that estimates based on past trends suggest that losses from flooding could devalue exposed homes by $30 billion to $80 billion, or about 15 to 35 percent of the value of the home by 2050, all else being equal. Now this is just looking at historical relationships between tidal flooding and home prices, but you could ask yourself the question of what happens if homeowners more aggressively start to factor this into their buying decisions? What happens if schools or infrastructure are affected? What happens if business activity in a particular part of the state is affected? So all to say that certainly the direct impacts from a changing climate are important, but knock-on effects could be as or more significant. And specifically when you look at financial markets, what they do is that they pull forward future risk. So once financial markets start to recognize future risk, they may start to factor that into decisions today and that may have implications for asset prices. It may have implications for capital allocation. It may also have implications for insurance prices and availability.
Michael Torrance: Unpacking that a little bit further. I mean, it seems like it's almost a tipping point type of issue that, you know, these could be not factored in for a while and then suddenly factored in, and that could have financial implications. Can you describe what rule you see financial markets playing in managing this type of risk? You've alluded to insurance and sustainable finance. Can you just describe what role is there for those markets to play in, and how would that role be taken up?
Mekala Krishnan: Yeah, absolutely. So insurance is very important when we think about managing risk and serves many functions, right? So firstly, it ensures that people don't face financial hardship when loss events occur. Oftentimes they create liquidity after events and help accelerate rebuilding efforts, but insurance also has other very important roles to play. Properly priced insurance sends a signal, an appropriate signal, of risk, which is very important because as you've said, we may be under recognizing this risk in parts of the world today. Insurance can also serve to incentivize adaptation investments, and we saw this, for example, in the case of building fire codes where the insurance industry played a strong role in ensuring robust building standards that helped reduce the incidents of fires in parts of the world. So insurance has many, many different roles to play and all very important. I think as we look forward, when we think about the role of insurance, there are many questions that we need to ask ourselves as we imagine the role that insurance can play in managing this risk. I think the first is around how we think about reducing insurance gaps around the world, that many parts of the world where insurance penetration still remains low, how do we ensure increased uptake of insurance where it's needed? How do we think about appropriately pricing insurance premiums so that they reflect risk, but at the same time manage the affordability of insurance? Today in many parts of the United States, for example, research has shown that flood insurance premiums may need to be repriced to appropriately reflect the risk in those geographies, but then doing so, of course, is a financial hardship for homeowners. So how do you appropriately balance both? So allow insurance to appropriately reflect risk, and allow homeowners to factor these risks into their buying decisions but at the same time not make insurance unaffordable. I think questions around how we can better use insurance to drive adaptation, the role that insurance agents themselves or the insurance industry itself can play in risk advisory services. The role that the insurance industry can play in continuing to improve forward-looking models of risk, right? So the insurance industry, of course, has a whole set of actuarial data that they rely on to make pricing decisions, but is now starting to incorporate more and more forward-looking climate models and climate analysis into their pricing. So what more can the insurance industry do to move us towards that? And then finally this question of a duration mismatch, so if you're a company or a homeowner, you're taking on long-term debt, for example, when you're financing your home. So you're taking on a mortgage, say, of 30 years, but your insurance premium gets repriced every year. And that, of course, creates this mismatch of expectations where the homeowner may be seeing that insurance premium as a signal of future risk, whereas really what it is, is a signal of risk over the next year. So lots of very important roles for the insurance industry, lots of questions about how we think about the future and the role that insurance can play in managing the stress going forward.
Michael Torrance: What are the key takeaway points, you would say, for companies, investors and even governments to be thinking about and asking themselves when they're analyzing their own thinking around climate-related physical risk and maybe what some new strategies they should be taking should look like?
Mekala Krishnan: Yeah, that's a great question. The research, essentially, identifies three imperatives for stakeholders. The first is, we need to find ways to embed and integrate an understanding of climate risk into all decision making. It can't be something that is separate from the day-to-day work that institutions undertake. So for cities, for example, it is integrating climate risk into their open-planning decisions. For a company, it is integrating climate risk into their capital allocation decisions or their supply chain decisions so on and so forth. That will require, of course, building new tools, capabilities, building a new muscle, but it's important that this is not an issue that sits within a sustainability function or sits within a risk function but is really part of the day-to-day of the business or the day-to-day of the institution. The second is identifying ways to adapt to the climate risk that is locked in. We identify a range of measures that you could take to manage risk. It's everything from finding ways to physically harden and protect assets or buildings or people to finding ways to build additional resiliency, whether that's having backup suppliers or holding additional inventory levels. In some instances, adaptation may also require reducing your exposure, and that's both being thoughtful about new investment decisions that you're making so that you aren't making them in harm's way, but also in some instances may require relocating buildings or relocating factories. And then finally the role of insurance and finance, really recognizing that insurance is crucial to be able to manage your risk, and adaptation finance will become more important in the years to come. The physical risk that we experience is as a result of warming, and the only way to stop further warming is to reduce emissions, and so in the long run, the only way to prevent further build-up of risk is through decarbonization. This research hasn't focused on decarbonization, but that's of course an important imperative for stakeholders to consider.
Michael Torrance: So just to wrap up then, we're looking, right now, at a very unprecedented situation with the COVID pandemic, and, you know, in some respects, there is parallels that you could draw, and many have, between this disruption that we're facing and the disruption that could be caused by climate risk. What's your take, just on what we've seen so far, in terms of those potential linkages and what we can both learn from with respect to emerging from the COVID pandemic, from research that's been done around climate risk, and vice versa? What lessons does this pandemic have for managing climate risk disruption in the future?
Mekala Krishnan: Yeah, that's a fantastic question. I think what we have found is that on the one hand; there is many similarities between climate change and what we're currently experiencing with the pandemic. These are both systemic forms of risk. They don't just impact one geography or one sector, but entire systems. They both could have nonlinear impacts. They both, in some sense, are risks that come from outside the economic system, outside the social system, but impact it. And then they both, of course, have implicit in them the importance of resiliency in managing risk, and resiliency, I'm defining very broadly. It's everything from being able to appropriately assess your risk to identifying a set of measures to manage the risk and to implementing that effectively. I think, of course, the big difference is that the time scales on which they operate are quite different, right, so climate risk manifesting over the coming decades, so much longer time horizon in the case of climate change than what we've experienced with COVID. Having said that, I think there are both headwinds and tailwinds as we think about the post-COVID world. What we identify is that on the one hand, that could mean many tailwinds, I think, from the COVID experience and the recovery that could be synergistic with the climate agenda. I think at the highest level what this experience has taught us is that change can happen very rapidly, in ways that we may not have thought were possible. So we all now are teleworking. We're using digital channels much more than we did in the past, and that, of course, could have climate benefits. This experience has also emphasized resiliency, and so some of the resiliency measures that I anticipate we will put in place post-COVID could also support climate resiliency, whether that is finding ways to assess risk, better price risk, monitor risk, so on and so forth. So I think this emphasis on resiliency is going to be very important in the post-COVID world that could be beneficial for the climate agenda. Of course it's also an environment where in the recovery we will be thinking about investment. We will be thinking about stimulus. We will be thinking about a low-interest-rate world, and so the question is, how can we find investments that are synergistic both with climate action and a COVID recovery and put those in place? I do think that it's important to recognize that there could also be some headwinds to the climate agenda in this post-COVID world. We're of course going to be focusing in the recovery on job creation and economic recovery and not on climate, and so again it's important to think about where there are synergies between the two and what ways that we can drive both agendas forward are. There is also, of course, a risk that there could be delays in investment as people experience economic uncertainty. So I think important to recognize that there could be real headwinds, but given the similarities between COVID and climate change as risks, also potential synergies and potential learnings.
Michael Torrance: Fantastic. Well, thank you so much for your time today to talk about your fascinating report.
Mekala Krishnan: Thank you for your great questions.
Michael Torrance: You can learn more about the McKinsey Global Institute at mckinsey.com/mgi. This link can also be found on the show notes on our website. Thank you very much to Dr. Krishnan for taking the time to share her research on physical climate risk. Thanks for listening to "Sustainability Leaders." This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at bmo.com/sustainabilityleaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider, and we'll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.
Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax and/or legal professional about their personal situation. Past performance is not indicative of future results.
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