Climate risks finally enter investment decisions

 

For more than fifty years—since 1972, to be precise—warnings have been issued about planetary boundaries and their implications for economic development. Those early models laid the foundations for what we now understand as non-financial systemic risks, which, even without considering the loss of human lives, translate into annual economic impacts amounting to trillions—with a T—globally.

Five decades have passed, yet these risks are still treated as if they were something new. Worse still, the idea persists that they are not directly related to finance or investment decisions, as if financial models could be abstracted from the physical reality in which assets and businesses operate.

Just ask yourself a few simple but uncomfortable questions:

• Should water stress or exposure to extreme weather events be considered when assessing asset deterioration?
• What are the projected losses from disasters?
• Will extreme temperatures affect the useful life of equipment and infrastructure?
• Will it be necessary to invest in adaptation to ensure operational continuity?
• Will production capacity or demand be affected?

 

The uncertainty associated with these variables is not neutral from a financial standpoint. When risks are not identified, measured, or managed, they can increase the volatility of future cash flows and weaken the assumptions underlying asset valuations. This translates into a loss of value that can manifest itself in higher discount rates, adjustments to terminal value, increases in risk premiums, insurability restrictions, or higher costs—or reduced access—to financing.
Perhaps the challenge so far has been to translate these questions into language that the financial market recognizes as its own: impact on terminal value, increase in WACC, rises in insurance premiums, insurability issues, assumptions about future investment under different climate scenarios, structural increases in operating costs, or variations—measured in basis points—in the cost of debt.

The entry into force of the IFRS Sustainability Disclosure Standards, IFRS S1 and IFRS S2, means that these questions are no longer optional. They must be addressed not only for climate change, but for all sustainability risks with potential financial impact.

And while climate change is one of the most studied risks of recent decades, its integration into investment processes has been gradual. Considering these risks in investment analysis and corporate policy design is now part of informed decision-making that is aligned with the environment and capital markets. However, this integration is not yet consistently reflected in financial statements or in the way that the risks identified in sustainability reports interact with the figures, assumptions, and estimates that support financial information.