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How to face the Knightian uncertainty of climate change?

Not so long ago, climate risk was perceived by most companies as a concern for governments and NGOs to worry about. However, as our net-zero ambitions require a complete transformation of the way we live, think and also invest, this is not the case anymore. As a new type of challenges arises, the way companies report on climate risk takes on new significance as investors look to accurately assess and measure the environment’s impact on their business models, assets and reputation, as well as the organisational preparedness to cope with these risks.

How great is the interest of the market in investment products with climate targets? What is so distinct in the assessment of climate risk and what metrics and analytical tools should be used to better understand these risks, to screen portfolio and new investments for future threats? These were the main questions of an expert panel discussion organised in the framework of the V4ESG conference organised by the Hungarian Business Leaders Forum.

A clear signal from the market

As Laura Segafredo, Global Head of Sustainable Research at BlackRock ETF and Index Investments said, currently we are in climate investing where we were two or three years ago in the sustainable or ESG investment space.

“The annual inflow into global sustainable ETF (Exchange Traded Fund) for example has grown from less than a billion US dollars in 2014-2015 to 88 billion US dollars in 2020,” she highlighted.

“We believe that financial markets are only beginning to appreciate the potential impact of the shift towards sustainability in asset prices and climate in particular.”

BlackRock believes that climate risk gives rise to investment risks and opportunities and accordingly, integrated sustainability into its investment process. As Mrs Segafredo pointed out a broad spectrum of investors are turning to ETF as a liquid, transparent and efficient way to build portfolios for the transition to a low carbon economy.

“Up until recently divestment was the predominant way to express climate oriented objectives but recent advancement of data and analytical tools as well as product innovation enabled more sophisticated methods of building climate oriented portfolios,” she underlined.

The Central Eastern European region is no exception to this general trend in climate investment.

“We see these themes rising in the forefront all around the world, specific regions have similar challenges but fossil intensive countries are also embarking on the trends of climate oriented investing,” said Mrs Segrafredo highlighting that the very first green sovereign bond was issued in Poland in 2016.

The V4ESG conference.

Climate risk equals reputational risk

As the market is clearly moving in a certain direction, it brings new challenges. As Clark Anderson, Managing Director of Morgan Stanley pointed out another important element for climate risk is that it adds the dimension of reputational risk to the matrix.

“As popular opinion changes and as our clients move on transition we risk being left behind.”

Mr Abderson underlined that in case of climate risk, public image and the reputation of the firm is out there and it’s not the same as financial loss. Dealing with climate risk requires the whole institution and not just risk management to be very clear on the messaging.

In fact, in terms of principles, everybody seems to agree but in term of practicalities everybody is searching for the best way to measure climate risk.

As Mr Anderson put it, data metrics and methodology are key challenges kind of the Wild West and transparency and thoughtfulness will be key in this process.

Getting ready for the “known unknown”

The two types of risk imposed by climate change are physical climate risks – where investments can be affected by climate change’s physical impacts and transition risks – where policies create pricing that devalues the investment.

“Lots of economists studying climate risk have realised that the so-called Knightian uncertainty applies here,” started Oliver Marchand, Global Head of ESG Research & Models at American finance company MSCI.

Economist Frank Knight formalised a distinction between risk and uncertainty in his 1921 book, Risk, Uncertainty and Profit. As Knight saw it, an ever-changing world brings new opportunities for businesses to make profits but also means we have imperfect knowledge of future events. Therefore, according to Knight, risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.

As Mr Marchand explained, the so-called Knightian uncertainity is the “known unknown” such as a pandemic situation, a cryptocurrency revolution and also climate change.

“It’s very clear to scientists that climate change is a non-linear process, so we don’t really know what’s coming, what we know is rising emissions come with the rising temperature that amplifies climate change, which points in a direction of a Knightian uncertainty.”

“As we can’t use past data, scenario analysis comes into the picture but it will never give the exact answer, it will never be 100 per cent calibrated and tell the probability of the outcome, so scientifically speaking is completely disappointing but still it’s definitely better than doing nothing,” explained Mr Marchand.

MSCI co-developed a metric called climate value at risk, which leads to very distinct profiles. According to this metric for instance Poland and the Czech Republic have an average of around 35-37 per cent climate value at risk whereas Hungary only has 25 per cent, which highlights that there must be a structural reason why Hungarian companies are less risky relative to transition risk.

“However, on the opportunity side, Poland has an average of 11 per cent while the Czech Republic and Hungarian 2-3 per cent, so companies even within the V4 region are very differently positioned,” explained Mr Marchand.

The accessibility and quality of data are also crucial for investors to manage climate risk in portfolios.

“To get better data we need better and more disclosures of emissions and today this data is broadly inconsistent and low quality, although there is an increasing number of companies that are disclosing,” said Laura Segafredo.

As Irena Pichola, Head of Sustainability & Climate Change at Deloitte Central Europe added, transparency is still a challenge in the CEE region as ESG disclosure just started to get into the mainstream thinking, however, there are already promising signs.

The new taxonomy for instance will certainly help in mobilising and structuring the discipline around disclosure.

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