[Sponsored Article] By Professor Entela BENZ-SALIASI CEO and Co-founder of Intensel* Adjunct Associate Professor, Department of Finance at HKUST Business School Risk related to climate change is a systematic and unpriced risk. It is the biggest threat to business and society today. Losses related to the climate are now four times higher than in 1980s. According to Aon, 2019 losses reached US$232 billion, and they are projected to increase fast at 30% per year. More importantly, only US$71 billion of that is insured, leaving US$161 billion as a direct loss to taxpayers and business . This is the main reason why regulators are now pushing hard for mandatory disclosure on climate risk. A series of countries have now introduced clear disclosure requirements which will target the biggest players in each country, especially in the financial sector where these risks concentrate. Closer to home, typhoons and storm surges, that is, strong winds and coastal flooding, are the main culprits when it comes to damage in the HKSAR. According to research from the Environmental Bureau of Hong Kong, an extreme flooding disaster may affect the low-lying area of Hong Kong every 5 to 10 years if the sea level rises by 3.5 meters in 2040 . As per the report, Hong Kong will experience long wet summers with heavy rainfall. All this is in addition to more frequent and more severe typhoons. As a consequence, buildings and infrastructure will be under additional stress. Super-typhoon Manghut caused HK$3.1 billion in insurance claims (90% claims on property damage alone), a figure that does not account for taxpayers’ money and the losses of SMEs. It is therefore important for both the asset owner and the government to develop new, greener, and stronger designs to withstand potential losses. The 2019 report from Geophy placed Hong Kong’s US$110 billion worth of REITs at the highest level of risk, given the exposure of very expensive real-estate market valuations to coastal flooding. For example, 25% of Sun Hung Kai Properties, at a value of US$56 billion, is classified as high risk. Other variables are important It is important to explain that economic losses caused by climate events such as typhoons, storm surges, floods, and so on, are not just a function of climate risk. The losses depend on two other equally important variables, which are the economic activity generated at that location, and the country’s level of preparedness to protect against climate events. The economic activity itself is a function of GDP, inflation, asset valuation, as well as a function of socioeconomic factors such as urbanization, population, and so on. As per the third dimension, the country level of preparedness determines potential losses. It is intuitive to assume that countries with higher GDP have the best infrastructure in place to mitigate climate risk. For example, China, Vietnam, Indonesia, and the Philippines top the ranking on climate related risks, especially given the exposure to typhoons and rainfall and river flood risks. Singapore has the least amount of climate risk although it does have exposure to rising sea levels. However, once we factor in resilience, that is, the country’s preparedness to deal with climate risk, China’s climate value risk drops below that of Indonesia, Vietnam, and the Philippines. The same logic applies when analyzing two locations which have equal exposure to risk but different levels of activity and urbanization. In other words, we should by no means limit ourselves to climate risk without taking the exposure and the vulnerability of the asset in that given location into account. Moving beyond theory and high-level concept, climate risk is mispriced, and mostly not a factor of business decisions in company valuations. We therefore lack the main mechanism, that is, the channel that will measure and translate climate risk into financial risk. Too few enablers We have very few enablers relevant to climate risk. This is because climate risk solutions rely on deep climate science and financial modelling, as well as big data and the power of supercomputers. Without strong financial support from government, business, and society, these are difficult solutions to bring to the market. What does a climate-risk solution look like? Let’s take a real estate company investing in a specific location. The climate-risk solution company will assess various risks, such as storm surges from typhoons, flooding by rainfall, flooding from a river, extreme temperatures, landslides, extreme rain, and so on. From the figure below, one can see that near-water locations have a high risk (red) while others have a low risk (white) even if they are within a 1-kilometer area. The big question is whether climate risk is priced into a property valuation. The answer is simple. It is not, and the reason is lack of climate risk information. But if the data is available, it is simply not smart to buy or develop a property that will be frequently inundated by problems by 2030. Ten years might seem like a long period, but once climate risk data is delivered to the market, repricing will be immediate. In Florida, a recent study indicates that coastal properties already dropped by 5% in value since 2018, purely due to coastal flooding concerns. By 2045, billions of dollars in property will be destroyed due to rising sea levels, according to US federal mortgage giant Freddie Mac . The above analysis shows that the Central district of Hong Kong is prone to high flooding risks related to extreme rainfall and storm surges. Taking account of the infrastructure, specifically the drainage system, many buildings such as Exchange Square, the International Finance Center, and so on, are at high risk. Given the level of economic activity generated in this area, it is important to include climate risk in the core of risk management strategies. Accurate estimates are necessary Unlike ESG, climate-risk estimates must be granular and accurate. That means we simply cannot work with proxies or generalizations. For example, we analyzed a Shanghai-based property and found that despite being near the river, the flood risk was low, due to the property’s elevation. Nonetheless, by 2050, under a business-as-usual scenario, this property, like many in Shanghai, will be subject to typhoon winds reaching 279km/h, and will incur significant damage, and also business interruption. These future loss projections, given their likelihood, should be part of business strategies and property valuations. Last but not least, extreme temperatures must be considered. Many Asian cities will experience a big temperature increase during the summer months. That will require more energy use, which will result in significantly more electricity costs, and a higher carbon footprint. A smart company will start cooling efficiency and energy efficiency measures now, before it is too late. Only stress-tests scenarios and forward analysis can reveal the extent of climate risk and any opportunities resulting from it. The other point we need to clarify, not least to answer climate sceptics, is the accuracy of the predictions. Climate science is very complex, as it consists of an ensemble of models with a high degree of interdependency. Hence the accuracy or prediction is, and will always be, challenging. But so is the asset pricing. No one can predict the next crisis, neither the timing nor the magnitude. The best we can achieve is a rough estimate. Similarly, we cannot expect to perfectly predict what will happen in 2030 in terms of climate change. But there is a high volume of research which provides some estimates on what climate change in 2030 might look like should CO2 emissions and equivalents continue down a certain path. Each path has a probability that is also time variable. We will probably not experience a 1.5 degree rise in temperature, and will have to deal with a much more severe reality of a rise of 2 to 3 degrees by 2100. The implications are existential for our society, let alone the economy. In a nutshell, we should not focus too much on one scenario, but should consider a variety of possible scenarios. That is why it is crucial to prepare a forward-looking analysis with a stress-test like the one presented below. Climate risk is a real risk, but it also offers immense opportunities. Those who have the data and the information come out on top, and ride the trend. Hopefully governments will learn to lead, and look beyond a four-year to five-year plan. Climate solutions should not be a privilege of those who can afford them, they should help the economy and society as a whole. *Intensel, a startup that provide climate risk analytics is able to address concerns related to climate risk as well as the climate value at risk not just for Hong Kong and Asia, but also globally. Intensel is focused on the application of AI, Machine Learning, and Geospatial Technologies in hazard modelling at granular level along with the development of first-of-its-kind ready-to-use Software as a Service (SaaS) platform to provide climate risk intelligence to potential clients.