10/24/2014 02:43 pm ET Updated Dec 24, 2014

Is Climate Risk a New and Troubling Source of Systemic Risk?

There are signs that environmental risks, particularly extreme weather and government regulations to reduce pollution, are becoming both more material but also systemic, with the potential to affect large swathes of investment portfolios. Asset owners should pay more attention to these developments, improving their knowledge and seeking out suitable hedges.

Investors generally welcome risk: at least the sort that both offers the prospect of a decent return and is also uncorrelated with other risks, such that a portfolio of affected assets has a low level of vulnerability to individual events. However, the financial crisis has reminded us of a more sinister side of risk: systemic risk that affects multiple assets in a similar fashion, where diversification is impossible. Many investors are now actively on the hunt to identify such risk in other areas.

Traditionally, environmental risk has been seen as similar to many other sorts of risk, i.e. specific to a particular asset, with independent events and the probability of occurrence defined by a bell curve or "normal" distribution of outcomes; in many cases, these risks are acceptable to investors within a diversified portfolio. For example, in early April 2010, most investors had investments in BP stock similar to the level in a generic stock market index; a few had researched BP's health and safety practices and track record and had reduced their holdings in the stock accordingly. When the Deepwater Horizon oil rig exploded on 20th April with the loss of eleven lives, the share price of BP dropped 53 per cent over the following ten weeks. Investors had taken a view of the stock-specific risk of holding BP and suffered accordingly, comforted that the explosion was unlikely to affect much of the rest of their portfolios.

Yet there are signs that outcomes in some areas of environmental risk are following a different profile, in which events are no longer independent and/or the normal distribution is no longer valid. For example, the rapid spread of mountain pine beetle across the Pacific Northwest and Rocky Mountains, has frustrated attempts by many holders of U.S. timber to diversify their portfolios by buying assets across the country. Last winter, rainfall in the UK was reported as one of the worst since reliable national records began in the mid nineteenth century, and several analysts report that a statistically significant change in the pattern across several years.

Equally, the potential for government responses to environmental problems can introduce new dimensions of risk. Since the 12th Five Year Plan, which prioritized air and water pollution control and environmental protection, was introduced by the Chinese Government in October 2010 (formally approved in March 2011), national suppliers of thermal power plant equipment have significantly underperformed the Hang Seng Index: for example Dongfang Electric by 65 percent, Harbin Electric by 55 percent and Shanghai Electric by 55 percent. Similarly, the 2011 decision by the German government to phase out nuclear power by 2022 without compensation to incumbent generators, has been a major contributor to the dramatic underperformance of the stocks of both RWE and E.On.

Climate change threatens to compound systemic risk in both areas. Last year's IPCC report from the United Nations indicated that the phenomenon is both "extremely likely" to be caused by human activity and will get worse unless emissions are reduced. Investors should therefore expect that historical weather patterns will lose relevance in predicting the weather of the future, and that "extreme weather" will increasingly feature as a systemic risk across portfolios. In many cases, it will be difficult to mitigate these risks through diversification: the shifting of climatic belts can sharply reduce (or enhance) the agricultural productivity of specific land banks; more frequent tropical storms can render certain coastal areas effectively uninhabitable; and a precipitous decline in snowfall can lead to the permanent depletion of water courses that have sustained population centres for millennia.

In parallel, there is a rising probability that policy makers will act to reduce greenhouse gas emissions. The European Union was for many years the only major economic bloc to limit carbon dioxide emissions; however, China is now experimenting with schemes in seven regions, while the U.S. Environmental Protection Agency is developing regulations that will impose limits across all fifty states. In the language of investment, it is rational to ascribe a higher risk premium to the ownership of assets that will be negatively impacted by so called "carbon prices" -- a second source of systemic risk affecting a portfolio.

In response, investors should give priority to action in three areas. First, learn more about these trends and analyze how they may impact their holdings; for example, recent work by the UK's Environment Agency Pension Fund has illustrated how asset owners can assess their exposure to fossil fuel assets. Second, explore options to invest in the opportunities that are being created by these developments; for example, a portfolio of stocks of companies providing energy efficiency services can preserve investors' exposure to retail energy prices while avoiding the reduction of wholesale prices that could follow from new "carbon prices" (or the equivalent). And third, engage with policy makers to ensure that the transition to a low carbon economy is managed optimally, ensuring that policy to reduce emissions is economically efficient (to minimize the risk of unnecessary value destruction), clearly signposted (to give investors as much time to adapt as possible), and consistently implemented.