Severe Weather Poses ETF Sector Risks

December 01, 2021

[This article appears in our November/December 2021 issue of ETF Report.]

Climate change is here, and it’s already wreaking billions of dollars’ worth of damage.

The National Oceanic and Atmospheric Administration estimates that severe weather events in 2021 so far have generated an inflation-adjusted $104.8 billion in damage, and that isn’t including the ongoing droughts and wildfires in the Western portion of the country.

While these disasters aren’t directly generated by human-driven climate change, a hotter world means drier forests prone to burning out of control, and warmer sea water that can intensify tropical storms and ultimately cause more damage to life and property.

Swiss Re, the second-largest reinsurer in the world, estimated in April that 11-14% of global gross domestic product is at risk if the world’s temperature rises past 2 degrees Celsius by midcentury compared with pre-industrial levels. That doesn’t even encompass the political instability and human suffering that would come from droughts, crop failures, deadly heat waves and mass migration out of environments newly inhospitable to people.

So what—if anything—can investors do to prepare for a crisis that at minimum will be highly damaging to the economy as we know it today, and potentially catastrophic if it can’t be solved?

Derek Lemoine, a professor of economics at the University of Arizona who has a doctorate in energy and resource studies, says it’s difficult to quantify the current and future costs of climate change on the economy because there’s no direct historical analog with which to compare a modern economy operating in an abnormally hot climate.

However, he expects the interconnected nature of the global economy will cause severe weather events to generate knock-on effects across the world in a way that’s hard to defend against in a portfolio.

“It does seem like it’s really hard to escape any exposure by focusing on certain sectors,” he said.

Climate Change Hitting Insurance
The shift in the climate is also forcing fundamental shifts to what the business world has taken for granted for decades.

Take the insurance industry, which faces the prospect of more loss events in the wake of climate-driven weather events like hurricanes and wildfires. More people and more property will congregate on a smaller amount of land around the world as rising oceans make coastal communities uninhabitable or too expensive to insure.

Lynne McChristian, director of the Office of Risk Management & Insurance Research at the University of Illinois Gies College of Business, said insurers are having to balance pressure both from regulators to be able to cover claims and from the rising risk of costlier weather events cutting into profitability.

That may mean the cost to build homes in wildfire or hurricane-prone areas can rise due to the higher premiums demanded to cover that property, with the knock-on effects rippling into other industries like construction and real estate.

These trends are here to stay, as the Intergovernmental Panel on Climate Change’s latest report estimates it would take anywhere between several decades and several thousands of years to reverse temperature increases caused by carbon emissions.

And damage from weather events themselves is setting up a vicious cycle. McChristian notes that wildfires burning available timber can reduce the amount of wood available to rebuild, and COVID-19’s effects on the global supply chain have disrupted the flow of key materials needed to rebuild property damaged by a severe weather event.

“What the insurance companies are doing—whether they’re mutuals or whether they’re stock companies—is trying to tell people they need to pay more attention to their vulnerability, and the costs are going to change,” she said.

Risk Across All Sectors
Derek Horstmeyer, a finance professor at George Mason University, said investors will need to demand better risk management from companies they hold. He points to Pacific Gas & Electric, a California utility that went bankrupt after fire officials determined its lapses in safety measures led to several wildfires, including the 2018 Camp Fire that burned 153,000 acres, destroyed 18,800 structures and killed 85.

The company’s stock was trading north of $70 per share in late 2017, but has traded around $10 per share since the start of 2020, after a sharp series of declines in late 2018 and early 2019. Horstmeyer notes that risk of share prices tanking will drive more volatility after several years of recovery from the 2008 financial crisis, and that volatility is likely to be spread unevenly across sectors.

For example, the real estate sector faces obvious risk regarding buildings being susceptible to severe weather damage. But if an affected building happens to host a server for a major technology company, it could easily disrupt services for a sector that isn’t thought of as carrying much climate risk.

“Maybe our notions of what are safe ETFs, safe sector ETFs, might change,” he posited. “Not so much in volatility, but maybe in crash risk.”

Racing Toward 2030
The Intergovernmental Panel on Climate Change’s latest report estimates that the world will breach the 1.5 degree Celsius of average warming from pre-industrial levels sometime within the decade unless severe decarbonization happens across every industry.

That poses a quandary in the finance world, where companies are incentivized to put quarterly results and shareholder value ahead of spending capital to mitigate emissions or build resistance to adverse weather events.

Horstmeyer said novel ideas like a special dividend that kicks in after a shareholder holds their position over five years could reduce short-term pressures for financial performance. However, he sees an opportunity for climate-minded activist investors to put pressure on heavy emitters or companies seen as unprepared because the cost of borrowing capital for a campaign is extremely low right now.

“Having activist investors target companies to hopefully change these things, to get these things in line, will add value to a company if they don’t have good protocols in place,” he explained.

But UofA’s Lemoine said there’s reason for hope. He points to the plummeting price of solar panels, commitments from automakers toward phasing out internal combustion-powered cars and carbon-capture technologies as promising ways to avoid a worst-case climate scenario.

While those technologies aren’t magic and their initial costs would be high, he argues that widespread adoption of zero-carbon technologies at scale will drop the price burden.

“There are ways to deal with the problem that I think don’t warrant just sticking heads in the sand,” he said.

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