Resources

• McKinsey reports Climate Risk and Response and Confronting Climate Risk describe climate risk and mitigation approaches.
• Examples of insurance innovation can be found in The Nature Conservancy’s effort to insure nature, including working in partnership with Swiss Re.

Guests

Host: Mike Toffel, Senator John Heinz Professor of Environmental Management and faculty chair of the Business and Environment Initiative.

Moderator: George Serafeim, Charles M. Williams Professor of Business Administration and faculty lead of the Impact Weighted Accounts Project

Guest: Wendy Cromwell, Vice Chair, Senior Managing Director, Partner, Sustainable Investment and Portfolio Manager of Wellington Management

Guest: Tony Davis, CEO and CIO of Inherent Group

Guest: Audrey Choi, (MBA 2004), Chief Sustainability Officer and Chief Marketing Officer of Morgan Stanley

Guest: Luca Albertini CEO and Founding Partner of Leadenhall Capital Partners

Transcript

Audrey Choi:
11 years ago for a Wall Street bank to do that it was a little bit of an article of faith, right? We had this sort of belief that we could harness the power of the capital markets to do things like protect the environment and strengthen communities. And we really had to find ways to prove the case that you could actually do both, right? That you could actually be a wise investor who does not want to give up returns at all and also be driving positive impact for environment and social issues.

Mike Toffel:
This is Climate Rising, a podcast from Harvard Business School. And I'm your host Mike Toffel, a professor here at HBS. Today's episode is the third in this series, recorded in early 2020 at the Harvard Business School conference on risks, opportunities, and investment in the era of climate change. We'll hear from four experts representing different aspects of financial services about how climate change is affecting the insurance industry and both large and small investors in the equity and debt markets. They'll also take questions from the audience about where the space might go next.

Mike Toffel:
Today's speakers highlight some of the approaches long term investors are using to uncover and price climate risk, which includes physical risks and transition risks. Physical risks include risks from natural disasters exacerbated by climate change. By transition risk, we mean risks that arise from new regulations such as carbon taxes that seek to make the price of goods and services better reflect the true cost of the greenhouse gas emissions they generate.

Mike Toffel:
First, we'll hear from Wendy Cromwell, vice chair and director of sustainable investment at Wellington Management, an independent investment management firm. She'll be followed by Tony Davis, CEO and CIO of the Inherent Group, an ESG focused investment management firm that invests long and short in the equity and credit markets. He'll talk about how his firm considers physical and transition risks in their investment decisions. We'll then hear from Audrey Choi, chief sustainability officer and chief marketing officer of the global investment bank, Morgan Stanley. She'll discuss how Morgan Stanley has developed ways to integrate climate analysis into their investment advisory offerings, both to mitigate climate risk and to engage proactively with companies developing climate solutions.

Mike Toffel:
Finally, for a perspective from the insurance industry, we'll hear from Luca Albertini, CEO and founding partner of Leadenhall Capital Partners. He describes some of the data and modeling work that insurance and re-insurance companies are doing to improve how they price insurance to reflect climate risks. So let's dive in with Wendy Cromwell, who leads a lot of the work on climate risk at her firm Wellington Management. My colleague, HBS Professor George Serafeim moderates the panel, and started by asking her about how Wellington is examining physical climate risks and how that impacts their investment decisions.

Prof. George Serafeim:
I want to start with you discussing about the role of physical climate risk a little bit, and the role of capital markets and how you are thinking about how physical risk is playing out, creating transition risks, and what are the types of things that you are looking to understand that an investment is well-protected or how you are identifying opportunities through that transition?

Wendy Cromwell:
So when we started thinking about our role and what we could do to advance the climate agenda and climate understanding in capital markets, we looked out into the marketplace and we saw that a lot of people were focused on transition risk, which of course is very important. Carbon footprinting, the carbon footprint of your portfolio, is it what you want it to be, are you aligned with the two degree scenario, will we get a carbon tax, will we get a carbon dividend, what will that look like, how will it impact the securities that you own. It's inherently mostly about companies and emissions, what's going to roll out over time with regard to those emissions.

Wendy Cromwell:
Inherently studying transition risk, there's a behavioral element. Will we get a carbon tax, what will it look like, will consumer preferences change, how will they change, will demand change, will asset owners shift from high carbon portfolios to low carbon portfolios. All of that has a behavioral element to it. Where we saw people weren't focused as much, although there are people focused on it, is on physical climate risk, and physical climate risk is actually studying heat, drought, wildfire, hurricanes, floods, access to water.

Wendy Cromwell:
Yes, I may have said that a thousand times of the past six months, but heat, drought, wildfires, hurricanes, access to water, what that looks like and how that's going to impact the companies that you invest in because companies ultimately create an economy which ultimately creates a society. And so that's not limited to emissions and focusing on emissions. It's actually looking at your real estate and whether it's in a compromised position or looking at your mortgages or your muni bonds, or perhaps even a regional bank that's making loans that are place-based.

Wendy Cromwell:
And so we wanted to embark on really trying to bridge the divide between climate science and finance. And to do that, we actually created a partnership with a climate science organization, Woods Hole Research Center. They happen to be located in Woods Hole, which is very convenient, but as you can see, they're a global organization. They do work around the globe. They're a top ranked think tank, et cetera, to focus exactly on this gap, bridging the gap between climate science and finance or investors.

Wendy Cromwell:
And my favorite story that I think is emblematic of that issue is when we sat down with Phil Duffy, who is the head of Woods Hole Research Center, and we said, "Hey, Phil, we want to understand in basis points the impact of heat, drought, wildfire, hurricanes, floods, access to water, on all of these different securities so that we can understand the implications for our companies, for our portfolios, for the beneficiaries, for economies and for society." He looked at us and he said, "What's a basis point?"

Wendy Cromwell:
And I love to tell that story because here you have this brilliant man, scientist, very analytical, knows everything about RCP scenarios and all of the climate science, doesn't know a basis point, and on the finance side you have everyone who knows all about basis points and nothing about RCP scenarios. So I always like to give examples. I mentioned those six variables that we wanted to cover in the first year.

Wendy Cromwell:
Heat was the first one. So if I take us back to January of last year we launched on heat. And what we do hand in glove with Woods Hole is they give us a big literature review. There's a lot of peer reviewed science out there. They say, "This is the best. Read this. We have exactly one week." And then we come back together in a week. And we say to them, "These are the types of capital markets questions we think we want to answer with regard to heat." And they say, "Okay. If you want to answer those types of questions, we think this metric, in this case, the heat index, is the best one to do that."

Wendy Cromwell:
So the heat index is actually the intersection of heat and humidity, and it's much more impactful on human beings and on some forms of infrastructure than heat measured alone. So it is the right index we think to look at heat and how it's changing over time. I grew up in Louisiana. My mother used to always say, "It's much hotter here than Arizona. Arizona it's a dry heat." She was actually right. It's a lot hotter at the same temperature dependent upon the humidity.

Wendy Cromwell:
So recently this past summer I was in San Diego and they were at 88 degrees Fahrenheit, 31 degrees Celsius, 85% relative humidity. And that equates to a heat index of 110. Okay? And then you can see the consequences on the human body where you have the danger and the extreme danger zones being pretty consequential. Woods Hole then goes about creating for us granular maps. In the case of heat, it's there 100 kilometers by 100 kilometers to see how that variable is going to change over time, place by place. What we saw was there's a lot of variability in the United States, particularly in the southern region.

Wendy Cromwell:
Houston is very, very red. And what that means is that Houston is going to experience two additional months of danger and extreme danger heat days unfolding in the 2020 to 2029 decade on an annual basis. And that to the untrained scientists seem like a lot. Two additional months, Houston is already a hot place. And we said, "That's very interesting. I wonder if the capital markets have already figured this out. Maybe we're the last ones to know. What does that look like? Have they figured out where might this be priced?"

Wendy Cromwell:
And this is a little bit of an art, right? You say, where would it be priced? We thought of municipal bonds. They're inherently place-based. They've got long horizons to them. They're relatively efficient. So we looked and we plotted municipal bonds all around the US, and lo and behold, we found that you can find two municipal bonds with almost identical financial characteristics and very different heat outcomes. And that's before you get to hurricane outcomes. And so I ask you, which bond would you buy, right?

Wendy Cromwell:
So this was our first indication that we were onto something that really the capital markets had not paid attention to this yet. We're not paying attention to this yet. This is within the investible time horizon for this muni bond. And we've expanded that analysis through asset class to asset class variable to variable, and that's how we're integrating it. And we're sharing that information with our clients. We're sharing that information as much as possible with the external companies that we're investing in, because we feel like by becoming exposed to the information and informed, we have a better chance of achieving a more graceful transition.

Prof. George Serafeim:
Once you developed the infrastructure, right? The information, the methodology, and so forth, what was the next step? How were you able to integrate that into the work that the portfolio managers, the analysts and so forth are doing?

Wendy Cromwell:
So that's a great question. And I left out a step because there are vendors out there and some of them are doing really good work that are doing physical climate risk work. And we evaluated six of them prior to embarking on a partnership. And what we determined was that vendor relationship for us was going to be problematic because they give you a number or a score for the security, and that wasn't going to be internalized by the investors. And so instead of going with a vendor relationship, we actually went with this partnership to build the knowledge in house with the investors along the way.

Wendy Cromwell:
So our insurance analyst, our utilities analyst, our muni bond analyst, is in the room each week when we're going through these working sessions looking at the science with the scientists, and they're adding questions to the mix. So it's been by design that they've been involved all along, which has been really powerful again.

Prof. George Serafeim:
Tony, I want to follow up with you. What Wendy described is deep fundamental analysis at the end of the day, right? And at Inherent you have the privilege to be able to do that because you run concentrated portfolios. But the other interesting thing is that because you take both long and short positions, you're looking both for unpriced risk that could lead to declines but also unpriced opportunity, right, that could be capitalized in the future. So can you tell us a little bit about how do you go about doing that and give us a few examples of where you see, for example, pricing and non pricing of those risks and opportunities in the markets and how they play out?

Tony Davis:
Yeah. Great. So first, just to kind of level set, we are active managers. We invest in the equity and credit markets. We invest long and short, and it's a team of folks that come from Anchorage, Goldman, Blackstone, King street. So we do everything that we did previously at those shops, but now we're really trying to integrate and think about material sustainability issues by sector that we invest in. We borrow a lot from the work that our friends have done at SASB mapping those material issues, but for today's purposes we'll talk about climate.

Tony Davis:
And I think on climate in particular as we look at a sector or a company we're assessing both physical and transition risks. For us, the physical risks tend to be sort of place-based or sectors that have significant value in fixed assets. Although, it's becoming increasingly an issue for supply chains. On transition risks, we quite simply say what would happen to this company in this sector if you price carbon at $100 per ton. And I think as we think about all of these material sort of externalities that might eventually be priced we see a very clear sort of path to carbon being priced. So I think it's especially timely to be considering that in our investment analysis.

Tony Davis:
So it leads us on the one hand to be aligned with companies that we think are solutions leaders. So wind blade manufacturers, bio-diesel, wind developers, utilities that are really leading on the transition. On the other hand being short companies that we think are going to be facing a headwind. So take convenience stores where they make all their money on gasoline, which peaked last year in the United States because of efficiency in internal combustion engines. But right behind that, of course we have EVs. The other place they make money is on cigarette sales, which are declining at 6% a year.

Tony Davis:
So we looked within sectors. We'll looked for companies that we think are at sort of a disadvantaged place in the cost curve as pricing of these externalities starts to occur. And I think it was said earlier, we don't think, for example, that aluminum is going away anytime soon. We think as carbon is priced, you will see some price elasticity and some demand response. But looking for companies like those that use hydro power to produce aluminum can be a good way for us to just think about how those cost curves will shift as carbon gets priced.

Tony Davis:
And I just make one last point, which is in the credit markets, I mean, what you're really looking for in credit, credit remember you've got sort of limited upside and you have all the downside. And conversely, if you're thinking back convexity being short credit you're really looking for companies or sectors where you can see a real change in the unit economics of the business. And the pricing of carbon in a meaningful way will meaningfully shift unit economics, and certainly industries that we look at will meaningfully shift cost curve positioning within those industries. And so we find in the credit markets often we think short opportunities where these risks have not been appropriately priced.

Prof. George Serafeim:
And if I can quickly follow up in what you're saying, Tony, if you would identify one biggest challenge that you have in this process of doing this work, what would that be?

Tony Davis:
Well, data, getting access to data. And then I think on the engagement front, because we do engage as an activist with the companies that we own, trying to get them to sort of think through the scenario modeling and sort of prioritize it in how they conduct their own businesses is a challenge. But I'd say we're really encouraged by the response that we're getting from management teams and boards.

Prof. George Serafeim:
Thank you. Audrey, I want to move to you. Obviously in Morgan Stanley, you have a big footprint, right, on the marketplace. I want to talk a little bit about new products, right? And new product innovation. And you have done some pioneering work in terms of the institutes, setting up the institute and then scaling up across the bank. So talk to us about what is new, right? What is new and interesting in the space in terms of integrating climate analysis in product design, portfolio construction, any of those ideas?

Audrey Choi:
Yeah. Sure. Thanks, George. I think it's been a really interesting journey because as you said, at Morgan Stanley, we started this 11 years ago that we founded our global sustainable finance group. And I'd say 11 years ago for a Wall Street bank to do that, it was a little bit of an article of faith, right? We had this sort of belief that we could harness the power of the capital markets to do things like protect the environment and strengthen communities. And we really had to find ways to prove the case that you could actually do both, right, that you could actually be a wise investor who does not want to give up returns at all and also be driving positive impact for environment and social issues.

Audrey Choi:
And so I think in the early years frankly there was a lot of us just actually looking at the data and trying to analyze it and saying can you do it, is there a significant enough overlap area in the Venn diagram where you can aim for appropriate risk adjusted market rate of return and environmental impact. And I think in terms of investor psyche at the time, clients who were coming to us either in our wealth management business, individuals, families, high net worth individuals, but also on the institutional side we saw the families come first. And the families were really coming again, in some ways because of an article of faith that they believed in the environment that they had their charitable things focused on the environment they want, and their kids their 20 and 30 something year olds were starting to say to the matriarch and patriarch like, "Daddy, when I get the money I'm not keeping it invested the way you have it."

Audrey Choi:
And so we had in early days it was a bit more of like charisma and conviction and passion for things that would be good for the environment. I think what we've seen over the past couple of years is this real shift where, as we've all said, increasingly there's been so much more recognition from chief risk officers, from chief investment officers, that this is a massive mega trend that is a fundamental material risk to earnings, that is a massive risk to portfolio. And so we've been doing a couple of different things, and we've seen a couple different things happen with products.

Audrey Choi:
One is, again, internally our risk department has been very engaged in saying, "Look, we really need to do all the work that everyone's been talking about this morning of how do you fundamentally price risk into your portfolios." It could be that every bank's real estate portfolio is fundamentally mispriced if you're not actually looking at climate risk, right? There may be whole swabs of real estate that have flood insurance but no fire insurance or vice versa, depending on where they are. And so we we're internally doing that.

Audrey Choi:
But on the product development side, what we've seen is a real shift to now I think I would say 10 years ago when we started the first biggest area of product interest was letting me sleep at night, right? So investors would say, "I don't want X, Y, Z sectors in my portfolios." And that's long standing sort of avoid sin stocks. We then have seen more and more of a shift towards ESG integration saying, "Help me use environmental social governance factors to get good quality portfolios, get best in class in a particular industry."

Audrey Choi:
But I think the real interesting thing that we're seeing now is much more of a focus of product innovation, is really people saying, "I don't just want to avoid climate negatives. I want to actually do both." So I want to get a portfolio that proactively is de-risking me over the short and the long term or more interesting the long and the short term, because now people are more and more seeing the short term effectsand at the same time I want to proactively engage. And so whether it's we've worked with a number of religious institutions who were following the Pope saying do something proactive about climate change and poverty, not just avoiding this in stocks, but also the most serious, significant institutional investors who were saying, "I actually want to skew."

Audrey Choi:
So I think the kinds of product innovations that we're seeing A, it's going to be more significant active climate engagement, more explicit climate risk avoidance and de-risking, and also, really much more sort of... And also looking frankly at long short. I think that's been an area that for much of the last decade a lot of the sort of socially minded investors were like, "I shouldn't short. I should just go long all the good stuff." And now we're seeing much more focused from hedge funds, some institutional investors saying, "Why wouldn't you long short where you see opportunity and risk?"

Prof. George Serafeim:
Audrey mentioned a lot about proactive, right? Luca, I want to ask you about that. You have to be proactive by definition, right? In your business, you are in the reinsurance business and you assume weather risk. By the way, good luck. Hurricanes, typhoons, floods, hail storms, sounds like a fun job by the way. Open the black box a little bit for us. How do you do that, especially in an environment where we see that the frequency of those events might be changing? But it's not only about the frequency, but it's about the magnitude of some of those events. So give us a sense of the process that you're using to recalibrate some of those models as you face with an update of environmental data.

Luca Albertini:
Exactly. Now, is very topical these days in terms of taking weather risk. And just as an introduction, I started as an asset backed securities person, so doing residential mortgages, credit card securitizations. When I moved to re-insurance, I was shocked by how little insurance risk is actually priced into everyday financial instruments, finding out that quake is not covered by a vast majority of the assets that are in an RMBS and I guess [inaudible 00:21:22] in place a very few basis points in the capital markets or a credit card securitization with a triple B tranche going at, I don't know, 40, 50 basis points and a pandemic cover to the level of the Spanish flu, nothing like what we're seeing today placing at 3 to 4 percent.

Luca Albertini:
So the first thing is the pricing that at least we apply in our insurance is actually explicit. What I found is when I moved into re-insurance the first time actually and getting paid for things that often in the traditional financial markets you don't get paid at all or you're completely neglect. And one of the key things you see in the market is when you having an insurance event, you have some statistics about what is the economic cost of the event and the insurance industry cost of the event. Even in the United States, that gap is massive. In Europe is mega massive. In Asia there's not even a gap because it's all held by the economic environment and not re-insured.

Luca Albertini:
So what this wealth of data and the higher frequency that you're seeing lately is actually doing is focusing the minds of very intelligent people like yourselves, but also the risk manager of the company saying “hold on,] I'm retaining this risk net," right? What we do is we collect tons and tons of data every year. And what we do is insurance and reinsurance reprices on a 12 months basis. There are a few cases like CAT [casptrophe] bonds where it's three years, but still you have an annual reset of the risk.

Luca Albertini:
So what we do is we always try to get as much information as possible about what we are actually seen in the prior 12 months. We use commercial model on one side, and these models update every year or two. And what they're trying to do is to front run the development on the event. So the two main commercial model used insurance are produced by AIR and RMS, the two commercial companies, and they have a warm sea surface temperature module as well as a long term model. And this is again, to allow underwriters to understand what is the longterm risk if you invest on a 100 horizon, as we heard before, and what is the short term risk given what you have experienced in the last few years.

Luca Albertini:
Now, quite interestingly, when you actually look at the actual loss from the hurricane experience, all of those models have shown a more conservative view of the actual loss than what you have seen in practice, but also, mind you, there were two very interesting events here, 12 years without a Florida landfall after 2017. That's a one in 200 year event, right? That was crazy, right? So when people then see four hurricanes making landfall in the following two years, they say, "Oh, my God, it's climate change." No, no, no. These things don't happen in a normal distribution. They come in a different fashion.

Luca Albertini:
And actually, what was more interesting about hurricane Irma that hit Florida was not the severity on the construction codes, but was more the social inflation due to the abuse of some local legislation that then the Florida Senate had to mitigate by enacting new legislation last year, something called assignment of benefits. So the amplification of the loss of Hurricane Irma in '17. 35% of that was litigation risk. That was a model by anyone because this legislation has never been tested in the 12 years prior to that.

Luca Albertini:
So what we're trying to do is to model the difference in risk because of the temperature. And by the way, when you're talking about hurricanes is not the absolute temperature but the difference between tropics and the Atlantic. So it's a relative difference. Then you actually need to see in concrete cases what is the actual behavior of the local population. So we're talking about abuses on claims. We're talking about construction codes, and that's what insurance does. Every time something happens if you can't renew your policy or your policy is too expensive, that's insurance industry telling you, "Sorry, you shouldn't be there," right?

Luca Albertini:
And that's when the risk moves from the private sector to the state, and then the state becoming aware that, okay, this area is hard to reinsure, then create the state pools. This is happening in the UK as well as in the US. And then the state pools say, "Okay. I have a concentration of risk in there. Maybe I should build a flood defense. Maybe I should have construction codes that change," and the interaction of temperature, construction codes, manmade operations, and all that is actually what comes into what is the price.

Luca Albertini:
I must say up to now the [inaudible 00:26:03] insurance industry maintaining the profit. So we think we are ahead of the game, but clearly the one thing that climate change is doing is creating more frequent, extreme events. So the question is are we pricing correctly and it is a question to which we don't have an answer. Are we pricing the extreme wildfire, the one in 200 years wildfire that happen every three years, right? That that bit is where the greatest focus and difficulty lies at the moment.

Prof. George Serafeim:
Thank you. Thank you very much, Luca. I would like to open to the floor for questions for any of the participants. Again, please identify yourself and ask the question if possible in a short and sweet way.

Speaker 7:
Luca, I'm not sure you don't know exactly how to price some of these risks. The interesting arbitrage between Houston and Detroit that exists today indicates that the market has not yet signaled. What are some of the signals that we can look to leading indicators such as say the cost of... I know the Woods Hole research was used with the McKinsey study, et cetera. So Florida, if flood insurance price starts to escalate but when the flood insurance actually goes away then you can't get a mortgage. Then the price of properties goes down. What from each of you are some of the leading indicators that you'd look at, including the price?

Wendy Cromwell:
Well, you ask a great question because I didn't walk through the whole logic chain behind the municipal bond example that I gave. So you may be left wondering, okay, you've got these two securities, they've got two different climate risks, but will it be priced within the time horizon that you're looking at. And I think for that you have to think about this logic chain of why place matters to municipal bonds. And there's a number of different issues. We've actually seen more work at reinsurers than insurers on climate science. One of the first things that we did after we did this municipal bond analysis was we went and we spent a full day with the claims university at a traditional insurance company and marveled at the fact that they actually weren't doing a lot with climate science because they didn't have to because they reset prices on a year to year basis.

Wendy Cromwell:
So they're not really assuming that risk. You're assuming that risk because if something happens to your property in California and you're impacted by a wildfire, they just raise your insurance costs the next year. We'd naively thought that all the insurance companies had it figured out, but they don't. But if you walk through that analysis, if the price of your insurance goes up by a significant amount or if you are no longer able to be insured eventually that results in perhaps reverse migration from some of these places that are more difficult to live in. Or if you're a municipal bond if one of these events impacts your infrastructure pretty significantly, it impacts your viability as an entity to have capital to improve that infrastructure.

Wendy Cromwell:
And you can imagine this chain of events. So no insurance, people move out, need to raise taxes to improve the infrastructure. There's fewer people to raise tax base on. That creates kind of this vicious cycle of reverse migration out of some of the more popular places we've seen migration to even within the United States. So that's sort of a small place based example.

Tony Davis:
A few quick things. We look at insurance costs. We look at the amount of down payment required by the banks. We look at our main stream, sort of the banks pulling back from certain sectors. So we saw in the credit space last year some of the underperformers in energy where you had long-dated reserves, certainly in thermal coal, oil sands, private prisons, areas where you're just seeing financing pull away. We look at carbon prices. We own CCAs in California. We watch EUAs carefully. And then just look at the equity markets. I mean, you really, even in the last six months, you started to see real out performance of companies that are leading on climate solutions I would say. It hasn't been as reflected as much in some of the shifting cost curves that I talked about, but we are seeing out-performance of renewables et cetera, certainly relative to traditional fossil fuels.

Speaker 8:
I have a question probably more for Wendy and Audrey, because you've both given very specific examples of fundamental research insights that you've been able to get based on evaluating either climate data or specific ESG data and how that gets embedded into valuation models. But we just heard in the prior presentation about this sort of focus on ETFs and passive investing and how that's the wave of the future. And I'm just trying to square this phenomenon because it does take time, energy, and effort to come to those stock-specific insights. But if clients aren't willing to pay for them, how will we actually advance the ball or will there simply be lost alpha that's never uncovered?

Wendy Cromwell:
It's a great question. I also think that this is very difficult to do quantitatively because quant investors are inherently looking for empirical evidence that something has unfolded in the past. And you're thinking about climate, the risks are increasing in the future. You're not going to find the answers over the past 20 years of analysis. Now, George has done great academic work to prove that if you're focusing on material factors that there's some alpha there and that is by using historical data. And so I often use that. I call it the seminal study for when people are asking for the academic paper that supports ESG.

Wendy Cromwell:
But I do think it's really hard to do quantitatively. And I think you're raising a good issue. If the active managers are doing deep dive research and we really feel like we're finding insights, but most clients are doing passive investing then what are we actually doing and how are we advancing this agenda within economy, societies, investments, capital markets? And once we started to see the severity of the information that was unfolding over a shorter time period than we imagined we felt compelled to do more than just invest on behalf of our client beneficiaries.

Wendy Cromwell:
And in terms of changing how we're making decisions, clearly we want to do that. That's our fiduciary role. But that's when we started to develop more engagement strategies. We created an engagement document. We started looking at all the CDP disclosures for the companies that we own, combining that with the map, seeing if they're actually acknowledging that they have this exposure. Often they're not. If they are, asking them what their plan is for deepening and diving into that and actually accommodating that physical climate risk. And by doing that, that's where we think that we're having more of an impact sort of at a greater level rather than just in our portfolios, because if you help those companies to prepare, if you make them aware, if they don't know you make them aware and you help them to prepare, then ultimately you're building resiliency into the system via engagement, which is different than the transition risk engagement that might be talking more, which we also do talking more about their emissions and their commitment to an energy transition.

Audrey Choi:
I would just sort of say, I mean, just add to that I mean, I think you're totally right. I mean, it is very hard right now and especially as you try to get to some of the products, that are more available to all investors, not just sort of the ultra high net worth or institutions that can get these highly tailored, highly specific customized products. I guess I would say just more on a kind of a macro basis to just think about where we are as the field is developing, right? I think that we are still in this incredible sort of primordial soup stage of the industry, trying to figure out how to tailor these products.

Audrey Choi:
And what I think has been actually incredibly both important and a real thing for us to watch out about is we've seen this enormous groundswell of investor interest, including from the millennials but also from large institutions. And look, I think we all have to be... I think everyone here who's involved in the industry I think this is a time where we all need to proceed with incredible rigor and caution. And we we were really excited to be able to work with Pepsi on their most recent green bond, billion dollar green bond, largely dedicated to plastic reduction in their beverage chain. That issuance was so oversubscribed that Pepsi really saw a significant financial upside from it where you had investors who could have chosen from a financial perspective and similar to what you had from a financial perspective almost identical paper that was available in the secondary market from Pepsi, and investors actually paid up to get the green paper.

Speaker 8:
Yes. This gets back to a issue relating to the science of climate change in which there are tipping points. And I'm amazed in the age of information that we have that the flow of information between science and economics is so slow or that the gap is so great. And my question is, do you on the panel, think there will be tipping points in the world of finance that will trigger rapid change such as when a piece of a glacier falls off and markets fall and what will be the signals? Morgan Stanley just said if we don't change course humanity's wiped out. So now it's the bankers who are starting to say this. But are there going to be tipping points in the world of finance or insurance that will cause disruptions?

Tony Davis:
I mean, Mark Carney has referred to this maybe as the tragedy of the horizons. And I think the way that we accelerate what the future damage is going to be and loss of economic output is a price today. So I think when you do see a real price, and there was some discussion earlier about what does that have to be, I personally think if the US and Europe were to move to pricing carbon and put it on a border adjustment tax that would be a tipping point.

Wendy Cromwell:
We may be in the midst of a modest tipping point, at least right now, because one of the things that I've observed as in the last 12 months this will resonate with this audience. It does not resonate with a millennial. But remember when you had a stereo and there was a knob and the volume dial? Okay, it could go from a 2 to a 10. That's what I-

Wendy Cromwell:
Pardon? That's what I've observed, is the volume has gone from a 2 to a 10 in 12 months around sustainable investment generally, but I think it's being driven by the intense awareness of climate change because climate change is starting to be recognized, the physical implications of it. So I think we may be in the midst of a tipping point now. One of the things I wanted to mention about physical climate risk because I want to emphasize, I think it's really important to work on transition risk and mitigation and aligning your portfolio with a two degree scenario and all of that. And I think it's important to understand your carbon footprint.

Wendy Cromwell:
But one of the reasons that we also need to work on physical climate risk is because no matter what we do, if we stop emitting everything today, or if we continue on the same path, those two scenarios don't diverge in terms of their implications until 2035. So what we have for us in store for the next 15 years is already predetermined no matter what we do. So we need to understand that in addition to working on the 2035 and beyond periods and how we make those better. And that's why we're all in trying to encourage everyone to focus on those physical climate risk issues.

Audrey Choi:
The only other thing I would add is, again, I think that whether or not there is one point where there was a huge glacial calving, I think that we may be more in a situation where we've got a number of snowballs that have started gathering sort of steam down the mountain. And I think one of the really significant ones has been, as Tony referred to you, some of the regulatory issue. The fact that you've got the NGFS with more than 50 central banks and multilaterals talking about climate change as a financial risk that Carney really started with all of the work there from financial stability board.

Audrey Choi:
We're definitely seeing more and more risk officers, whether it's at insurance companies or banks or asset owners saying, "This is a fundamental risk. It has to be in it." We're seeing more regulators saying it has to be there because... And again, while certainly the role of leadership and US leadership is important, the fact that we all live in a global market, if the PRA in England says we have to do it, it doesn't really matter that we're US domiciled, right? So I'm actually encouraged that between regulatory moves and frankly also the voice of consumers saying that they're going to really vote with their feet and their dollars in their decisions could be sort of the snowballs we need to get rolling down hill for an avalanche of good.

Luca Albertini:
Very briefly from my perspective, the landslide for me is business interruption, which is one part of what we insure, and business interruption sometimes shows the risk where no one understood it was in the first place. So I give an example, the Thai floods in 2011 blocked the Japanese electronic industry, right? A number of reinsurers say, "Hold on a sec. I got a Japanese claim out of a Thai flood, right?" And things were not coming to London, cameras were not coming around Christmas. And what this is showing is first sometimes because we are trying to delegate or to buy from the cheapest place we do not necessarily have the supply chain in the best places in the world or the most well defended. And the second one is the claim properly insured or not.

Luca Albertini:
And again, so my point for me in terms of tipping points is when shareholders see that there was an uninsured loss to the supply chain or business interruption they should ask questions. And why asking the questions why were you there, why were you not insured. And if you answer these two questions, well, you start going in the right places and buy insurance.

Prof. George Serafeim:
Thank you very much all on this super interesting information, both on adaptation and mitigation.

Mike Toffel:
In hearing the diverse perspectives on this panel two important points stood out to me. First, we're starting to see some interesting innovations from the financial sector regarding climate change. Luca Albertini talked about the risk climate change is posing to coastal properties. This is an area ripe for innovation. Swiss Re for example, teamed up with The Nature Conservancy and regional governments in Mexico to develop an insurance product to protect coral reefs along the Yucatan Peninsula, which are vital to the tourism industry there. The insurance product covers the cost of repairing coral reefs after a storm as coral reefs are known to protect coastlines and prevent beach erosion. Protecting this natural resource protects the coastline that drives the local economy.

Mike Toffel:
Second, the growing amount of climate data being collected will increasingly highlight current mispriced risk in both the debt and equity markets, which will begin to send a stronger signal to companies to assess and manage their climate change risks. As partnerships like the one between Wellington and Woods Hole produce more data on the physical risks of climate change and incorporate them in investment models managers seeking funding will be motivated to demonstrate their understanding of these risks and how they're managing them. These growing connections between climate data, investors, and managers provides an important and exciting opportunity for the investment community to create value by changing how they manage portfolios and also how they influence the companies they invest in. That's it for this episode of Climate Rising. Next time-

Speaker 10:
You have to think about worst case scenarios. There's always going to be a distribution of potential outcomes in the future. The purpose of risk management is to think about how bad could it be.

Mike Toffel:
Thanks for joining us. I'm your host, Mike Toffel. This is Climate Rising, a podcast produced by the Business and Environment Initiative at Harvard Business School you can subscribe on Apple podcasts or wherever you listen, and please leave us a review. We appreciate the feedback. You can also find show notes and links to resources discussed on this episode on the Climate Rising website, climaterising.hbs.edu.