The Fed is concerned about climate change, are you? | Smart Beta Channel

By Eric Dutram, Contributor, DWS

Twice a year, the Federal Reserve puts out an assessment of the “resilience of the U.S. financial system”, highlighting key risks and potential flashpoints that Fed members are watching. While this often focuses on traditional metrics such as valuation, borrowing levels or leverage, the latest edition added a new issue. For the first time, the Federal Reserve’s Financial Stability Report mentioned climate change as a threat to the overall health of the system.[1]

In this landmark addition, the Fed stressed the potential for climate change to increase the “likelihood of dislocations and disruptions in the economy”. Part of this is based on the fact that it remains to be seen how and when a changing climate will impact assets and to what degree. In addition, there are often limited disclosures in terms of which assets could bear the brunt of a changing climate. As such, the Fed notes that we could see “sharp repricings” of risks for some assets which could hit the overall financial system.

While the Fed noted that it is still in the beginning stages of its evaluation process, we think this is an encouraging start nonetheless.

Here at DWS, we welcome the Fed’s addition of climate into the overall risk picture. We believe that this is something investors need to be aware of and consider when building portfolios. In fact, climate risks have been a focus of ours for quite some time and we have recently highlighted just how intense the threat from climate change may already be according to some metrics. One in particular that is rather striking is climate risk by net capital invested.

NCI in focus

Net capital invested takes a closer look at companies’ investment into items such as property, plant and equipment, helping us to quantify how much of that investment is at risk for climate change. Our model breaks down this net capital invested into four major buckets of risk: “low”, “moderate”, “high”, and “excessive”.

For investors, this analysis is vital because, according to our research team, potentially the “best way to measure the genuine climate impact of a company is to focus on its capital”.[2] Capital-intensive assets can often have a stronger link to climate, while net capital invested may provide a more accurate risk assessment than simply by looking at market cap-related climate risks alone. And from this metric, no major economic region is safe:

Climate risk by net capital invested

As shown in the chart, Japan is the “best” positioned with just 20% of net capital invested at a potentially high climate risk level, though all major regions have a plurality of net capital invested in at least the “moderate” climate risk level, if not more severe.

For the United States, a full third of net capital invested falls into the “high” risk bucket or greater, underscoring the potential of climate issues to wreak havoc in the future. Meanwhile, over half of the net capital invested in GEMs (global emerging markets) is classified as “high” risk, putting it by far in the most precarious position from this perspective and suggesting this is a worldwide problem as well. No wonder the Fed is incorporating climate risks into their models as well.

Bottom line

The Fed is taking climate change seriously as a potential threat to the American financial system and its stability. Given the importance of the Fed in the marketplace and the possibility of directives coming down the pike from either a political or regulatory perspective, it may be increasingly important for investors to take these kinds of risks into account for their own models as well.

Fortunately, we have extensive research on the topic from both a regional and company specific basis in our ESG research center. Incorporating Environmental, Social and Governance metrics into a portfolio may help investors take key risks—such as climate change—into account. For more on ESG and climate-related research, make sure to check out our ESG page for additional details.

Originally published by DWS, 11/19/20

1. Financial stability report 11/09/2020

2. Climate risk and corporate capex, DWS Research Institute, June 2020

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