How climate risk integration is disrupting the Chinese investment landscape

That investors should care about climate risk seems like a statement of the obvious; acceptance of the potential dangers of climate change and the need to accelerate the green transition are now widely accepted among policy makers, financial market participants, and beyond. Indeed, assessing and quantifying the impact of climate risk on individual investments and portfolios is now standard practice across much of the industry, with climate-related reporting and disclosures becoming mandatory in some jurisdictions. Yet, amid an increasing global focus on these issues, many investors in Chinese equity markets have, so far, largely ignored the significance of climate risk, while others have certainly been put off by a perceived unwillingness among Chinese corporates to address these issues. However, this is certainly set to change as the impacts of both global and domestic Chinese regulation, as well as consumer preferences and the possible impact of extreme adverse weather events, are increasingly factored into analyses of the future growth potential of Chinese companies. These changes will lead to an evolution of the Chinese equity landscape, as well as bringing in potential investors who were previously sceptical of attitudes towards these risks in the Chinese market.

Chart 1: Global equity return sensitivity to increase in the climate risk indices

Source: HKMA, Research Memorandum 08/2021, ARE INVESTORS SENSITIVE TO CLIMATE-RELATED TRANSITION AND PHYSICAL RISKS? EVIDENCE FROM GLOBAL STOCK MARKETS. This charts shows global equity’s return sensitivity to changes in climate risk indices. Each pair of blue and purple bars represents equity return sensitivity to increases in the transition and physical risks indices, respectively, for firms in the green/brown categories specified along the x-axis.

Climate risk can be broken down into two areas: physical risks and transition risks. Physical risks encompass the potential for damage to assets and productive capacity caused by acute climate-related events such as wildfires and floods, as well as the impact of chronic changes such as temperature, water shortages, and sea level rises. Indeed, issues around water present unique challenges for Chinese corporates in several ways. In terms of sea level rises and extreme weather, China’s population and its economic output is focused on densely populated low-elevation and coastal cities, accounting for around 33% of its GDP.1 Furthermore, problems with water scarcity and pollution have long been potential causes of political and economic instability in parts of China, and resolving these issues will be key to China’s ambitions to be a global biodiversity champion.

Whether recent extreme weather or weather-induced events seen across the globe – such as wildfires in the US and Australia, and floods in Europe – are linked to climate change or not, climate-related physical risks certainly represent the greatest potential financial hazard for corporates in the short term, and something that perhaps requires particular attention in China. Furthermore, these types of risks can be hard to assess and quantify, and often depend heavily on corporate disclosure of relevant data.

Transition risks, on the other hand, largely stem from the impact of government policy, but also include the effects of both technological development and changing public sentiment on company performance. These types of risks are, in many cases, easier to quantify through rules and mechanisms that allow us to assess potential impacts on asset value and business costs. This relative ease in identifying and quantifying transition risks means that it is these risks that are now receiving the greatest attention are set to be thoroughly integrated into analysts’ and investors’ assessments of Chinese equities.

For transition risks – both with respect to Chinese companies and beyond – decarbonization is the main theme driving changing regulations, technological developments, and public sentiment towards companies and brands. Looking domestically, China’s “3060” decarbonization plan – the goal of hitting peak carbon dioxide emissions by 2030 and carbon neutrality by 2060 – encompasses several elements that will impact companies in different sectors to varying degrees depending on their absolute carbon emissions and their intensity of carbon use. For instance, the Chinese national emission trading scheme (ETS) began operating 2021 covering over 2,000 companies in the power sector, and its scope is set to expand to cover further industries. Aside from its expansion to cover more sectors, the aims for the ETS in the coming years include specifying long term carbon reduction targets, building out the necessary legal framework, enhancing corporate carbon data quality and disclosure, and potentially increasing the carbon price. These are all factors that present varying risks – and potential opportunities – to Chinese companies, and the growing impact of the ETS is something that all investors in Chinese equities must now consider.