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5 Investment Risks Created By Global Warming

5 Investment Risks Created By Global Warming

Climate-change deniers and believers alike would be wise to prepare for the worst.

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By Investopedia.com 04.05.2011

If the Earth's climate continues to see more weather and temperature volatility, new types of risk will rise to the forefront of corporate and individual concern. Investors should begin making themselves aware of some of the major threats to future economic growth and some of the industries that could be most affected. This article will look at how the nature of insurance and risk prevention may change as various climate-based risks continue to be assessed globally by governments, corporations and individuals.

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What Can We Expect?

There is still discussion over exactly what will happen if the Earth continues to heat up, or if the Earth is truly heating up at all, but this is not an article aimed at the ins and outs of that debate. Instead we will look at some of the most commonly cited effects of global warming and what they could mean to investors in the future if they come to pass.

According to the Intergovernmental Panel on Climate Change, there are five effects that we can reasonably expect to see as a result of continued global warming. They are: 

   1. Warmer weather (more hot days, and heat waves of longer intensity)
   2. Drought (prolonged periods of low precipitation)
   3. Rise in sea levels
   4. More "severe weather" incidents (hurricanes, flooding/fires, winter storms)
   5. Health issues (heat-based illness and disease)

Source: Climate Change 2007: Impacts, Adaptation and Vulnerability, Intergovernmental Panel on Climate Change, April 2007.

Some of these events may happen over long periods of time, while others could strike suddenly. Any of them will cause economic loss on a wide scale should they come to pass. Next let's examine five risks that - while not absent from the corporate horizon today - may take on new twists as they become increasingly costly to protect against in a future with unpredictable climate shifts.

Five Emerging Risks to Watch

In addition to general concerns such as higher energy costs and property loss from bad weather incidents, companies could also face increased risks that a major supplier won't be able to provide base goods and services, or that a major shortage in one or more raw materials leads to a hyperinflation scenario where costs skyrocket and corporate profits evaporate. Companies can often hedge against major price changes or other business risks by trading in derivatives, but even their pricing is determined by simple volatility assumptions that could be proved terribly inaccurate in one fell climate swoop. Let's look at some of the emerging risks in greater detail:

Agricultural Risk

This risk could be the result of many scenarios described above; most crops have a specific list of needs and climate factors that must be met to grow. And because food is an absolute necessity, any shortages will lead to severe price increases and eat away at the discretionary income for ordinary consumers. Globalization may become a strong ally here; as an economy develops more trading partners, it can partly diversify against this risk. For example, if a nation in the far-Northern Hemisphere were exposed to increasingly warmer temperatures, it might partially become a new major exporter of agricultural goods to nations that previously could sustain their own consumption.

In extreme cases, agricultural risks like widespread flooding could even lead to population migration, which would put simultaneous strains on several different economies.

Energy Risk

If carbon taxes, market-based carbon trading or the like is implemented, energy costs could rise dramatically. It may become relatively cheaper to create or purchase alternative energy for both businesses and individuals. However, this will come at loss of short-term profitability or disposable income.

The fact that worldwide crude oil demand is steadily increasing paves the way for higher prices for our current sources of energy as well. Because energy is a major cost component for almost every industry, the list of those affected will be large. Opportunities will exist, however, for energy companies that can produce low-cost power or serve areas where higher temperatures lead to more demand for cooling.

Property Risk

This will affect various industries in different ways, but all will be affected if higher property/casualty insurance becomes widespread. Insurance costs are already on the rise in certain geographic areas seen as high risk, and these trends will continue. Property-based industries like travel, REITs, hospitals and retail will face markedly higher risks. In extreme cases insurers may withdraw coverage altogether for certain areas. This could force some businesses to shut down completely. Private and government residences also face increased insurance costs, which could lead to lower investment-based real estate activity in some densely-populated areas of the globe.

Litigation Risk

If regulations on carbon-based emissions become more stringent, we will see more litigation against major offenders to the environment. Obvious targets include the major carbon-emitting industries, like energy, forestry, transportation and agriculture. Litigation concerns will linger over companies regardless of the outcome of specific cases, and could cramp asset and stock market valuations that are based on a long-term estimate of cash flows.

Risk to Climate-Based Industry

Tourism revenue is typically skewed toward coastal areas and temperate climates. Many of these areas are at the highest risk to be affected by major weather incidents and broad global warming. Future projections for travel could be adjusted downward well in advance of actual events, which could affect a wide swath of companies who make money on tourism, such as hotel operators, airlines, cruise lines, restaurants and entertainment providers.

Looking Forward: What Needs to Be Done

Highlighting these risks isn't meant to scare you away from investing in companies that face them. Rather, the goal is to make you aware of what may happen, so that you can identify those companies that show leadership in preparing for these scenarios, whether it is by measuring carbon emissions, sourcing alternative energy or funding other green projects. Many companies will be able to succeed (and even thrive) by finding innovative solutions to mitigate these risks.

It is the insurers who will pave much of this road - they will set the pricing for the ability to ensure against the risks mentioned here, or they may choose not to at all. The broad investment community will also be casting millions of votes regularly in the form of industry and company stock valuations, access to the credit markets, and mutual fund flows. Companies with poor operating histories toward the environment may get depressed earnings multiples in the market, as the perceived ability to generate earnings in the future will be questioned.

Parting Thoughts

By fostering initiatives they might otherwise have shunned, companies can create their own insurance policies by promoting public goodwill and creating new potential sources of revenue to make up for losses in other business areas. Citizens - and the governments that represent them - can help spur innovation by pledging themselves to combat climate change and support initiatives that do so.

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