Avoiding a 'carbon bubble' is front of mind for a growing number of investors. Credit:Simon Bosch The group's draft report in December called for sweeping changes to how much big companies should tell investors about their climate change exposure, and how they plan to manage these risks. And as a carbon-intensive economy with $2.1 trillion in retirement savings that is heavily exposed to equity markets, Australia has plenty at stake in this debate. "I think the penny is dropping for everyone that climate change represents one of the most important financial risks for investors," says Ross Barry, head of research at $59 billion fund First State Super. "It's not a 50-year thing, it's a here and now problem."

Yet at the moment, these risks remain highly uncertain, and therefore have potential to be a source of market instability. Of most concern to regulators, assets spanning energy, mining, agriculture, transport and manufacturing could be significantly affected by policies to stem carbon emissions, or shifts in technology. Financial markets are designed to "price in" such risks, but they cannot currently do that because they simply don't have the information. Bank of England governor Mark Carney said in December it was clear investors don't have the information they need to determine which stocks would be most vulnerable to weather risks of climate change, or who might have the winning strategies to profit. It's not a 50 year thing, it's a here and now problem. First State Super's Ross Barry

"This must change if financial markets are going to do what they do best: allocate capital to manage risks and seize new opportunities. Without the necessary information, market adjustments to climate change will be incomplete, late and potentially destabilising," he said. Avoiding this scenario – a "carbon bubble" – is front of mind for a growing number of investors, pressuring the highest levels of corporate Australia to take the issue seriously. Most corporate commentary on climate change is buried in sustainability reports that few investors read too closely. It's handled by the teams that deal with environmental, social and governance issues, rather than the bean counters. And even when companies do disclose more systematic data about their carbon foot print, this too is patchy and inconsistent. It's been estimated there are 400 schemes around the word designed to boost carbon disclosure – but such an ad-hoc approach makes it near impossible to get a clear picture of where the climate risks lie in the financial markets.

Concerns about such risks among investors, regulators and the emitters themselves prompted the G20's Financial Stability Board (FSB) to appoint a taskforce looking at climate risks in the markets, including some of the world's biggest companies and investors, such as Blackrock, AXA, JP Morgan and BHP Billiton. BHP Billiton's vice-president of sustainability and climate change, Dr Fiona Wild, is one member of the panel, which is chaired by billionaire Michael Bloomberg and is recommending a voluntary disclosure regime on climate risks. It will report to G20 leaders when they meet in Hamburg this July. "Corporate reporting of material risks has always been a feature of disclosure regimes. But I think reporting on climate change is often potentially misunderstood, or unavailable, or non-comparable or incomplete," Wild says. Such a lack of consistent data creates an information vacuum of sorts – and in financial markets,that can breed instability. That risk is particularly acute when there are deep-seated or "structural" changes taking place, such as moving away from fossil fuels towards new types of energy.

There is a fear this instability could spill into the broader financial system, through loans held by banks, insurance policies, or investments of pension funds. And Australia may well be more exposed than most. AMP Capital last year estimated Australia's economy would need a bigger reduction in its emissions intensity than the United States, Europe, China, India, Japan, Korea and Indonesia, if we are to meet a commitment to limit global temperature rises to 2 degrees. It found a carbon price of $50 a tonne would put about 9 per cent of the ASX200 index at risk, with the vast bulk of these emissions coming from utilities and miners. Surprisingly, this was lower than the MSCI world index of global shares. But either way, it is a very substantial pool of at-risk assets. The Australian Prudential Regulation Authority last week also made the first detailed comments from a domestic regulator, showing how seriously they view these risks.

The shift towards less carbon-intensive forms of energy could trigger a "significant repricing of carbon-intensive resources and activities and reallocation of capital," executive board member Geoff Summerhayes said. APRA was "keenly aware of potential systemic implications". APRA's Geoff Summerhayes. Credit:Jessica Hromas Globally, Bank of England researchers conducted a "thought experiment" recently on the central bank's blog, which sought to quantifying the potential size of losses that could face investors. If big energy companies were forced to start cutting their dividends by 5 per cent a year from 2020, until dividends reached zero in 2050, they said this would wipe out some 40 per cent of these shares' value. That would be equal to a fall of 11 per cent in the entire world's stock markets. "If such a repricing were to take place reasonably rapidly, as we have argued it could, it might have the potential to entail risks to financial stability. And, historically, equity price changes of this size have sometimes been associated with shocks affecting the wider economy, not least given the impact they have on individuals' wealth," the researchers wrote.

It is these types of broader financial stability risks, as opposed to environmental concerns, that are primarily motivating investors and regulators through the FSB. The response being proposed is to elevate climate change into an issue that is no longer buried in sustainability reports, but something that's in the financial reports released to market. "Once you put it on your financial statements, companies start to treat it differently," says the chief executive of the Investor Group on Climate Change, Emma Herd. "Climate change is one of those issues that will never be material in any historical reporting period, right up until the point where your whole industry goes out of business." For Australian companies, which have seen climate change slip off the agenda of government, this could all prove to be quite a wake-up call.

BHP and AGL Energy – which are regularly cited by climate investment experts as disclosing much more on climate risks than most – may provide a taste of what awaits much of corporate Australia. Both have released detailed modelling that sets out how they would be affected if the world meets its target of limiting the temperature rise from climate change to 2 degrees. AMP Capital's head of ESG investment research, Dr Ian Woods, says this is a very different exercise to estimating how a company would fare under current government policies. A world in which temperature rises are kept at 2 degrees or less should be "a very core policy that companies should be thinking about and disclosing on", he says. Yet beyond AGL and BHP, Woods says disclosure by Australian companies along these specific lines is "pretty patchy".

Scenario planning in corporate offices may not sound too exciting, but Woods says it is important because it is a way to force executives to think about uncomfortable outcomes – like forcing banks to "stress test" themselves against a collapse in the housing market. "It forces them to think of the world in maybe a way, they don't want the world to go, and to think about how will their business be positioned in that scenario," Woods says. AGL, an electricity giant, conducted this type of scenario analysis in 2016. It showed that while current government policy would lower the net present value of its power stations by 5 per cent, limiting global warming to 2 degrees would lower the base NPV by some 25 per cent compared with no carbon price. There is also potential to gain, of course, such as by investing in renewable energy assets. Tim Nelson. Credit:Michele Mossop

Chief economist at AGL Energy, Tim Nelson, says that by revealing their climate change modelling, companies could give investors greater assurance they were attuned to the risks, and opportunities, on offer. Aside from disclosing their climate strategies, companies also need robust governance arrangements to show the issue was being taken seriously and acted on, such as board level engagement, he says. "It's not just the materials, but it's also the governance and strategic aspects of how boards are dealing with climate change," Nelson says. More broadly, initiatives such as the FSB-led push on climate change disclosure can make the inevitable change to cleaner energy a less bumpy ride for investors, customers, and affected staff. "The more sudden the structural change in the real economy, the more you see negative effects, whether it's on consumers, employees or investors," he says.

If there is a "glide path" rather than abrupt change – something that greater disclosure should encourage – "it's a better outcome for all those stakeholders". BHP, the world's largest mining company, also undertook a similar analysis in 2015. Wild says this showed that even on a fast move away from fossil fuels, the low cost and diversity of its energy and mining assets shielded returns. "Even if the world shifts away from fossil fuels, there's still value there from those high quality, low-cost assets in our portfolio." Even so, the exercise still forces boards to look through any current decisions through the lens of climate risks. "It gives you a frame to think about the future. We don't know what the future looks like, but scenario analysis enables us to think about a broad range of plausible but divergent futures, and make investment decisions today that are resilient across that range," Wild says.

As well as big emitters, companies with indirect exposure to these risks, such as banks, face pressure to reveal more about how they are handling climate risks. Westpac, ANZ Bank, National Australia Bank and Commonwealth have all made noises about shifting towards more renewable energy and managing their carbon risks. After shareholders pressure, they all disclose more data on their "financed emissions" – the carbon footprint of their business customers. Kate Mackenzie, head of finance and investment at the Climate Institute, says another important recommendation from the FSB taskforce has been for banks to disclose extra details on their potential exposure by geography and industry. Insurers would also be asked to disclose their modelling of climate risks. "The location of assets or collateral is important for climate impacts and an increasingly useful way of analysing carbon risk going forward," Mackenzie says. As companies grapple with the many unknowns, pension funds are getting on with making their own assessments of how climate change might hurt their members' nest eggs.

This is happening across several funds' entire portfolio, and not only in the "sustainable" options. One fund leading the charge is Local Government Super, which manages savings of council workers. It was at the forefront of moves to divest from tobacco stocks, a move many others have followed and it has predicted a similar level of awareness about the investment risks from climate change. Bill Hartnett, head of sustainability at the $10 billion fund, says it already applies a screen to all of its investments to determine potential climate change risks. This policy, introduced in 2014, has resulted in the fund divesting from 25 companies that derive more than 33 per cent of their revenue from coal mining, oil tar sands and coal-fired generators.

"Once you start to accept the science of climate and that there are significant risks associated with it, and it's fundamental to fulfilling our fiduciary duty," Hartnett says. "Screening is one of many approaches we take, along with low carbon investments and shareholder engagement and voting, to address these risks." He says the FSB taskforce proposals, if adopted, would give investors a better handle on managing climate change risks on behalf of members. "It will enable us to better understand and compare the risks and measure the risks," Hartnett says. First State Super has taken a different approach, though it too is putting all of its assets under the microscope to test their vulnerability to climate risks. Head of research, Ross Barry, says while it has the option of dumping stocks because of climate change risk, it has not yet gone down this path.

Rather than divestment, the fund is more focused on engagement with big carbon emitters. Barry says this too can have a real impact for investors, especially in a market like Australia where a few large pension funds can be very influential. "There is increasing activity among large pension funds, who are engaging with corporate Australia in a constructive way," Barry says. "Over time there's a meaningful return dividend." Divestment also comes with risks. Some coal prices doubled in 2016 – so investors who dumped coal stocks at their lows have missed out on that rally. "Excluding fossil fuels altogether can lead to quite significant variations in returns relative to a broader benchmark," Barry says.

One of the largest for-profit fund managers in the country, AMP Capital, is also conducting an audit of climate charge risks across its entire $64 billion in equity funds under management. The findings, which includes overseas and some managed externally, will be released later this year. AMP's Woods also emphasises that the global push from the G20 give big fund managers such as AMP the chance to have "a more focused discussion" with the companies they invest in. When someone as powerful as the Bank of England's governor is talking about climate risks, he says "it gives the discussions we have with companies much greater weight". It is hard not to contrast this momentum with domestic politics, where the government led by Prime Minister Malcolm Turnbull, once a keen advocate for a price on carbon, last year abandoned plans to consider an emissions intensity scheme, a type of carbon price. Loading

But government policy is only one influence on how large corporations respond to a threat as complex as climate change. Whatever the politicians decide, boards can expect to hear more from their investors and regulators about how they are managing the risks created by a warming world.