136: Circle the Square – Environmental Risk and the Repricing of Stability

In this special episode of the  [i3] Podcast, we're partnering with the University of Technology Sydney for the Circle the Square roundtable discussion. Today's topic focuses on environmental risk and the repricing of stability. For most of financial history, the environment was treated pretty much as a given, stable enough to model around, reliable enough to insure against, and predictable enough to build on, but that assumption is now under pressure. Follow the Investment Innovation Institute [i3] on Linkedin Subscribe to our Newsletter Explore our library of insights from leading institutional investors at [i3] Insights Key Takeaways The foundational assumption is breaking. Finance, insurance, and infrastructure planning were all built on 12,000 years of environmental stability. That stability can no longer be taken as a given, which undermines actuarial models, long-duration asset valuations, and infrastructure design. Insurance is the canary in the coal mine. Insurers were among the first to feel climate risk directly through claims. APRA has flagged that one in four Australian households may soon be unable to afford home insurance — effectively making the taxpayer the insurer of last resort. Disclosure isn't the same as resilience. Reporting frameworks like TCFD are a useful starting point, but simply mapping risks doesn't mitigate them. True resilience requires collective, systems-level investment — not just individual firm-level action. Short-termism is a structural problem. Pension funds have long-term liabilities but face peer-comparison pressures that punish near-term deviation, creating a mismatch between the time horizon of the risk and the incentives of the managers. The Monday morning question: Are the assumptions underlying your portfolio — on insurability, asset longevity, and gradual linear change — still valid, or are you already running on outdated models? Speakers Martina Linnenluecke, Director, Centre for Climate Risk and Resilience, University of Technology Sydney Kristy Graham, CEO, Australian Sustainable Finance Institute Rob Prugue, Lecturer, University of Technology Sydney, Anchor Fund Wouter Klijn, Host, [i3] Podcast Overview of Circle the Square podcast 06:00 The world has seen a stable climate for the last 12,000 years. What happens when we move into a new regime? "We've assumed that environmental stability was a freebie, but the last 20 years has shown that is not necessarily the case. And the markets are beginning to take notice." 09:00 "Climate and environmental risks are no longer abstract externalities; they are felt across sectors." 11:30 We are seeing that in some countries, climate change is factored into infrastructure planning. Does that happen in Australia? No, but it should 13:30 "Climate science has become a political debate. As a result, policy is set based on the political climate not the science itselft." 16:00 We are seeing increasing standardisation of tools or frameworks across asset classes and providers and that matters because it enables you to look across your portfolio 17:00 "It often starts in an ESG function, which develops a centre of expertise, but in the organisations we work with now it sits right across the whole organisation." 24:30 There seems to be a disconnect between the way in which the investment industry assesses climate risks compared to how climate scientists assess it. "We do see more sophistication around how scenario modelling is used. But there is certainly a communication issue" 25:30 "It certainly is not just a temperature increase; it is a much broader, systemic issue." 29:00 "For a pension fund, to walk away from your long-term liabilities when it comes to climate risk doesn't really add up." 35:30 "APRA is concerned that one in four households will not be able to afford insurance in the future. In coastal towns, it is 50 per cent." The rise of insurance deserts 37:30 The silver bullet is building models that support resilience, rather than the current model, which is disaster recovery after an event has occurred. 50:30 "We don't have DCF (model) for opportunity cost" Full Transcription of Episode 136 Wouter Klijn 00:00 Welcome to the i3 podcast. In this special episode, we're partnering with the University of Technology Sydney for the Circle the Square roundtable discussion. Today's topic focuses on environmental risk and the repricing of stability. For most of financial history, the environment was treated pretty much as a given, stable enough to model around, reliable enough to insure against, and predictable enough to build on, but that assumption is now under pressure. Environmental risk is moving through the financial system in a way that is becoming harder to ignore. Insurance premiums are rising and cover is narrowing. Infrastructure built to last decades is now decommissioned ahead of time, and capital is being asked to fund a transition whose policy settings keep on changing. So, this is not an ESG conversation. It's a question about the structural foundations that finance has always taken for granted, and what happens when those foundations start to reprice. Today we have three speakers who are well placed to assess where the pressure lands in this discussion, who absorbs it, and what the response could look like. We have Martina Linnenluecke, who leads the Centre for Climate Risk and Resilience at UTS, and has spent a career examining how environmental change reshapes companies, industries, and financial markets. She was also a key contributor to the Intergovernmental Panel on Climate Change's sixth assessment report. We also have Kristy Graham, who is the inaugural CEO of the Australian Sustainable Finance Institute, an independent body that works with Australia's largest financial institutions to realign the finance sector and ensure capital flows to activities that will create a sustainable, resilient and inclusive economy. Kristy, I think you were also involved in the establishment of the first Australian Government Impact Investment Fund. And, of course, we also welcome back Rob Prugue, who is honorary industry lecturer at UTS and one of the driving forces behind the UTS Anchor Fund, an educational investment fund managing real money managed by students. The question we're here to explore today is, what does finance do when the assumption it was built on is no longer holding? Rob, maybe I can ask you to set the scene. Has environmental risk moved from externality into something that investors now have to price, underwrite, and perhaps insure? What do you think? Rob Prugue 02:37 Thanks, Wouter. And thank you for this opportunity. I guess, like the rest of us, I too have been wondering for quite some time now about the impact on the environment, not just in my everyday life, but as an investor thinking about capital markets, pension funds and superannuation, and how they manoeuvre around these highly heated discussions around environmental science. What triggered it for me was some years back when I did the Camino de Santiago, and had the good fortune of meeting many people, one of whom was a professor at Oxford, a palaeontologist and climatologist, which is an interesting mix. Naturally, it raised a few eyebrows, and I asked, "Please explain." He said, "Well, we study the environment through studying Earth's history," and he reminded me that, of Earth's 4.5 billion-year history, roughly the last 12,000 years have been the most environmentally stable, and humanity, as we know it, thrived and flourished under that stability. Of course, we had storms, of course we had volcanoes erupting, of course we had floods, but for the most part the environment and the seasons were predictable. That allowed farming, agricultural growth, town growth, and a level of prosperity that humanity had not necessarily seen before. So that got me thinking. If that's true, what happens if we start moving into a new regime, and how will we adapt? We're so accustomed to that stability and predictability that it flows through everything from actuarial science and the pricing of insurance products through to assumptions on long-duration real assets. The generator is going to be there. The airports are going to be there. The assets are not necessarily going to be damaged in ways we haven't priced. For many decades, if not centuries, we've assumed that environmental stability was a freebie, a free get-out-of-jail card. The last 20 years, or even 15 years, has shown that is not necessarily the case. So, while politicians and others debate the science behind environmental science, there are movements afoot. The markets are beginning to take notice. Wouter Klijn 05:22 Yes, Martina, if I can move to you, do you already see a realisation of this entire strategy and potentially more on the operational side of businesses? Martina Linnenluecke 05:35 Yes, I think we are definitely seeing that climate risks are increasingly factored into decision making, and the science is clear. We are going to see very fundamental changes in environmental conditions. We are going to see massive shifts in temperature. We are going to see changes in extreme events, which are going to be very impactful, and in the conversations that we have with leaders in industry, we can definitely see that these risks are already felt. Certainly not across every sector to the same degree or extent, but we do see that some sectors are starting to be very concerned, especially when we look into changes in extreme events and how that affects everything from supply chain, cash flows, asset values, insurability, financing costs and operations, but also strategic viability. So, there's now a real question around where should we invest, how are we investing, and what can we do to protect these investments in the long run. In many sectors, especially those with long-lived assets, these are very difficult considerations, because some assets have lifespans of 30, 40, 50 years. We can't just go in and replace all that infrastructure all at once. That also means it's very important at this point in time to really see how we can make those decisions going forward, so that they last us for the next 20, 30, 40 years, in a way that is climate adapted. So, from my point, climate and environmental risks are certainly no longer abstract externalities. They are felt increasingly across sectors, they're already impacting strategic decisions, or have at least started to in many sectors, and we also see that these risks are becoming more visible generally across our communities as well. Examples include flooding, bushfires, and heat stress. In particular, we're getting more and more days with extreme heat. We see supply chain disruptions as a result. We see water insecurity concerns, also around food supply and food supply chains. But that's only the impact side. Then we also have the transition risk on the other side. What's happening in terms of changes in regulation and technology is certainly very impactful in some sectors as well. In Australia, now we've got mandatory climate-risk reporting, which to some extent is more of a reporting than an adaptation exercise. But I think it is definitely raising awareness that there are physical risk and transition risks coming in. In other markets, we already see carbon being priced in, but also investor expectations are changing. So, yes, we see that these environmental risks are starting to become more visible, and they're starting to be integrated. Environmental change is definitely starting to matter from an economic perspective. But in particular at this point in time, the question is also, how can we adapt to these changes, and adapt to them in a way that makes sense, while factoring in the very significant environmental changes that we're seeing. Wouter Klijn 09:01 Yeah, so you mentioned that some investments have longer term horizons, 30 years. What does that mean when you look at it by asset class? Infrastructure often has a very long lifespan. You can take that both ways, either, well, we won't divest from this investment for another 30 years, so we have time, or you can think, well, we're going to hold this for 30 years, we have to start now to understand what's happening to this asset over the longer term. Do you see any approach to that? Martina Linnenluecke 09:33 What we definitely see is that in some countries climate change is very much factored into infrastructure planning. So when infrastructure is built now, there needs to be a provision, for instance, for sea level rise. When we look at road infrastructure, bridges, especially in exposed and vulnerable areas, they are being built with a certain consideration for flooding, for sea level rise, and for other types of extreme events. Has that necessarily happened here in Australia? Perhaps not. Should it? I think so. But that includes every type of asset that is longer lived. We've got power stations, transmission infrastructure, transportation infrastructure, road infrastructure. Even things like housing are also, I think, a very big area where we need to see changes in climate adaptation happening as well. A lot of the housing stock that we've got here, when you look locally here in Sydney, is not really adapted to climate change. These are not really infrastructures that are built for a changing climate, so I think there's a lot of work to do. The smartest way would obviously be to start factoring in these decisions right at this very moment, so that we are not unprepared 10, 15, 20 or 30 years down the track from here. Wouter Klijn 10:55 Yes, it's a very sort of, I think, already tangible issue, because I was just reading an article about Tuvalu, and they have one international airstrip, and they're trying to raise the land around it, because it's already being affected, not just from high tides, but also from water coming in from the ground because of the rising sea levels. Rob Prugue 11:16 I know that well, because I was meant to be in Kiribati as well, and Kiribati and Tuvalu are going to be among the first climate refugees. But that aside, in long-duration assets, particularly real assets, there's another factor above and beyond what was just mentioned, and that's policy. For some reason, in the last 10 or 15 years, science has become a political debate. We see that in health science. We see it in economics as well, including the idea that tariffs are somehow a straightforward revenue earner, which contradicts what we know. The same is true in environmental science. Policy settings can now change depending on the political agenda, not necessarily on the science itself. Generation is one good example, whether it's coal, gas, nuclear, solar, or in the case of the US, wind farms that were nearly finished and then became too green, so let's turn it all off. Policy is another situation that needs to be considered. Wouter Klijn 12:35 Yep, for sure. Kristy, if we may turn to you. You speak with a lot of the financial institutions here in Australia. Do you see them starting to build tools and frameworks around this problem? Kristy Graham 12:47 Yeah, absolutely. And I would add that it's not new for the finance sector to be thinking about and integrating some of these environmental risks. Just this morning I was at the 20th anniversary of the UN Principles for Responsible Investment, so that is an initiative that has been going since 2006. It now includes in its signatory base over half of the assets under management globally. So it is not just the longevity of long-term investors thinking about and integrating these issues using a range of tools, but also the uptake, particularly in the last five to 10 years, and the penetration right across the financial system. I would say insurers have also been very acutely aware of these physical risks because it impacts very directly on their business models, and banks are increasingly recognising and using a range of different tools and approaches. Where we've got to now is that there are industry-wide standard tools and frameworks, which is very helpful, because previously you could assess transition risk or physical risk in a range of different ways, and it depended on the advisory firm or the expertise you were able to have access to. What we saw with global frameworks like the Task Force on Climate-related Financial Disclosures, and now the ISSB taking up those standards, is that there's a much more standardised way that not just investors and the finance sector, but also the corporate sector, can use to assess and mitigate the risks, but also identify the opportunities. The finance sector are obviously aggregators of information from the real economy, and that consistency and standardisation really matters, so that you can aggregate and look across your whole portfolio. We're not only seeing standardisation of the tools and frameworks, but also a much more sophisticated way of applying them and taking decision-useful information to inform strategy and the future direction of these institutions. Wouter Klijn 14:45 Yeah, we started in the beginning by saying this is not an ESG conversation, this is a much more systemic financial stability discussion. Do you see this as well in the way that organisations approach this? Is it very much like these are a series of ESG tools or ESG framework taxonomies, or is there more a growing sense that this affects everything we do throughout the organisation? Kristy Graham 15:12 I think what we're seeing, as organisations become more mature in their understanding of the commercial realities of all of these risks, is that it becomes integrated into core business, whether that's investment teams, risk teams, product development teams. So we see in lots of the organisations we work with that it will often start in a responsible investment, sustainable finance or ESG function, and they will develop a centre of expertise. But where lots of the organisations we work with now are is that that's integrated right across the organisation. Its reporting might sit under the CFO or the finance function, but there are inputs and expectations that the investment teams and right across the different product teams will all contribute to both mitigating risk and identifying opportunities. Wouter Klijn 16:02 Yeah, now environmental risk doesn't fit neatly into financial models. I was thinking we had one time a conference where somebody stood up during one of these discussions about environmental risk and said, well, one of the reasons why it's hard to deal with is because it's an unaccounted for risk. We don't really know how to incorporate it into our system, and that has to do with different sets of information out there, no standardisation, but also because when you model this out, there are a lot of assumptions that you have to make. These are long-term trends, very far into the future, and it made me think, I was talking to Rob about it, Peter Drucker, the management consultant. He said, "What gets measured gets managed." He didn't say it exactly like that, but close enough. And this is hard to measure. Maybe, Martina, I can ask you, is it possible to build a comprehensive framework around this in a way that is easier to deal with? Martina Linnenluecke 17:03 We've definitely seen the attempt to build a framework with the TCFD recommendations, and now also the adoption of climate-risk reporting here in Australia. I think that's provided a starting point. Organisations are exposed to different categories of risk, and they are guided through a process to assess those risks, looking at physical risk, transition risk and other risk factors. Importantly, it also changes the outlook towards the future. This reporting is no longer about past performance and past financial risk. It's really about assessing what is going to happen going forward. How does our exposure look when we factor in different climate scenarios? In my view, this is the most interesting part of the reporting exercise, but also the most challenging to implement, because it requires a lot of expertise in understanding climate risks and modelling. That is not necessarily expertise that has traditionally been held by companies, or traditionally factored in. There's still a lot of sense-making going on around how best to do it, and a lot of uncertainty around how to make scenarios that sometimes seem very abstract more tangible. How can we operationalise them for the company? What do they mean for specific sectors, locations and assets? There are all sorts of different ways to downscale them, but more importantly, it is forcing exposure to a changed reality. We no longer have business as usual. There will be a different reality, and the question becomes, what does that reality look like? The impacts will be felt differently across sectors, firms and locations, based on exposure, operations, infrastructure and indirect exposures such as energy costs. So there is definitely a lot to think through. It really requires an understanding of future change, and how future change is going to have consequences. There are indicators that companies can now use to report, and under the current reporting structure there are categories that need to be reported on. But in my mind, the interesting part is where we see that there's still a lot of expertise needed to fully engage with future scenarios and what they mean. There is uncertainty in these scenarios, which obviously we have to acknowledge, because the scenarios are not a given. They are changing as we are changing as a society as well. Factoring in different types of policy changes and different types of physical risks will lead to different future scenarios. Sometimes it's confusing when it comes to selecting the best scenario, and there is not necessarily one best scenario to select. That creates uncertainty around what future we should look at or prepare for. But again, it forces exposure and engagement with a changed future. It also requires companies to think through how to address it. For instance, two firms may disclose the same type of exposure to heat or extreme weather, but ultimately it comes down to who has the operational flexibility, resources and capital required to adapt. In my mind, those are the interesting questions that we get into with these types of reporting exercises. Wouter Klijn 21:25 Yeah, so a while ago I looked into the criticism around integrated assessment models and the tendency to look at a very isolated environment and not necessarily take into account trends that move across countries, across jurisdictions, and it struck me that when I looked at the literature that's out there from climate scientists and the way that the finance industry incorporates it is quite different. To give you a tangible example, I've looked at a couple of superfund reports, and they do these scenarios where they say, okay, this is the impact on our portfolio at two degrees, three degrees, four degrees, five degrees, six degrees, and even I think at six degrees it was like, ah, we think it's about 1.2% lower than what it is now. Then I showed it to the climate scientists, and they were like, at six degrees we're dead. So there's a big difference in how they deal with these forecasts. Is there any improvement on that, or what do you think about that? Martina Linnenluecke 22:26 Yeah, look, I think sometimes the scenarios that we see coming out from the sciences are used in a very instrumental fashion when they are incorporated, like you just mentioned, in a report, in a straightforward way, without looking at the bigger picture behind it. We do see more sophistication around it, which is part of this evolution in how companies are engaging with climate risks and future scenario analysis. Part of the issue is that these fields have traditionally not really connected to each other. Climate science was never started with a view towards informing finance, and finance was never started with a view towards needing to be informed by climate science. So, there's definitely a communication issue at the intersection of these fields. But there's also where people like myself come in, with the work that we are doing within the Centre for Climate Risk and Resilience, where we are really looking at ways to communicate those risks, visualise them and make them tangible. The point is to bring them to life rather than have them remain an abstract risk that is just factored in as a number in a modelling exercise. It is definitely not just a temperature increase. It is a very systemic, comprehensive change that we are going to see, affecting all levels of society. If we've got a six degree rise, just to take your extreme example, here in Sydney, there will be parts of Western Sydney where areas might become uninhabitable, or where it will be very challenging to provide enough cooling and shade in some communities. So all of that creates a much bigger systemic issue. Water stress, how do we get enough food on our plates under such a scenario, and other risks like that. I think the systemic nature of the risk is a really challenging part to fully incorporate and fully understand, but I think we need to engage with those questions. Wouter Klijn 24:37 Yeah, and Kristy, what efforts do you see to convert these types of risks into action? Kristy Graham 24:43 Yeah, I think this point that you were making, Martina, about the capability that is needed, and that being probably developed in other disciplines, is something that we work with across the finance sector quite a lot. There's a multidisciplinary approach that is needed for financial institutions to understand these risks, to make sense of them, and to apply them in a business context as well. So we see that being a huge unlocker of not just better mitigating risk, but also capitalising on those opportunities, and being able to forecast, not predict, but to look at the range of potential future scenarios and what that would mean for business models and strategy. At that point, what we do see, and this is across business and finance, is people, because they don't necessarily have the technical capability, find tools and frameworks that make it very clear what and how you need to do as a base level. That is really important and a really critical way to get started in better understanding these risks. As I said, the tools and frameworks are growing, both in sophistication, but also importantly moving from a risk to an opportunity lens, and that's where taxonomies come in place. They identify what sorts of investments and economic activities will support the climate transition. So, rather than needing to understand how different sectors may evolve, and crunch all the science on an individual investment level to see whether a particular technology or activity will support the climate transition to net zero, a taxonomy outlines those activities and measures, so that it's much easier for capital to flow towards those measures that are supportive of the transition. And we see now the taxonomy being adopted across the market. I think we're up to the sixth or seventh taxonomy-aligned transaction in the debt capital market space, and a number of sub-sovereign, as well as bank sustainable finance frameworks, are now aligned with the taxonomy. So, it is something that the finance sector both supported the development of, and now is finding really useful as a tool. Rob Prugue 26:57 Yeah, what I don't understand, because I've heard that before as well, Wouter, is that other than maybe endowment funds, pensions have a long-term liability that we're trying to immunise. So, by definition, we have a long-term outlook. Some of the biggest investors in unlisted real assets are pension funds, because they say we like the long tail of it, and it matches our liability. So to then walk away from the long-tail implications of the environment doesn't really quite add up. I'm not really sure about that. Secondly, I think we need to differentiate between inputs and outputs. The output is that we're seeing the numbers firsthand because many super funds are large investors in insurance companies. Even catastrophe bonds are now an asset class that they're looking to invest in, so they are investing in these asset classes. They have access to this information. Whereas the data may be difficult to model, not trying to model it or understand it is an active bet. It's an active bet that may or may not pay off, but if you look at the numbers, it probably won't pay off. Lastly, I think it's true that most boards and ICs don't necessarily understand the full implications, and I respect that. But do they understand the billions of dollars going into data centres? Do they understand what the payout is going to be? Do they understand that the shelf life of many data centres is five years, yet the amount of money required to build them runs into billions? So the irony is, we have a long-tail outlook, we invest in long-tail and long-duration assets, but when it gets complicated, even though the numbers are right in front of us, we claim it's too difficult and put our arms in the air. That's where I would challenge trustees and IC members. Wouter Klijn 29:03 There is that inherent tension between the short term and the long term within the finance industry, because you obviously saw that when Russia invaded Ukraine, there were a lot of funds here in Australia that had moved to low carbon indices as benchmarks and got hit more severely than other funds, and that caused a little bit of a rethink with some of those funds. So you will have these types of points during the next couple of years as well. How do you deal with that short-term tension where we have to be the best fund over the next five years versus the longer term systemic issues that this is referring to? Rob Prugue 29:46 Complete mismatch, and it starts from the top. You've heard me numerous times bickering about heat maps, where it's a race to the middle, where if a pension fund moves in a certain direction, and for a short period of a long-duration portfolio objective it is not meeting that relative to peers, they get penalised. So what almost requires, in your example, is everyone has to do it, so therefore there won't be financial consequences and regulatory consequences for veering into something that's in front of us. The regulatory system around many super funds requires all or none, that everyone has to move in that direction. To do that in the world of investments, where there's always a buyer and always a seller, is very challenging. Wouter Klijn 30:46 You brought insurance up with catastrophe bonds. I think we've seen some of the insurance companies becoming probably first aware of climate change and the impact on their business, just by the nature of it affecting their claim experience, and affecting how they price their coverage. But ultimately they can't carry all of the risk, and that will filter through at the same time. Some insurance might become impossible, and I think it's sometimes said that for any economic activity to occur, you need to have insurance first, otherwise nobody's going to take any risk. How do you see that moving when environmental risk becomes too much for insurance companies to carry, and it filters through? Does it filter through to other companies, to members? What do you think around that? Rob Prugue 31:35 Well, let's look at insurance and why it exists in the first place. It takes away the sting of the unexpected. If we date back to insurance roots, or Lloyd's and shipping, through to modern day, as investors, as lenders, obviously we want to know that there is an exit where a return is not only generated but at least the capital is returned. The reality, though, particularly with insurance, is that while politicians debate the science around the environment, right beneath them is a situation where households are feeling it immediately. Ask any household what their home insurance was five years ago versus what it is today. APRA itself is concerned that in future, one in four households may not be able to afford insurance, with some rural and coastal communities facing even higher pressure. So who insures these homes? Who insures these farms? Who insures these businesses that exist up and down? We know here in Australia, 90% of our population live within 100 miles of the coast. I think it may be even higher than that, but regardless, we are a coastal community. Whether we're talking floods, bushfires, or any other type of environmental damage, these rural communities are feeling it immediately. The challenge, however, is that even though we see these numbers, it's become politicised, where the rural community is now concerned about sustainability of their livelihood. I'm not talking about their actual homes or businesses, but employability. Whether there's an affront against carbon energy, whether it's coal mining towns in the Newcastle area, or whether it's LNG in WA, these communities are very vocal about climate issues, and politicians, particularly populists, are grabbing into that. Regardless, insurance is an environmental risk that has now become an input. It's now visible. It's not just visible in portfolios, it's even more visible in households. And so now we need to understand that insurance affordability is creating these insurance deserts where people can no longer get insured. Do we honestly believe that the government will let these people go uninsured if a catastrophe occurs? If not, then the ultimate underwriter is the taxpayer. And before anyone gets overly up in arms, we've handed out more billions to corporations that were on their knees because it was necessary, so-called. Ask yourself that same question. When a large portion of rural Australia is unable to insure themselves, who is the ultimate underwriter of that insurance package? It's you and me. Wouter Klijn 35:10 For sure. Kristy, when we talk about insurance, it's more or less like an expectation that an event has occurred, and insurance is dealing with the aftermath of that. How do you look at models that firms come up with that try to anticipate these things from happening and potentially direct capital towards mitigating these risks? Kristy Graham 35:36 Yeah, and I think that is the absolute silver bullet in this adaptation resilience space, shifting the investment to build resilience in advance rather than the current model, which is supporting disaster recovery and rebuilding after an event has occurred. Governments have that model of funding as well, and that is the insurance model. That said, a number of insurance companies are working much more proactively with their customers to support them to build resilience at the household level, but there's still a lot more that can be done in that proactive space. There's been lots of research that has demonstrated the economic payback of that. For every dollar invested upfront, you save $9.60 in recovery costs. The Australian government is already spending 38 billion annually on natural disasters, across governments in Australia, and that's projected to go up to 73 billion a year by 2060 if there's not a huge amount invested up front in adaptation resilience. So the numbers are very clear and compelling. There's a range of reasons as to why that value is not able to be captured in investment models at the moment, and why it's difficult for both governments as well as private businesses and investors to make that case for those upfront costs and expenditure. That said, there's a range of things that the work we've done with other players right across the finance sector shows will help to shift that dial. One is around valuation approaches and frameworks, and the Actuaries Institute has done a huge amount of excellent work on the relatively small tweaks that you can make to the way valuation frameworks that the public and the private sector use to shift that business case, to make it much more compelling to make the investment upfront rather than the recovery investment. The other issue often with adaptation resilience investment is the benefits or the avoided losses don't necessarily accrue to the same actor that is making the investment upfront. So if you're investing in community-based infrastructure, a local council whose source of revenue is from all ratepayers, there will be only a certain small portion of those ratepayers that will benefit in terms of reduction in their insurance premiums, for example, those that are most flood affected if it's flood resilience works. So there's a range of interesting models that are being used internationally to try and use various different structuring approaches and multi-stakeholder collaborative co-design processes, so that you can solve some of those issues. The other issue often is that there are projects at small scale, and so for a commercial investor, that's not necessarily at the scale or the aggregation that makes it attractive for them, and they're not always able to capture the commercial benefits. Again, structuring and project preparation facilities can support with that, and blended finance is another approach, where it's combined public and commercial capital, so that you can put those investments at a risk and return that's acceptable to a commercial investor over time. Wouter Klijn 38:53 Yeah, on this list is also adaptation finance. What's that? Kristy Graham 38:58 Yeah, so all of those models that I was talking about are a version of different types of adaptation financing structures. There's also when you've got existing assets and you're a long-term investor in an existing asset, increasingly those equity holders are seeing value in improving the resilience of an asset to reduce operational expenditure over time, particularly when there is a disaster. So, there's a number of fund managers and others who very actively work with their assets, whether they sit on the board or they're a minority shareholder, but a significant shareholder, to improve not just the understanding of the risk but to invest capital to improve the resilience of those assets, which will over time reduce operating expenditure and insurance premiums for those assets. Wouter Klijn 39:47 Yeah, Martina, we often talk about disclosure is not the same as resilience. You can show where all the risks are, but what are you doing about it? Can you tell me a little bit from your perspective, what does real resilience look like? Martina Linnenluecke 40:02 That's a big question. I'm not quite sure if I can answer that in the time we've got available, but I'll try. When we look at resilience, and I've done a lot of work around resilience, there is this common understanding that there is a negative impact, be that on a company, on a household, or on some other type of entity, and then the effort is always to go back to where we used to be, to bounce back to previous conditions. That is what we typically understand as resilience. The challenge with climate change, or the added challenge we are now facing, is that simply building back to where we used to be is often not the answer anymore. For example, when communities are flood affected, there has been a negative impact, and if this community builds back in exactly the same way, it could be seen as resilient, because we go back to exactly the same state we were in. But that is not really creating any type of risk mitigation or insurance against future events. If we're exactly in the same position, exactly in the same spot, doing exactly what we used to do, it's not really preparation against future risks. So the added challenge with climate resilience is that we need to think about ways to build back that factor in the future risk that is unfolding. We need to see resilience in relation to a changed future. Simply bouncing back, or building back, is often not the answer in these situations. Disclosure alone, as you said, does not necessarily lead to resilience. I can disclose all sorts of things. It doesn't mean I'm resilient when the time comes. I think what is very important with resilience is that resilience is a collective effort. With mitigation, let's assume I'm a high carbon emitting company. I can look internally for solutions. How can I emit less carbon by innovating, or by looking into more energy-efficient infrastructure investments? With resilience, it becomes much more difficult, because resilience does require a much more concerted effort within society. For instance, if I'm a company affected by sea level rise, it's often not sufficient to build my own seawall around my own assets. I'm part of a broader societal problem. I'm embedded within broader infrastructure that's affected by sea level rise. Consequently, if I'm not located in a resilient community, or in a community that at least has some level of adaptation in place, then it just means I can't be resilient under those circumstances. So it is much more of a systems issue, which means it's also much more of a coordination challenge and an investment challenge, which creates real questions around who should be paying. Kristy, you already said who is benefiting from this, who makes these types of investments, and it often does require public-private partnerships to make these types of changes that pay off. But there are also real difficulties in seeing the payoffs, because we are very bad when it comes to recognising avoided losses. Everyone sees the big impact that a disaster has and how quickly we can build back, and that's often seen as the success story. The faster we can go back to normal, the better it is, and that's often equated with success. But where we do not look for success is in avoided losses. We can't see them. They don't feel like we've accomplished anything. It's invisible, and this invisibility is a real challenge. People can't really see what would have happened if we hadn't made those types of investments, and that's often stopping these considerations. It is much more impactful to act when something has happened, rather than prevent it from happening. I think these are big considerations here, but one additional important point is that resilience is not just about having defensive infrastructure in place, or defensive assets. It's a proactive approach around how we absorb shocks, adapt operations, be flexible and recover effectively. Sometimes it requires a transformation of business models. It requires a much more multi-level way of thinking as well, and obviously does not just relate to climate change alone. We've had many other shocks, and a lot of them are really impactful. Resilience is definitely something that should not be developed just with one particular threat in mind, but as a capability that allows a lot of flexibility, no matter what the extreme event or adverse condition is that we are facing. Wouter Klijn 45:29 Yeah, Rob, from the investment industry, we look at risk from two sides. Of course, it's risk that can wipe out your capital, but also, you can't make money without taking on risk. That's where the returns, to a degree, come from. Why is more money not flowing into this area in terms of prevention and dealing with environmental risks? Rob Prugue 45:51 I've always said, if we could patent air, water, and a clean environment, we would invest in it, but we disregard it because it's free, or we underestimate its value because it's free. The thing to consider, I guess, is that for many of us, we are accustomed to market cycles, and those market cycles were met with enthusiasm, and then eventually mean reversion. As Martina mentioned, this is much more structural. This is itself a very structural event, and how we build a resilient model around it isn't just a portfolio issue. It's a policy issue. On top of that, Martina's point was very valid. Imagine, being Dutch yourself, building only a wall around your small house, but there's no wall around it, or New Orleans, or southwest England, or southeast England. Excuse me. It would serve no purpose. This is a societal problem. Our challenge right now is that we're trying to look at it through lenses that aren't necessarily built for that, and because those lenses aren't disclosing what we need to see, we either disregard it or put it aside as too complicated. I'll deal with it tomorrow. But the more we go down that path, the more, pardon the pun, the wave builds, and therefore the longer it takes to unwind from that. As for portfolios, as I mentioned before, how we address that, the numbers are there. Whether we agree on the validity of whether it's one degree or two degrees, talk to any actuary, talk to an insurance company, they have the numbers to show you of the claims, they have the numbers to show you. We can debate all we like about the science of the environment, but when we equate it back to the actual economy, at least as expressed through insurance, the numbers are already showing a huge uptake. Whether you see it directly through the insurance books, or through the premiums that we've been paying, it's getting increasingly harder to ignore. Wouter Klijn 48:16 Yep, and what do you think of Martina's comment that, to a degree, what you're trying to achieve with addressing these risks is for things not to occur. So, if you're trying to put capital to work, you often want an outcome. In this case, you often work to prevent things and hope that stuff doesn't happen. Rob Prugue 48:33 We don't have a DCF for opportunity cost. Wouter Klijn 48:36 Yeah. Rob Prugue 48:37 It was that simple. What is the growth rate that I would use for environmental issues? Martina said it well, that environmental science was on its own. We, as investors, we're the generalists, particularly pension fund investors. We're paid to take long-term views, and we have a portfolio that has large exposure to long-duration assets. So there perhaps is a gap between our due diligence and how we manage the portfolio, and what the inputs are that we assess versus what we're investing in. Wouter Klijn 49:19 Perhaps we can draw the conversation a bit closer to home. Look at Australia, obviously we have a very unique economy in the sense that it's heavily reliant on resources, heavily reliant on energy, and also agriculture to an extent. These are all sectors that are in the crosshairs of environmental risk. What is your sense, and maybe Kristy, I can come to you. What's your sense of how stakeholders deal with this issue, that any action that we take will be felt in the economy, and then an extension of that, especially in regional Australia. And sometimes these communities are not always brought along in the discussion, they just get rules imposed on them. What's your sense around that? Is it harder to implement here, and what can be done? Kristy Graham 50:11 I'd like to reframe the question, which is all about when you mentioned crosshairs of change happening to communities. There are many communities that are driving this transition and see huge economic opportunity from a green export future economy that Australia is in the box seat to take advantage of. So yes, we have an agriculture industry that is among one of the best performing sustainability-wise in the world. We also have a huge mining and resources sector that can provide things like copper, critical minerals, iron ore that will be absolutely needed for the transition, not just of Australia, but for the world. There are a number of different regions and communities that are seeing and working to develop what that economic development vision for the future looks like, and are bringing in investors and partners and different parts of government around that community-driven vision. So I absolutely agree there is a need for communities to be in that driving seat, and to be actively shaping, driving and bringing others in to support what will be a big transition globally, but particularly in a number of different local communities. But I wouldn't want what we see in mainstream media to be the prevailing narrative of this happening to regional communities, rather than many regional communities absolutely getting in front and driving this transition so that it benefits them and the future prosperity of the businesses and the regions that they live in and have lived in for a long time. Wouter Klijn 51:44 Yeah, Martina, what do you think about this? I mean, risk does tend to hit differently in different areas. Does it make it harder to create policy or frameworks? Martina Linnenluecke 51:54 Yeah, what we're definitely seeing is that there is a very uneven distribution of risk and impact. There are definitely parts of Australia that are much more exposed, but we also see a huge variability in terms of the extremes that communities are exposed to, and certainly also different needs for support and different transition requirements. Not all of that is reflected in policy decisions, especially when they're taken in a very top-down fashion. It's not necessarily giving that diversified policy set on the ground. But I agree with the comments that Kristy made. We're definitely seeing a lot of momentum at the moment. We are seeing that a lot of communities really want to be part of a transition that's happening. We're seeing a lot of momentum, both in rural and remote areas, but I think also in the cities as well. There is a lot of momentum, actually, to see what we can do, and the underlying driver, I think, for a lot of people is to live in an environment that's worthwhile living in. There is so much that we can do, and create a much more liveable environment. Certainly, we see that in Europe, just putting cycling infrastructure in has so many benefits. This is such a small-scale example, but it takes cars off the road, it allows for more physical activity, it makes people feel a lot better about their day if they're not just stuck in traffic, and so on. There are all these small-scale changes that we can implement quite easily that add up to a lot of change as well. But coming back to the more fundamental issues, we definitely see an uneven distribution of climate risk, physical risk, and transition risk as well, and it's deeply tied to the sectors and distributions that we see in Australia around resources, agriculture, energy, energy export issues, and climate-sensitive sectors. There's obviously huge exposure in parts of Australia, but then, as I said, there's also a huge variability in terms of the physical risk, ranging from bushfires to drought. In some parts, we see other types of extreme events, extreme heat, cyclones. So there's also a lot to deal with from the impact side. When we look into the climate projections, none of this is really forecast to get much better, which creates a significant concern. But more to the point, looking into any type of transition, I think it's really important that this is an equitable transition, that this brings people along in being part of it as well. As I mentioned, it's not just about infrastructure investment, it's also a huge part around social and regional resilience, and cultural change within society as well. So, yes, at the end of this, I think there are also huge opportunities involved, because we can really look into building a better future. Wouter Klijn 55:24 So I was speaking a while ago to an economist, and he suggested that perhaps if you look at areas like the Hunter Valley, that is very dependent on coal, perhaps there should be more of a government-driven push to restructure these sectors and potentially build an EV industry in the Hunter Valley. Do you think it needs to be more government driven as well, to force almost this change? Martina Linnenluecke 55:53 In my mind, the most effective change is the change that's occurring across all parts of society. I don't think it's particularly good if policy just steps in and forces an issue. It's not really going to be accepted within local communities, especially if it goes against some of the locally held values. By the same degree, just having this ground-up movement can sometimes also be ineffective if there's no supporting policy trigger. I think, looking across what the evidence tells us, and the research tells us, the most successful transitions in society occur where every part of society can actually benefit from the transition, but can also have input into these types of decisions. So it's not top-down, it's not bottom-up, but I think it really needs to happen at all levels. Certainly, that's hard to achieve. There is no perfect solution to it. But in my mind, it really requires supportive policies that encourage new sectors to evolve, that encourage investment in renewable energies, that certainly support a phase out of fossil fuels, but at the same time it really needs to bring the communities along as well. Simply discontinuing fossil fuels is not going to be a solution for some regions. It really needs to be part of a broader transition, and there needs to be consideration around, how do we best structure this? How do we create other opportunities? And how do we do it in a way that this is an equitable transition and provides opportunities to people as well. Wouter Klijn 57:38 Yeah, Rob, you got some views on this as well, because I think you say policy risk is an investment risk. Rob Prugue 57:43 Absolutely, I would add social consent to that. Wouter Klijn 57:46 Yeah. Rob Prugue 57:47 Before I do, to your point about communities that have ties to carbon energy, be it coal or LNG, let's look back at Wollongong versus Newcastle. Back in the 60s, they were both economically thriving off steel. Steel left. Newcastle had an advantage. It had big black rocks underneath it, or nearby, that opened up a new industry. If we look at the history of Australia, we've had many industries come and go. In the mid-1800s, one of the largest industries and exports was fur, seal fur. In fact, we almost went to war with the US over a land fight over seals. My point is that economic history is full of cycles of what works and what does not. But if we work to create moats that protect certain cycles or certain industries, as opposed to protecting the broader system, those are two different things. We've become more transactional. What's in it for me? And that transactional politics has, I would argue, been a key factor in driving the breakup of the LNP between the city conservative and the rural conservative. The city conservative is more willing to embrace the challenges of environmental issues and has morphed away from the traditional conservative movement towards the teal. The rural community has been more hesitant because, again, their chequebooks depend on it, their salaries depend on it. So some have been gravitating more towards the populist rhetoric of One Nation, Clive Palmer and others. Whether mainstream politics recognises this or not, this is not just a social and structural issue. It is a heavily political issue founded on a level of social consent. And as we all know, there's a hell of a lot of misinformation out there. Case in point, on the South Coast, if you drive or walk along the coastline, you'll see houses with large banners saying no wind farms. Never mind that the wind farms are going to be so far out. I respect that people have a democratic right to vote against it and be against it, but some of the reasoning I saw was not necessarily logical, and that lack of logic was driving a lack of social consent, which was influencing policy out of frustration. Wouter Klijn 1:01:03 So how do you get them to come along on the journey? Rob Prugue 1:01:07 Ironically, these are the same towns that are seeing their insurance premiums rise, and at a substantial amount. So whether we embrace it or not, climate issues cannot just be treated as a political debate. We have to find a way to look at it fundamentally for what it is, strip away the misinformation and politically motivated rhetoric, and look at it for what it is. Is it perfect? No. But this is how the political divide works. If it's not perfect, if it's not yes or no, I'm not interested. No, our world is in the middle. Wouter Klijn 1:01:58 Does it require a big disaster, you think, before we see some real change happening in this space? Rob Prugue 1:02:05 Define big disaster. My friends in Kiribati will tell you we're there, so big disaster depends on who "us" is, perhaps. But it's interesting to the point I think Kristy made, that some rural communities are embracing this. I'm going to take a punt, and I'm going to assume that those communities are not necessarily tied towards carbon energy, such as the South Coast and the bushfires that we see in the South Coast. I know they've been very proactive on these environmental issues and building resilience because they suffered so severely during the bushfires, whereas that same level of interest towards a more resilient outcome is less visible in carbon energy rural areas. Then you have the areas that are more exposed to tourism that probably have more of a stake in mitigating climate change, but even the city people as well, the city conservatives in the eastern suburbs, few would be negating the issue around environmental challenges, and I think that was one of the big drivers of why they were frustrated with mainstream politics, and they went towards the independents. Wouter Klijn 1:03:20 Yeah, so Rob, you suggested to end up with a thought experiment to a degree, where let's assume it's tomorrow, Monday, you come back into the company floor, the boardroom floor. If you're a CIO or a trustee or a policy maker, what different questions should you ask on this Monday morning than before we started this conversation? Do you want to have a crack at this? Rob Prugue 1:03:48 Sure. I guess at the end of the day, it's the same question we should always be asking. Where are the risks? Where do they lie? And where does the portfolio still assume that the old hedge is holding? I would fathom to guess it's going to be more exposed in the long-duration real assets that are illiquid, where they're having a 20% exposure. Sizable. That doesn't mean that if the proverbial hits the fan for those assets, it's not going to hit the other assets. Of course it is. It's going to hit government bonds, it's going to hit spreads, it's going to hit equity markets. But with an illiquid asset, you hold it. You cannot unwind. And where are we assuming some linear adjustment to this nonlinear risk? If we look at it that way, perhaps that will flag, and super funds and pension funds have been very proactive in attempting to quantify this, but again, I would just put it more simply. What parts of our portfolio are assuming that the old hedge will hold? Wouter Klijn 1:05:04 Martina, can I ask you the same question? What questions should we ask on a Monday morning? Martina Linnenluecke 1:05:09 Yeah, absolutely. I'm not sure if that's just the question for Monday morning, probably more a fundamental one, but I think one of the important questions is, what do we value? I think that's very important. Do we want to be part of the problem? Do we want to be part of the solution? In my mind, that is a very fundamental question, because it really comes down to what's driving the change, and whether or not people want to change and do things differently. More fundamentally, it would also be around the assumptions on which the business model, or any type of risk modelling or financial modelling, is built. I think there's a set of really important questions around what assumptions we are making, and are they still holding? Are they still the same assumptions? Historical data points have always been very important around insurance pricing, infrastructure design, planning and capital allocation. But are these assumptions still holding, or are there a different set of assumptions that might have to be made because climate change is obviously complicating a few things? Historical baselines are now becoming less applicable and less reliable. Tail risks are becoming more important, extremes are becoming more important, but also on shorter time horizons. There are sometimes these, it's a one-in-50-year event, or one-in-100-year event. This is no longer as applicable in this day and age. So, questioning those types of assumptions is, in my mind, very important. Perhaps as a thought experiment as well, go with a different set of assumptions and see where they take you. Is that still what you're doing? Is it still viable if you are using a fundamentally different set of assumptions? You might not want to keep them, you might not want to implement them, but as part of the scenario planning that I mentioned, having different assumptions can be a really important starting point just to challenge some of the thinking. It might be something people want to adopt, it might be something they don't want to adopt, but at least having that awareness of the assumptions being made is already, in my mind, a really important point to start the conversation. Wouter Klijn 1:07:38 And Kristy, maybe not on Monday morning then, but what are the fundamental questions? Kristy Graham 1:07:42 Mine is building on Martina's, so they can tackle her question first, and then come to mine, which is also based on this idea of scenarios. If you were to think of what the world, Australia, our industry looks like in 10 years' time, what is the range of possibilities? What is the range of best case, worst case scenarios? And then if we as a company or an organisation were to lean in to give the best chance of success at the best case scenario, what would we do differently to what we're doing today? How can we use all of the things that we have at our disposal to get us closer to what that best case possibility looks like? Rob Prugue 1:08:27 It's not a lack of investability. I mean, we've shown it. The world investment world has invested billions and billions and billions towards AI, where none of us really know how that's going to end. We have invested in a story without certainty of some terminal value. So therefore, if we're willing to do it with AI from an investment point of view, perhaps we should look at the same approach from a positioning point of view. Wouter Klijn 1:09:01 Yeah. Rob Prugue 1:09:01 With regard to the challenges, and to Kristy's point, the best, worst-case scenarios, we do that in most assets already, and to extend this into this matter is challenging, but it's challenging in every asset that we do it under. Wouter Klijn 1:09:17 Yeah. Rob Prugue 1:09:18 Other than cash. Wouter Klijn 1:09:20 So we started the conversation with looking at whether the assumptions on climate and climate risks have changed, and whether this will filter through more and more into the financial system. I think, for my audience in the investor world, it raises a lot of questions around whether the portfolio is running on assumptions that no longer hold true. Are you assuming a level of insurability that might have already moved on? And as you said as well, is there an expectation of a gradual change that might turn out to be much more jumpy and much more volatile going forward? Now, I'm not sure if we answered any of these questions, but hopefully we certainly have given people something to think about. I would like to thank you for participating in this discussion. So, thank you, Kristy, Rob, and Martina.