The risks of the El Niño weather phenomenon can be approached as an opportunity, but large investors are showing caution and prefer not to seek out these risks. Quantifying the effects of this and other climate factors is complicated enough.
Every three to seven years the weather phenomenon El Niño hits. A still unexplained warming of the sea surface around South America changes weather patterns in several continents. The result: six to 12 months of extreme weather that causes human suffering and also affects businesses. US asset manager Morgan Stanley recently mapped the attention paid to El Niño in various sectors, as well as the potential impact on companies’ value trends.
Topic in figure presentations
El Niño is high on the agenda of companies and shareholders worldwide, Morgan Stanley researchers observed. Especially as meteorologists warn that the current El Niño is a powerful version, similar to that of 2016. That one caused floods, drought, storms, wildfires and frost in more than 40 countries. Since the first signs of El Niño in early 2023, the subject has featured in the majority of figure presentations.
Especially companies in the food and energy sectors discuss the expected effects of El Niño with analysts and shareholders. At companies in the chemicals, banking, insurance and building materials sectors, the topic also comes up frequently. This affects the share price, Morgan Stanley’s data shows. Companies discussing the risks around El Niño are achieving returns as much as 28 percentage points lower than the returns on the S&P500 index last year - until mid-November.
Worse cocoa harvests
For investors, concrete information on El Niño risks is valuable. After all, the extreme weather affects companies and sectors to varying degrees. Depending on the location of farmland, factories and other activities in the area. German chocolate producer Lindt & Spruengli, for example, is reckoning with worse cocoa harvests and higher prices due to the expected drought in West Africa. Brazilian sugar cane processor Sao Martinho is running at 90 percent of capacity; sugar cane producers are suffering from lower harvests due to high rainfall.
The weather impacts are not negatively affecting all companies. Brazil’s AES Brasil Energia expects to finish 2023 well, helped by higher wind farm revenues due to increased wind. Even (re)insurers are not only negative due to potentially higher claims costs. Stronger winds during El Niño are reducing annual tropical storms. For instance, the hurricane season in the Caribbean is milder during this period.
Production sites
For most investors, the influences of El Nino are included in the models they use when analysing the effect of climatic factors on the investment portfolio. Portfolio manager Rosl Veltmeijer of Triodos Investment Management maps the effect of extreme weather on individual investments, as well as the exposure of the entire portfolio. “That is relatively low,” she said. “The departure point for our investment policy is to minimise the climate impact of our portfolios. We exclude investments in mining, petrochemicals and other heavy industries.”
For the companies that do make it into the portfolio, the team has an overview of the risks. “We look at the physical and financial risks of drought, hurricanes, flooding, earthquakes and heat stress.” That requires very detailed information, Veltmeijer explained. Many of the risks are related to the exact production location. “For example, it matters which side of the river the company has a factory on.”
Good contact with executives also provides insight into risks. “Climate conditions were not an issue until three years ago, that has changed. A telecom company now explicitly mentions that the poles over which the telephone lines run can withstand prolonged flooding.”
For Veltmeijer, information on the country’s economic situation is also crucial. “How resilient is the country’s economy and how does the government handle risk management?”
Modelling opportunities and risks
At Achmea Investment Management, El Niño also plays a role in portfolio composition. Fiduciary advisor Mark Leeijen explained that the teams use the climate value at risk method to estimate the risks of structural climate change and more temporary effects like El Niño. “We use multiple datasets from external ESG data providers to model opportunities and financial risks due to climate change.”
The combination of sector data and individual company data is plotted against different warming paths. This provides insight into the longer-term effects of weather changes. And ultimately the expected loss of value at sector or farm level due to physical risks, says Leeijen. “Based on insights, we steer in the portfolios to reduce exposure to climate risks.”
Panama Canal
El Niño affects not only individual stocks, but also the economy as a whole. Higher food prices and disruptions in supply chains contribute to inflation. A substantial part of global food production comes from China, the US, India, Brazil and Argentina, countries affected by El Niño. Morgan Stanley researchers also point to the impact of the drought on the capacity of the Panama Canal in Central America. A key route in many global supply chains. The canal’s capacity has already dropped from the regular 36 transits per day to 31 transits, with the prospect of a further drop in capacity to 18 if the drought persists. Veltmeijer said this could further fuel inflation. “The effects of disruptions in the chain, of course, we also saw during covid.”
Whereas asset management Morgan Stanley’s report shows how investors can respond to El Niño, Triodos and Achmea IM’s investors are cautious. The data is mainly used to identify and prevent risk exposure. Ralph Sandelowsky, portfolio manager commodities at Achmea IM: “We don’t time the uncertainties around momentum. Impact and location are too great for that.”
Instead, the team uses relevant data to interpret long-term developments. “For example, specifically for agricultural crops, we see that more extreme weather conditions mainly cause larger outcomes, both positive and negative. The impact varies; depending on the region and at what point in the crop life cycle the phenomenon occurs. On average, this gives more volatility without any additional reward.” Reason for Achmea Investment Management’s investors to mainly take positions later on the futures curve (future contracts with an end date further into the future, ed). “In order to optimise the return-risk ratio.”
Further reading on Investment Officer Luxembourg:
- €1 mln available to support creation of new climate funds
- Climate risks insufficiently priced in by real estate investors
- Is climate change really a financial risk?