Key takeaways

• With floods, droughts and storms ranging across the globe today, it is time for investors to wake up to the reality of climate change and invest not just in mitigating its causes, but also in adapting to its consequences.

• The adaptation finance gap is significant and widening. Annual adaptation costs in developing countries are estimated to be $160-340 billion by 2030. Adaptation finance needs are currently between 5 to 10 times higher than adaptation finance flows.

• It is clear that public finance alone is not going to close the widening gap, but less than 2% of adaptation finance currently comes from private sources. This is despite the growing evidence of the quantifiable benefits that adaptation can deliver.

• But existing barriers to private finance are being addressed and there are increasing opportunities for private investors to invest in adaptation solutions. These will only expand in the years ahead as temperatures continue to rise.

• Another important implication for investors is that the physical risks to assets need to be understood and incorporated into investment decision-making in order to mobilise capital towards climate resilient investments.

The urgent need for adaptation

Whilst much of the climate narrative focuses on achieving 'net zero' in the decades ahead, it is becoming increasingly apparent just how dramatically our climate is already changing.

The last year has once again delivered record climate events with devastating impacts - deadly heatwaves across Southern Asia, severe flooding in Pakistan, South Africa and Brazil, drought across China and south-western states in the US, and ice shelf collapse in Antarctica, to name a few. 2021 losses from climate related events were estimated by Munich Re to be the second highest in history and this is likely to be exceeded this year- with clear risks to society, businesses and the economy. Adapting to these physical impacts of climate change is therefore absolutely critical.

A year on from COP26, and Climate Action Tracker shows that country pledges will still fail to limit warming to below 2°C, let alone the 1.5°C target. But even the most optimistic climate scenarios result in an increase in warming and therefore a continuation of the rise in frequency and severity of extreme events and a worsening of chronic changes. It is therefore too late to focus on climate mitigation (i.e. decarbonisation) alone. We need to ensure that our communities, businesses and economies are resilient to these impacts.

The widening adaptation gap

The 2022 Adaptation Gap Report identifies that, whilst adaptation finance is rising as a proportion of total climate financing (34% in 2020 compared to 14% in 2019), combined mitigation and adaptation flows have actually fallen over the last reporting period. The UNEP report estimates that the annual adaptation costs in developing countries alone to be in the range of $160-340 billion by 2030, and almost doubling again by 2050. By this assessment, adaptation finance needs are currently between 5 to 10 times higher than adaptation finance flows, and growing. We highlight this adaptation gap as one of four critical interconnected gaps that need to be adequately addressed at COP27.

In addition, it was agreed at COP15 in 2009 that developed nations would provide climate finance of $100 billion a year by 2020 to developing nations for mitigation and adaptation. That promise was broken. A key minimum requirement for COP27 is ensuring that this commitment to public financing is met. However, even if this was met and it was all allocated to adaptation it would still fall far short of what is required. There needs to be a more integrated approach to mainstream adaptation finance- as current approaches tend to be piecemeal, localised and responsive to current impacts. Lessons learned from the pandemic need to be applied to ensure coordinated global, national and local response to improve resilience and adaptation financing.

The Global Commission on Adaptation has identified $1.8 trillion in adaptation investments that could deliver net benefits of $7.1 trillion by 2030. Despite this growing evidence of the benefits, less than 2% of adaptation finance currently comes from private sources.

There are a number of reasons why private investment in adaptation has been limited to date:

• The lack of adequate, disclosed climate-related risk data to inform investment planning;

• The need for clearer national-level action that ensures adaptation needs and goals are clearly identified and financial incentives for private participation are strengthened;

• The often limited clarity on financial returns which may be indirect and a generally stronger focus on social benefits rather than investor return

It is clear that public finance alone is not going to close the widening gap. So existing barriers to mobilising private finance need to be addressed to grow opportunities for private investors.

It is time for investors to wake up to the reality of climate change today and invest not just in mitigating its causes, but also in adapting to its consequences.

The importance of investing in adaptation

Physical impacts of climate change affect every sector and region on the planet. Some however are more severely impacted than others and we highlight three particular sectors below:

1. Real assets - Changes to the climate require the adaptation of many areas of the economy. Infrastructure and property are particularly vulnerable as they face storm and flood damage, rising insurance costs, greater energy costs and, potentially, the need for backup generators and emergency systems. The way we build will need to change, so that real assets can withstand severe rain, storms and, in some areas, much higher temperatures. In addition, cooling systems for high temperatures need to be compatible with a low emissions future.

2. Utilities - A world of increasing climate extremes will need different infrastructure: much better drainage systems and 'sponge city' capabilities that allow densely built-up areas to cope with the flash floods that severe rainfalls bring. Electric grid systems will need to be 'hardened' so that they can cope with extremes of weather and temperature. Durable electric microgrids have been trialled in Texas, that kept going and kept revenue flowing when there were widescale outages. In the US, utility companies like Consolidated Edison, are spending over $1 billion a year on resilience. Utility companies not building in resilience will be out of step as the world seeks to decarbonise.

3. Agriculture - Agriculture will also have to change so that planting and harvesting seasons won't be so affected by less predictable, and more extreme, weather. Restoring degraded pastures, maintaining and planting forests and many other adaptations will help to both capture carbon and protect against the effects of extreme weather. Emerging market regions are particularly vulnerable to damage from climate change. Acting and investing now in the necessary adaptations will lead to lower costs than repairing after further damage and decrease the threat to food security.

Without adaptation, businesses face physical damage and power outages. Extreme weather may also interfere with renewables providing a reliable energy source. It's likely there will also be more supply-chain disruptions, insurance losses, commodity shortages and inflation. This provides a clear financial case for incorporating climate adaptation into investment decisions to build resilience.

Investment opportunities for adaptation and resilience

1. Understanding and incorporating the physical risks of climate change into decision-making

Financial institutions need to understand how the assets they invest in assess and manage the physical risks of climate change in line with the recommendations of the TCFD and integrate this into asset valuations. The Coalition for Climate Resilient Investment (CCRI) is a private sector-led initiative launched in 2019 which abrdn are members of and aims to ensure that physical climate risks are systematically integrated into all investment decisions by 2025. The goal is to improve the pricing in of climate change in order to de-risk the investment for financial partners, provide investor confidence and help mobilise capital towards climate resilient investment. A key output of the initiative is the PCRAM framework which provides a methodology for pricing physical climate risks into infrastructure investments.

Incorporating an assessment of acute and chronic physical risks is a core part of our due diligence process for new infrastructure investments, but this can differ considerably depending on the type of asset and its location.

This is equally important for publicly-listed assets. Our bespoke climate scenario analysis framework provides a forward-looking view of the impact of climate change on asset values. Our approach to scenarios allows us to disaggregate the company-level results from different scenarios into the impact drivers, including physical risk and adaptation. This provides an indication of the potential direct physical impact on assets that companies are facing. Given the location-specific nature of physical risks, this then needs to be explored in more detail at individual-asset level. For this reason we are focussing on in-depth scenario analysis at building-level for our own real estate portfolio.

2. Investing in adaptation solutions

There are vast opportunities for investors to become involved in helping countries and businesses strengthen resilience against climate extremes. This includes utility companies creating more weather-resistant grids; homebuilders specialising in heat- and flood-resistant designs; and governments with innovative resilience projects. These opportunities will only expand in the years ahead. Research by Munich Re has shown that linking adaptation and insurance, for example by restoring coral reefs that reduce storm damage, or by planting to alleviate flooding, could lead to reduced premiums and a six-fold return on investment.

Adaptation investments should be a growing and important part of the investment universe for climate-focused strategies. By including these opportunities alongside climate change mitigation ideas, thematic investors can diversify their exposures while contributing to a critically underfunded part of the solution to climate change.

In fixed income at abrdn, this process seeks to determine an understanding of the link between a bond issuer and its impact on adaptation. Assessing the nature and extent of the relevant physical risks and how these are being addressed by the issuer's actions has led to several investment ideas that contribute to climate change adaptation. Three examples of bond issuers and their approaches to adaptation are highlighted in the table below.

It is time for investors to wake up to the reality of climate change today and invest not just in mitigating its causes, but also in adapting to its consequences. The need for adaptation solutions will only expand in the years ahead as temperatures continue to rise.

Author: Tzoulianna Leventi, Investment and ESG Analyst

There hasn't been a year quite like this one for investment markets - just look at where @darioperkins plots 2022's returns. While we are sticking with that theme, CNBC tallies $US3 trillion in lost market cap from just seven companies in one year. As a valuation check, Amazon is now trading well below its long-term average EV/EBITDA multiple - while Apple remains above its own. With the "M2" measure of money supply in the US plunging the most on record in a six month period, as highlighted by @CharlieBillelo, Morgan Stanley chartered the historical correlation between M2 and inflation; and True Insights looked at the correlation with stock valuations. An exploration of the pre-and-post COVID worlds has us looking at Australian temporary visas through Grattan Institute's chart, student arrivals in Australia via Pac Partners and finally, a significant shift in communter preferences that suits toll road operator Transurban just fine.

Annual US bond and equity returns since 1870

Source: @darioperkins

$US3 trillion lost in seven companies in one year

Source: CNBC

Forward EV/EBITDA of Amazon and Apple

Source: Equitable Investors, TIKR

US "M2" money supply experienced its largest decline over a six month period on record

Source: @CharlieBilello

Inflation relative to changes in the "M2" money supply for the United States

Source: Morgan Stanley, Bloomberg

 S&P 500 Forward PE change relative to changes in "M2" money supply

Source: True Insights

Change in temporary visa-holders in Australia since pre-COVID

Source: Grattan Institute

Student arrivals per month into Australia

Source: ABS, PAC Partners

Preferences for commuting mode before and after COVID

Source: Transurban

November Edition

Google's Artificial Intelligence (AI) is at the heart of its search engine and has powered Alphabet to become a $1.5 trillion market cap company. However, the sophisticated AI that drives Google and other big technology companies around the world is not without risks.

One of these risks was highlighted recently when Google engineer Blake Lemoine was suspended and then fired after claiming that LaMDA, a computer chatbot he was working on, had become sentient and was thinking, reasoning, and expressing feelings equivalent to a human child.

Lemoine's critics are quick to point out that this is nothing more than the ELIZA effect: a computer science term that refers to the tendency to unconsciously anthropomorphise computer generated responses to make them appear human. In LaMDA's case, this could mean that a huge number of chatbot conversations were edited down to result in a narrative that only appears coherent and humanlike. Indeed, Google's position on this is that LaMDA, which stands for Language Model for Dialogue Applications, is nothing more than a sophisticated random word generator.

Google is not alone in presenting AI risks. Meta's BlenderBot 3 has self-identified as "alive" and "human" and was even able to criticise Mark Zuckerberg. An MIT paper titled "Hey Alexa, Are you Trustworthy?" shows that people are more likely to use Amazon's assistant if it exhibits social norms and interactions thus creating an incentive for parent companies to develop AI that is, or at least appears, sentient. Nor are AI risks solely in the realm of big tech. Autonomous driving, financials services, manufacturing and industrials also have AI risks that are potentially underappreciated by investors and by society as a whole.

AI as an ESG and Sustainability Issue

By far the majority of ESG and sustainability research focuses on planetary boundary related issues such as climate change and biodiversity. However, if the development and application of AI is mishandled and technological singularity becomes a possibility, that is potentially the biggest human sustainability issue of all.

So how should investors think about the ESG and Sustainability risks associated with AI development and application? The table below outlines 6 features of a responsible AI design which can provide a checklist for engaging with corporates on the sustainability of their AI design process:

Feature and Comment 

Human Centric

Human centric AI works for people and protects fundamental human rights. It is continuously improving because of human input and is aware of the risks of singularity.

Transparent    

Transparent AI allows humans to see whether the models have been thoroughly tested and make sense, and that they can understand why particular decisions are made by the AI system (i.e. no black boxes).

Secure  

Secure AI refers to the protection of AI systems, their data, and their communications is critical for the ultimate users' safety and privacy.

Contestable    

Contestable AI enables humans to meaningfully contest individual automated decisions made by AI systems.\

Accountable    

Accountable AI means that every person involved in the creation of AI at any step is accountable for considering the system's impact.

Fair and Unbiased  

Fair and unbiased AI aims to identify, acknowledge and address bias in the underlying data.

Forward Looking  

Forward looking AI aims to address potential ethical issues in AI at the start of the design process rather than at the time of application.

On the ESG side, specific AI governance measures are  also critical to ensure a sufficient level of oversight with respect to AI risks. These include an AI Ethics Committee, AI related disclosures and aligned KPIs.

Governance best practice is for corporates to have a specific committee for responsible AI that is independent, multi-disciplinary, rotating and diverse. Microsoft is an example of best practice in this regard. MSFT as an AI, Ethics and Effects in Engineering and Research (AETHER) Committee with representatives from engineering, consulting, legal and research teams. Microsoft also has an Office of Responsible AI which is headed by a Chief Responsible AI Officer and a Chief AI Ethics Officer.

Disclosure around AI products and their design and commercialization is obviously critical. Despite the criticisms of LaMDA, so far, Google is one of the only large tech companies that discloses a list of AI applications it will NOT pursue including applications that cause harm, weapons, surveillance that goes against international norms and AI that contravenes international law and human rights. They highlight that this list may change as society's understanding of AI evolves. Increasingly we expect companies to address sustainable and responsible AI in their annual ESG and Sustainability Reporting.

Aligned KPIs is likely the most difficult aspect of AI governance to determine and analyse. In principle, it means that KPIs are not geared towards commercialization of AI at all costs. This could create a disincentive for employees working on AI design and application to raise concerns or discontinue AI projects that conflict with the company's AI principles. This is an area for engagement as very little is currently disclosed on KPI alignment.

Conclusion

Google's LaMDA has reignited the debate about the ethical risks of AI development and application. While most experts agree that technological singularity (i.e. technology becomes uncontrollable and takes over) will not happen in our lifetime, that doesn't mean AI development and applications are not a risk that needs to be taken seriously. The bulk of ESG and Sustainability research tends to focus on planetary boundary related risks like climate change and biodiversity, but if singularity risks are mismanaged by AI companies, that could be the biggest risk to human sustainability of all.

Author: Mary Manning, Global Portfolio Manager

This information is for advisers & wholesale investors only.

National property prices have fallen for the sixth consecutive month, with values declining a further 1.2% in October. Whilst the price correction continues, there is some signs of easing within the capital cities, with the rate of decline slowing following falls of 1.6% (August) and 1.4% (September), reducing to a 1.1% decline in October. 

Queensland capital cities recorded the most significant monthly change with the Home Value Index recording a 2% reduction. New South Wales, Tasmania and Canberra experienced further declines of 1.3%, 1.1% and 1% respectively. Smaller falls of 0.8% for 

Victoria and the Northern Territory, with South Australia and Western Australia experiencing the smallest reductions of 0.3% and 0.2% respectively.

Despite the continued reduction in house prices, at the combined capital city level, housing values have fallen just 6.5% following a 25.5% increase through the upswing, with Sydney recording the largest falls of 10.2% since the January peak (after a 27.7% rise), and Melbourne down 6.4% since February (after a 17.3% rise). Interestingly, unit prices have held value better throughout the downturn (down 4.2%), likely driven by surges in rental returns, as well as experiencing smaller growth during the upswing. 

Supply remains lower than previous years, with the number of newly listed capital city dwellings in October down 25.2% from 2021, and almost 19% below that of the previous five-year average. This lack of supply is likely to contain the price falls to an extent, as there has not been any significant upswing in panicked selling or forced sales. The last weekend of October saw a total of 1,908 auctions take place across the capital cities, well below the 3,546 on the same weekend in 2021. 

Clearance rates also remain lower than last year, with the weighted average clearance rate across the capital cities at 59.8% (down from 76.8% in 2021) in the last weekend of October. Similar to last month, clearance rates in Adelaide were the highest of the weekend, with a clearance rate of 68.2%, followed by Sydney (62.3%), Melbourne (60.7%), Canberra (59.8%), Brisbane (45.7%) and Perth (38.5%). 

Whilst it is too early to determine if the worst of the decline phase is over, the RBA's decision to raise the cash rate by a further 0.25% instead of 0.5% for the second straight month, despite the high inflation reading for the September quarter, indicates they do expect inflation to start moderating.

Quick Insights
Housing Accords     The Federal Government's new policy of targeting 1  million new homes over 5 years could be a difficult  target to achieve based on current estimates however  the policy has merit in attempting to deal with the  ongoing structural under supply of housing across  the country with significant economic benefits.

Low Vacancies Co-living and build-to-rent operator UKO expects to  more than double its portfolio to over 2500 rental  units  over  the  next  two  years  after  leasing  up  its  newest building in inner Sydney in just four weeks.  Near  record  low  rental  vacancy  rates  in  Sydney  has  lifted  occupancy  across  UKO's  portfolio  of  18  buildings and more than 1000 apartments to 98 per  cent and allowed it to bump up asking rents.

An Opportunity Presents  Some seasoned landlords are now taking advantage  of the lull in the market to bulk up their portfolios.  Domain calculated that a 4.34 per cent gross rental  yields  will  cover  the  mortgage  repayments  on  an  average standard variable rate loan, taken on a 20  per cent deposit over 30 years. This means houses  in 11 per cent of all suburbs in NSW are earning high  enough  rents  to  cover  the  mortgage  repayments  and even putting some extra cash into the landlords'  pockets.

The RBA hiked rates for the seventh consecutive month as it seeks to stifle inflation. Global central banks continue aggressive monetary tightening despite early signs of moderating inflation and weaker forward growth indicators.

With the consumer bearing the brunt of high inflation and tighter financial conditions, the RBA has backed away from aggressive rate hikes for now. Will other central banks follow, or is this a temporary reprieve?

Speakers: 
Darren Langer, Co-Head of Australian Fixed Income &
Chris Rands, Senior Portfolio Manager

Plastic wine bottles, jam jars and long waiting lists for luxury glass items may all become part of daily life as a result of the energy crisis.

Glass manufacturers are heavy energy users, so have been hard pressed by the rapidly escalating costs of oil and gas. They are currently having to put up the prices of their products by around 35%, although this may rise further. The concern is that passing this cost on to the consumer means prices will increase in a way that makes glass packaging, especially for food and drink, too expensive. Consumers will demand cheaper alternative packaging.

Glass half empty

Already, the luxury end of the glass market is bracing itself for much higher energy costs. Many of the Venetian glass workshops on the Italian island of Murano have already closed their doors because the cost of energy has made their decorative items too expensive. Customers looking to buy Venetian vases and fine crystal glasses could face extensive waiting lists this winter. The world-famous manufacturer of Riedel glass in Austria and Germany is also contemplating a shutdown. That's because furnaces can break if they cool, so pausing during periods when gas is rationed is not an option.

Glass half full

Nonetheless, glass is completely recyclable, so remains one of the greenest choices for storing food and drink. Given the challenges, we are seeing some surprising effects of the energy crisis as companies strive to develop innovative solutions and better opportunities.

Virdrala is one of the leading glass container manufacturers in Western Europe, operating in Spain, Portugal, Italy, the UK and Ireland. It produces a full range of glass containers, selling eight billion per year. Of its products, 35% are for wine, 26% are for beer, and the balance is split between food, spirits and soft drinks.

Adapting to the challenges, Vidrala is increasing its focus on glass recycling - in 2021, 48% of the glass it produced was recycled. It's also raised the collection rate of used glass to improve both manufacturing efficiency and earnings. Currently, the company is cooperating with a non-governmental organisation, which encourages people to recycle, collects the glass and delivers it to Vidrala for melting and recycling.

Looking to the longer term, Vidrala is working together with other companies from the glass industry to investigate hybrid hydrogen furnaces that could power the industry in the future.

Glass manufacturers are also exploring innovations such as reducing the melting temperature of glass by adding ash, allowing a more 'imperfect'-looking glass with less clarity and more bubbles, plus increasing the use of wind and solar energy at factories.

What about the future?

There's no doubt that the energy crisis will bring all kinds of innovative new solutions. Could we see milkman-style deliveries of wine in reusable bottles? Or more food and drink in aluminium cans? Will much more food move to recyclable plastic packaging or paper-based packaging?

Dutch company Corbion is at the forefront of innovative packaging solutions. It produces PLA, a bio-based and biodegradable plastic packaging, made from renewable resources. PLA is strong enough to replace conventional plastics. And, once used, it can be composted, breaking down into CO2, water and biomass.

To tackle the many challenges ahead, innovative thinking is needed alongside a more sustainable and, where possible, more traditional way of doing things. Inspired by the humble soap bar, shampoo is now available in solid bars, packaging free. Could the future see us taking our bottles to local shops and supermarkets for wine and oil refills, as is the norm in many parts of Southern Europe?

What does all this mean for investors?

As a society, we need to reduce our dependence on fossil-fuel energy. The current shortage could be the pressure we need to make dramatic changes. Meanwhile, many of the glass companies affected by the energy crisis are small caps. Due to their size, they are nimbler than their larger peers, putting them in pole position to both adapt quickly and create alternative solutions. So, challenging times can create opportunities for well-managed, innovative companies. Such businesses also create potential opportunities for diligent investors. Maybe it's time to raise a glass after all?

Author: Tzoulianna Leventi, Investment and ESG Analyst