Chemical risk – the biggest financial risk you’ve never heard about

At the center of modern finance is the asset manager, a large institutional investor that manages assets on behalf of their clients. For the people working in these institutions, perhaps no word is more central than financial risk. They, therefore, spend a whole lot of time and resources trying to “manage” – meaning identifying, measuring and controlling – those risks. As Amundi, Europe’s largest asset manager, puts it: ”Asset management is first and foremost a risk management activity”.

Some common forms of risks that portfolio managers and financial analysts look at are called market risk, credit risk and liquidity risk.

But recently, a new form of risk has started to beep on their radar: “chemical risk”. This is a financial risk that all companies that produce or use hazardous chemicals are exposed to. For example, a chemical company may need to pay large settlements for bodily injuries or cleaning up a contaminated water system. Or their cash-cow product may become unsellable as regulators try to deal with the unfolding chemical pollution crisis, leaving some of their valuable machinery and patents obsolete (“stranded”). Or the company might not be able to find adequate business insurance (insurance companies are also all about risk) or recruit or retain talented employees because their reputation is damaged.

There is no shortage of looming chemical disasters linked to the production of bisphenols, phthalates, halogenated flame retardants, heavy metals and so on.

Just a couple of years ago, chemical risk was not something asset managers cared much about. But over the last couple of years, it’s become difficult to ignore. Let’s take a concrete example.

3M is a US chemical company that for decades has been producing per- and polyfluoroalkyl substances (PFAS), which do not break down in nature and many of which are toxic. In 2018, 3M agreed to a settlement to pay the state of Minnesota $850 million for having contaminated the drinking water with PFAS.

One analysis found that PFAS-linked lawsuits have skyrocketed in the US in later years. Since 2020, at least three PFAS-linked lawsuits a day have been filed against 3M. And on June 22nd of this year, 3M agreed to a $10.3 billion settlement over a period of 13 years with a number of US public water systems to resolve claims of PFAS pollution, a figure exceeding the company’s 2022 profits.

One research firm estimates that 3M may face cleanup costs of up to $140 billion. That’s more than double the size of the company’s total market value. This means the company might have to take on significant debt (if someone wants to lend) or issue new shares (if someone wants to buy them). Or, as a bankruptcy lawyer commenting on the case in Bloomberg Law said: “Bankruptcy may be the only real alternative”. In other words, a Fortune 500 company, employing close to 100,000 people, may be sued out of existence.

What does this mean from the perspective of the asset manager? Obviously, 3M’s stock has not performed very well, as seen in the graph below. Shares have declined around 60% since 2018, wiping out tens of billions of dollars. For asset managers who’ve been invested in the company, a lot of their clients’ money has gone down the drain.

This example highlights the importance for asset managers to understand chemical risk. An asset manager informed about chemical risk would probably have excluded 3M from their portfolio decades ago, “shorted” it (bet against it) or – perhaps most responsibly – used their voting power to transition the company to safer alternatives.

And this is just PFAS. There is no shortage of looming chemical disasters linked to the production and use of, for example, bisphenols, phthalates, halogenated flame retardants, heavy metals and so on.

Different industries are exposed to chemical risk to varying degrees. The chemical industry – the set of companies that creates the chemicals in the first place – is probably the riskiest. But there are also other high-risk industries, for example, Construction Materials, Electrical Equipment and Personal Care Products.

So far, we’ve talked about chemical risk as something that companies are directly exposed to. But the companies that produce and use hazardous chemicals also create risks for the financial system as a whole. These are called “systemic risks”. For example, a report released by ChemSec estimates the annual societal costs of PFAS to be a staggering $17.5 trillion worldwide. That’s trillion with a t. For one thing, this means that massive capital and human resources – that could be spent on researching and developing green technologies and building the infrastructure of the future – will need to be employed just to clean up the mess. That’s not good for the financial system. Furthermore, chemical pollution is a key driver of the ongoing biodiversity crisis, which might lead to the collapse of the entire financial system if it is not halted.

To conclude, chemical risk is a financial risk. For asset managers, this means three things.

1. They should educate themselves about chemical risk, including the health and environmental issues linked to chemical pollution.
2. They should start dialogues with the most-high risk companies in their portfolios and ask them to transition to safer alternatives.
3. They should escalate their pressure – divest from the company or file resolutions and vote against the board – if there’s no progress.

The deepening chemical pollution crisis ripples through all human systems, including the financial system, which ultimately relies on a healthy and functional society. Chemical risk must be understood and tackled. A task worthy of a truly responsible asset manager.