SUSTAINABILITY IN FOCUS
Three Avenues of Reflecting Climate Change in Portfolios
Climate change has risen to the top of the political agenda
With the publication of the Stern Review on the Economics of Climate Change in 2006, a wider audience became aware of the economic consequences of climate change. The combined negative effects on the global economy are expected to be significant and most likely non-linear. Effects will be felt across a variety of primary and secondary impacts. The primary impacts include increased severity of droughts, rising sea levels, and higher incidence of natural catastrophes. However, it is the secondary effects such as increased migration and higher intra-regional conflicts, or more frequent disruptions to production infrastructure and supply chains that account for a larger part of the expected impact.
Given the long-term economic impact, it has been accepted that climate change needs to be accounted for in investment portfolios. However, given the complexity of the inter-linkages between climate change mitigation and other ESG objectives, many investors are overwhelmed. The following article provides a framework on how climate change can be integrated into the investment decision process, both as a source of potential risks as well as an investment opportunity.
The Task Force on Climate-related Financial Disclosure (TCFD) defines two main categories of climate-related risks: physical risks and transition-related risks. The first describes the direct impacts from changing climate, such as severe weather or floods. The second describes the risks that arise as companies fail to prepare for the transition to a low-carbon economy. Thirdly, climate change mitigation might open new opportunities in supporting the transition. This requires new product and services that facilitate an alignment with goals of the Paris Climate accord, and creates an attractive space for companies and investors. In the following, we lay out how these three different dimensions can drive financial returns.
Physical risks: Climate change puts company assets at risk
The effects of climate change are evident around the world with more frequent heat waves, hurricanes, wild-fires, and floods. As such, climate change creates tangible economic losses around the world. Five of the top ten weather-related losses happened in the past ten years, which exemplifies the correlation between rising temperature levels and extreme weather.
However, it is mostly the secondary effects that create the highest economic losses. The increased frequency of hurricane landfalls in Florida have severely reduced access to private insurance of facilities close to the coast, requiring the State of Florida to provide a backstop hurricane insurance. The heavy monsoons in 2011 in Southeast Asia wreaked havoc in the technology sector as most of the manufacturing of hard-disk drives was concentrated within an area that was flooded for weeks.
As such, climate change puts physical assets and the production capacity of companies and its suppliers at a direct loss. Physical risk is the most direct result of climate change. While detailed modelling of physical risk has been a mainstay of insurance companies for decades, the detailed data is often inaccessible for investors. Fortunately, companies increasingly address the topic as part of their sustainability report. In addition, the processes companies have to manage physical risks are dis- closed and can be assessed and discussed with management.
Insured Weather Catastrophe Losses
Transition risks: Climate change mitigation puts earnings at risk
As governments prepare the political measures and regulations for a low-carbon future, companies will experience both a push from increased carbon taxes and laws as well as a pull from changed customer preferences and behaviours. These changes will put business models at risk, and could represent a significant headwind to future profitability if not properly addressed.
There are several methods to assess the exposure of companies to the climate transition. The easiest to assess are risks to assets that have been explicitly valued by financial markets or accounting standards. As policies, technology, and markets changes, some assets are at a risk of being prematurely written down or devalued. These stranded assets will be no longer able to earn their cost of capital before the end of their economic life. For example, Bloomberg New Energy Finance estimates that between 2030 and 2035 it is likely to be economically viable to shut down a coal plant and re- place it with an alternative energy source, as carbon taxes rise and renewable production becomes more efficient and cheaper. Any coal plant with an economic life beyond that point might become obsolete.
As part of the climate transition, the assets most at risk of becoming stranded are fossil fuel reserves. Stranded assets in fossil fuels are concentrated within a few companies and sectors such as energy, materials, or utilities. The top 10 impacted companies account for more than 75% of total exposure.
Potential Carbon Emissions (MSCI World)
Source: CarbonDelta, MSCI, Bloomberg, Bank J. Safra Sarasin, 04.05.2020
To be sure, the analysis above shows only the direct exposure of companies to fossil fuel reserves. To assess the full extent of the exposure of companies, the entire value chain underlying these industries needs to be analysed. These include the suppliers, such as producers of compressors for the shale industry, service companies providing drilling rigs and crews, as well as mid- and downstream companies such as pipelines or trains used for transportation. In the end, as fossil fuel-driven technologies become obsolete and overtaken by cleaner solutions, the current production capacities will need to be written down.
As a proxy for this exposure, we use the current carbon intensity of a company. This measure takes the total greenhouse gas emissions (GHG) in tonnes of CO2 equivalent and normalizes them by the invested capital of the company. It can be shown to correlate other measures of cost and resource-intensity and can be used as a quality indicator. In addition, as regulation increasingly requires the societal costs of GHG emissions to be internalized through taxes, they are a risk of higher future costs. At this point, reliable data is available on scope 2 emissions, which include direct emissions from the production or service-provision process, as well as indirect emission from externally produced energy consumption.
Forward-looking measures of Paris-alignment
In a more forward-looking perspective, we analyse the decarbonisation objectives companies have set for themselves. As economies align themselves with the goal of the Paris accord to limit global warming to well below 2°C, individual companies are being judged on their efforts to achieve these targets. The targets as well as their historical success in achieving carbon intensity reductions are used to calculate an alignment with a climate temperature scenario path. While still dependent on many modelling choices and assumption, it should provide a clearer perspective on companies’ preparedness for the transition.
Both measures evaluate companies on their carbon emissions. However, given the backward- and forward-looking nature, the results are aligned, but give different perspectives. To understand the risk to a company, a more detailed analysis is required.
Measures of Carbon Exposures of Companies
Source: CarbonDelta, CarbonMetrics, MSCI, Bloomberg, Bank J. Safra Sarasin, 04.05.2020
Green revenues: The carbon transition provides opportunities
A successful climate transition requires new solutions to provide low carbon replacements for existing needs. It provides new entrants with an opportunity to compete effectively with established players for new markets. This happens across a large cross-section of sectors. Tesla was founded only 17 years ago, but is already the largest seller of luxury cars in the US, ahead of over 100-year-old European stalwarts such as Daimler-Benz or Audi. GE’s own onshore wind business generates similar revenues as its legacy gas turbine unit.
To ensure that capital is directed towards activities which have a significant impact, the European Union has defined 70 climate change mitigation and 68 climate change adaptation activities that should be considered as beneficial to combat climate change. The detailed regulations, known as “EU Taxonomy for sustainable activities,” measures the green revenues associated with these activities. High exposure should enable the respective companies to gain market share and grow faster than their competitors.
“One size fits all” does not work
Reflecting the complexities of climate change in investment portfolios is a daunting undertaking. It is upon asset managers and asset owners to decide how their portfolios should reflect the upcoming challenges. Starting from assessing the risk of physical asset destruction to measuring alignment with policy intentions to benefitting from new opportunities, investors have an increasing set of tools at their disposal. And given the stark consequences of climate change which await us, it has become a necessity to integrate these into portfolios.