While climate change is a complex issue often discussed as a source of risks, it also creates a new realm of opportunities for investors. However, if investors are to be successful over the long term, they must have the capability to identify and manage these risks and opportunities efficiently, which requires a deep understanding of the relationship between climate and the financial markets, two highly dynamic and interacting systems.
Carbon foot-printing is one of the tools available to help understand historic exposure to transition risks and when paired with comprehensive knowledge of the business, it provides valuable insights into a company’s ability to manage the impacts of future climate change. The outlook generated by the analysis, however, can sometimes be less useful in evaluating the future resilience of an asset or portfolio. On the other hand, scenario analysis, that includes a range of reasonable climate transition outcomes, can provide better insight into the strengths and weaknesses of a portfolio as well as its level of alignment with desired climate outcomes. In this article, we will discuss the application and assessment of climate scenarios for investment portfolios.
Investors can apply scenarios to investment strategies in the same way companies apply scenarios to their capital planning process to test resiliency under a variety of potential future outcomes. The International Energy Agency (IEA), Intergovernmental Panel on Climate Change (IPCC) and the United Nations-backed Principles for Responsible Investment (PRI) all offer a wide range of scenarios that are calibrated to climate change-related outcomes ranging from “business as usual” to “Net Zero by 2050”. There are three key considerations when applying these types of scenarios to investing:
- Scenarios ≠ Forecast: Scenarios involve numbers and a view of the future that can lead investors to an assumption that there is a single path to one future outcome. With any scenario, especially multi-decade climate scenarios, there is a great deal of uncertainty associated with factors such as international coordination, consumer behavior, technological innovation and corporate strategies. Therefore, the resilience of portfolios can really only be tested by using a range of scenarios that focus on what “could” reasonably happen rather than what “should” happen. Key outputs are the distribution, magnitude and likelihood of events that can be mapped back to long-term investment value creation and current market expectations.
- Investment-relevant parameters: Most current scenarios require knowledge of a specific business and expertise in translating factors like warming potential and carbon price into parameters that can influence a financial model. More recently, a joint effort was initiated by central banks and governments to standardize a range of scenarios that will likely further delineate key metrics such as credit and liquidity risk. Even more granular scenarios like the IEA Net Zero by 2050 will also help to bridge the existing gap.
- Time Frame: Although there is a general sense that the impacts of climate change are more imminent than ever, the larger and more likely impacts on earnings and cash-flows are potentially still outside of the 5.5-month average holding period for assets like U.S. equities. That being said, a more thoughtful approach to the implied long-term growth rates in multiples and terminal assumptions of a valuation model can help to incorporate medium- to long-term changes into even shorter-term investments.
With the increased momentum in country and corporate transition strategies and the growth in physical changes influenced by climate change, it seems sensible to include a net-zero scenario in the range of options to test the resilience of an investment portfolio. However, the term “net zero” is used in different ways by different groups. The IEA’s recent Net Zero by 2050 provides a detailed and economically relevant example of a scenario that defines “a” path and applies additional analysis looking at the sensitivity of their scenario to key areas of uncertainty such as changes in consumer behavior, technological innovation, energy security and use of nuclear and carbon capture. Regardless of the label, investors need to critically assess a number of parameters to understand the commitments made by companies and the commitments they may consider for their own portfolio:
- Accountability: Who has the mandate to achieve the goal and how are they incentivized to reach it? For industries with high levels of exposure, it could involve the implementation of a specific board committee and climate-related linkages to executive compensation.
- Alignment: Alignment with the capabilities and value creation of the business (or investor) and the relevant commitments of peers and local governments. The path to net zero can have varying meanings across different industries and regions.
- Base Year: The reference year for emissions is usually not the current year and needs to be assessed based on the quality of the data available and the percentage of reductions that are expected to come in the future.
- Scope: The decision to commit to intensity or total emissions reductions will depend on the growth trajectory of the business or the portfolio. However, there is often an expectation for businesses to be focused on total emissions over time. According to the GHG Protocol Corporate Standard, a company’s emissions can be classified in three scopes. Scope 1 and 2 reductions should be seen as standard disclosures. Scope 3 emissions should be critically assessed for coverage, available data and reasonableness, as they are voluntary and the hardest to monitor.
- Milestones: At a minimum, there needs to be high-level targets and milestones for 2030 and 2050, but some indication of an iterative process with 3- to 5-year windows for reassessment would be positive.
- Offsets and Innovation: It is difficult to imagine achieving Net Zero by 2050, without the use of carbon offsets and new technology. Offsets should be evaluated on transparency, total contribution, whether they avoid or reduce emissions and the relative risk of reversal. Innovation’s contribution should be transparent about uncertainties and the amount of reductions coming from earlier-stage technology.
Despite the challenges related to the kind of analysis required, there is likely to be value for investors and other stakeholders in trying to integrate the analysis of the risks and opportunities associated with climate change across their portfolios. Ultimately, successful investors are ones that have greater or faster access to information and find inefficiencies enabling them to better manage risk and capture return. Building portfolios that can be resilient through a variety of different climate futures can be beneficial to asset owners and society as a whole.