There is growing recognition within the investment community that climate change poses material risks to investments.
Investors are eager to understand and address material carbon risks in their portfolios not only to achieve better performance of their investments, but also to take advantage of opportunities arising from the shift to a low-carbon economy.
In addition, the Task Force on Climate-related Financial Disclosures (TCFD) and other regulatory bodies have emphasized to investors the importance of disclosing climate-related risk in portfolios and called for a focused approach to manage these risks.
Understanding climate risk in portfolios starts with investors asking two important questions. What climate risks is the portfolio exposed to? And what is the degree to which the companies in the portfolio are exposed to these risks?
Applying a materiality lens to take a closer look at investee companies reveals two types climate risks – transition risks (or carbon risks) and physical climate risks. Depending on the industry and geography, both risks could have a significant impact on a company’s business and therefore, increase portfolio risk or decrease portfolio performance.
The need to reduce man-made greenhouse gas emissions and the shift to a low-carbon economy has the potential to disrupt many established practices, processes, operations and products of companies. These risks, commonly referred to as transition risks, are spurred by regulation, customer preferences and low-carbon technology alternatives.
Physical climate risk such as threats to businesses due to heat stress, extreme rainfall, drought, storms, sea-level rise and wildfires and second-order effects such as ecosystem collapse, hunger, disease and mass migration would have serious impacts on companies depending on the degree to which they are exposed to these risks.
One could conclude that physical climate risk would continue to increase if sweeping measures to reduce atmospheric greenhouse gases are not adopted. Drastic greenhouse gas reduction measures would invariably increase the transition risks on companies as they would have to adopt and survive under these constraints.
The degree to which investee companies are impacted by transition risk requires an understanding of how these companies are exposed to these risks and how they are managing them. Assessing a company’s exposure to transition risks leads to the conclusion that different industries are exposed to transition risks differently. In addition, within an industry, companies have varying degrees of exposure to transition risk. For example, an oil and gas exploration company has significantly higher transition risk than a healthcare service provider.
This has significant implications on how investment portfolios are constructed. A sectoral view of a portfolio reveals a higher portfolio weight in high transition risk industries would inherently make the portfolio risky. This also has implications on portfolio types. An energy sector portfolio will inherently have significantly higher carbon risks than a healthcare sector portfolio. Interestingly, a well-diversified portfolio with exposure to all the sectors would have lower carbon risk as low risk sectors such as healthcare and information technology (IT) would balance out higher carbon risks from energy and utilities sectors. Another notable point would be the impact of portfolio styles, such as value or growth, on carbon risk. Typically, value portfolios tend to invest in energy and utility sectors which have high carbon risk, while growth portfolios tend to have high exposure to low carbon risk sectors such as IT.
In conclusion, both physical climate risks and transition risks will impact portfolio returns through their holdings and a careful and deliberate analysis is needed. Interestingly, these two risks have somewhat of an inverse relationship – an increase in transition risk would result in lower physical climate risk. Understanding the degree to which sectors and companies are exposed to these risks is paramount for addressing climate risks in portfolios. This would determine not only the type of holdings within a portfolio, but also portfolio type and style.