Understanding climate risk: How carbon footprinting can help

Climate change is no longer just a potential investment risk in the distant future – it already is one today. It represents an urgent threat to corporations, economies, society and the planet. The imperative to transition to a lower carbon economy is a core investment consideration and effectively climate-proofing portfolios requires an informed approach.

Being proactive can help investors mitigate the risks associated with climate change, estimated at a loss of return of 0.82% per year1 for developed equities. Carbon footprint analysis is one tool for understanding climate risk – but how can investors adopt this to support their investment decisions and what’s next?

Why does climate change matter?

In December 2015, over 190 countries agreed to take immediate action with the Paris Agreement, an international commitment to stay within 2oC of warming above pre-industrial levels. This goal necessitates the transition to a lower-carbon economy. The transition is already underway and set to accelerate as changes in policy and regulation, the falling cost of technology and demand are leading to fundamental shifts in sectors such as energy, auto and utilities.

Our current trajectory is closer to 4°C above pre-industrial levels by 2100 if no action is taken. The physical impacts of climate change associated with this temperature increase are severe – in both social and economic terms. The financial consequences of these physical changes are no less severe. An Economist Intelligence Unit report2 calculates the value at risk to global manageable assets from climate change to be $4.2trn, in present value terms. In many cases, regional impacts can be more pronounced.

What are climate-related risks?

A report by the Financial Stability Board (FSB) backed Taskforce on Climate-related Financial Disclosures (TCFD) classified climate-related risks into two major categories – physical risks and transition risks3.

Transition risks relate to the impacts and costs of policy, legal, technology and market changes that will be required to mitigate and adapt to climate change. In concrete terms this will result in a higher carbon price associated with carbon emissions.

Physical risks relate to the physical impacts of climate change. These include an increase in the frequency and severity of extreme weather events, such as droughts, floods, storms, or longer-term changes in climate patterns, such as rainfall and temperature. These will all contribute to negative impacts on human health, ecosystems and the economy.

Companies that fail to respond to the impacts of the transition to a lower-carbon economy face financial and reputational risks, potentially harming their credit ratings and share price. How they respond and adapt their business strategies and models will be critical, and there will be winners and losers. However, the consequences of a failure to transition are far greater.

What is a carbon footprint?

The Greenhouse Gas Protocol, the most widely used international accounting tool for GHG emissions, classifies a company’s direct and indirect emissions throughout the supply chain into three ‘scopes’ – direct operational emissions (scope 1), purchased electricity, steam or heat (scope 2) and emissions resulting from the activities of the company but occur from sources not owned or controlled by the company (scope 3)4. Security level carbon footprints can be aggregated to portfolio level.

How can carbon footprinting help investors?

The TCFD recommended that asset managers provide the weighted-average carbon intensity, where data are available or can be reasonably estimated, for each product or investment strategy. The Task Force acknowledges the challenges and limitations of current carbon footprinting metrics but views this disclosure as a first step.

While carbon footprints do not tell us about the physical climate risks – the most important risk for some securities – it can act as a reasonable proxy for understanding transition risk, identifying the most-exposed securities.

Investors can use carbon footprint analysis to understand the exposure of companies to the potential effects of carbon pricing and as a simple proxy for gauging climate-related transition risk, both as a standalone tool and in combination with a carbon target, as part of an investment strategy.

What’s next for carbon footprint analysis?

As disclosure improves, we expect the use of climate footprint analysis to develop in three respects.

Firstly, we believe there will be improvements in coverage and accuracy. Carbon reporting is particularly challenging for smaller and emerging market companies and for other asset classes beyond equities and corporate bonds such as sovereign bonds. We expect the adoption of the TCFD recommendations to accelerate both coverage and the quality of the information, making carbon data more complete, accurate and useful for investment decisions. The requirement for the financial sector to disclose its carbon footprint is also likely to spur more comprehensive coverage and methodologies beyond equities.

Secondly, going forward, carbon footprints are likely to be used in combination with exposure to climate-related investment opportunities (e.g. ‘green revenues’) to provide a more accurate exposure profile to determine if it is aligned with the two-degrees transition.

Thirdly, carbon footprints will likely be used in combination with geographic and product information, allowing investors to combine transition and physical risk information.

The implications of climate change and transitioning to a lower-carbon economy are core investment considerations – today and for the coming decades. Carbon footprinting presents a useful tool for investors to make these key decisions.

 

Stephanie Maier is director – Responsible Investment, HSBC Global Asset Management

 

[1] Source: Mercer, Investing In Time of Climate Change, June 2017 – Portfolio Transformation (Median Annual Return Impact Over 10 years)

[2] Source: Economist Intelligence Unit – The cost of inaction: recognising the value at risk from climate change (2015)

[3] Source: Recommendations of the Task Force on Climate-related Financial Disclosures, June 2017

[4] Source: World Business council for Sustainable Development/World Resources Institute. For further information and full definitions see  World Business council for Sustainable Development/World Resources Institute GHG Protocol Corporate Accounting and Reporting Standard (2015), and http://www.ghgprotocol.org/standards/scope-3-standard

[5] Carbon intensity is a financial metric that measures the efficiency of a company to generate revenue based on the amount of carbon (and carbon equivalents) that is utilised in the process. It is calculated by using company GHG emissions normalised by company revenue and quoted as tCO2e per $1m revenue. This can be used to compare company performance across sectors and geographies to make portfolio investment decisions.

[6] Divesting it is the process of selling an asset for either financial, social or political goals.

 

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