Making better use of climate-risk data

Please note: This article is designed to be thought leadership content, to offer big picture views and analysis of interesting issues and trends that matter to our clients and the world in which we live. It is not designed to be taken as expert advice, investment advice or a recommendation, and any reference to specific companies is therefore not an opinion as to their present or future value or broader ESG credentials.

Reliance upon any of the information in this article is at the sole discretion of the reader. Some of the views and issues discussed in this article may derive from third-party research or data which is relied upon by Barclays Private Bank and may not have been validated. Such research and data are made available as additional information for the reader where appropriate.

Key points

• As companies transition to a low-carbon world, investors now face wading through a flood of climate-related disclosures in companies’ financial reports. As climate-change costs become more evident, this article aims to help them to find the risks most relevant to them.
• Emerging metrics are identifying factors such as implied temperature rises or a novel classification of industries into emission sectors. Indeed some, like those tracking climate value at risk, can provide investors with a fresh lens by which to view their portfolio risks and potential opportunities. 
• The value of forward-looking metrics, such as climate value at risk, lies in the ability to compare them across scenarios and to understand their key drivers, not just one number itself.
• In looking at portfolios from a climate-risk perspective, perhaps the most important question is the period over which they plan to hold investments.

The amount of climate-related information available to investors has mushroomed in recent years. But for all the fresh data, is it making much difference to how investors are positioning their portfolios?

The Task Force for Climate-related Financial Disclosures (TCFD) has been a very successful British innovation, and one that is now being adopted in many jurisdictions around the world. It’s so successful in fact, that the original body producing it, declared it was a case of ‘mission accomplished’ and disbanded. Indeed, the TCFD and their reporting guidelines are now part of the International Financial Reporting Standards (IFRS) reporting framework.

Following the lead of the TCFD guidelines, investors around the globe are receiving reports disclosing information both on how financial institutions are incorporating climate risks and opportunities into their processes, as well as assessments of the climate risks and opportunities inherent in their investments.

More information available

The adoption of climate considerations in reporting standards gives them more weight. It should also lead to more streamlined thinking around the topic. 

A small number of providers have become dominant players in generating climate-risk assessments. For example, MSCI and Willis Towers Watson (WTW) have developed tools which produce a host of climate-risk characteristics when prompted with a list of assets.

As an investor, no matter what your stance on climate goals may be, more information should help. This article aims to help you to use TCFD reports most effectively and to add a new lens through which to look at risk and opportunity in a portfolio.

Footprints, commitments and scenarios

The direct or indirect emissions associated with a portfolio are identified in a section of the TCFD reports. This backward-looking information is most useful in helping investors to track their progress towards meeting their climate-transition goals. 

An interesting innovation for goal-tracking, introduced by MSCI, is implied temperature rise (ITR). This metric estimates what global warming path the world would be on if the global economy had the same effect as a country. From this, average portfolio ITRs can be estimated.

Forward-looking metrics, such as climate value at risk (climate VaR, MSCI) or climate transition value at risk (CTVAR, WTW), combine company characteristics, the commitments made by the companies and scenario projections on how the world might evolve in models that aim to quantify potential climate risks in a portfolio. 

The scenarios are often comparable across providers, as they leverage the same scenario providers¹. However, the applied methodologies can be complex and difficult to compare.

Getting to grips with the assumptions

MSCI’s climate value at risk, the most prevalent framework in TCFD reports, identifies climate opportunities, transition risks and physical risks. For each aspect, scenario-dependent future costs and gains in relation to the current asset price are estimated.

Importantly, the MSCI framework assumes that none of these climate risks are currently reflected in the market valuation of companies. The target horizon for all estimates is 15 years, though the evolution is estimated until 2050 for transition risk, and 2100 for physical risk. 

These are important assumptions, as a 15-year investment window is unrealistic for many investors. However, the choice of time horizon is central to using forward-looking estimates, since transition risks are sensitive to policy changes. Physical risks, however, do not materially differ between even the most extreme scenarios (see chart) in the short term, but can vastly differ as time horizons grow beyond ten years. 

As such, while physical near-term risks exist, the path of policy is unlikely to change them. This may be one of the reasons why WTW’s approach focuses on transition risk. Instead of estimating the potential impact on economies of various climate scenarios, WTW considers what costs would be associated with a transition in order to be in accordance with the Paris Agreement of limiting global warming to 1.5°C above pre-industrial levels (see chart).

From 2035 onwards physical scenarios diverge

Median (50%-percentile) and 95%-percentile projections of global warming projections for Network for Greening the Financial System climate scenarios Nationally Determined Contributions and Net Zero 2050

The value lies between the estimates

Turning to MSCI’s climate VaR metric: Despite there being a potential cost estimate, the estimate itself is not that insightful. Not only do time horizons not match those of most investors, but there is much uncertainty regarding the likelihood of scenarios and the potential outcomes within scenarios (see previous chart). The usefulness of this approach lies in the ability to compare risk estimates across climate scenarios and to understand in which positions there might be concentrations of a specific climate risk.

Switching lenses

Leaving exact estimates behind, investors equipped with climate-risk estimates can now add another lens to their portfolio analysis. As with any risk, be it geopolitical, concentration or currency related, one can overlay a climate lens to explore the robustness of a portfolio. 

A first, helpful tool by MSCI is the re-arrangement of traditional economic industries into so-called emission sectors. A typical balanced multi-asset class portfolio with a focus on capital-light businesses might have emissions exposures that look like those shown in the following pie chart. This re-grouping of traditional industries can already shed light on the climate-risk concentrations, based on the type of climate risk each emission sector might be most exposed to (see chart).

Emission sectors instead of industries

MSCI emission sectors for a typical balanced multi-asset class portfolio

Going deeper gets more involved

But transition risk is about much more than emissions: TCFD guidelines name policy, legal, technology, market and reputational risks as subcategories. While the mining industry may face significant transition risks in all subcategories, transition risks for the finance industry are concentrated in legal and reputation risk. 

Unfortunately, the MSCI transition risk framework does not capture this notion directly and one has to build a scorecard of transition risks and physical risks themselves, as identified in our article, ‘Is your portfolio at risk from the low-carbon transition?’. 

For physical risks, the MSCI model differentiates between slowly evolving chronic risks, that may cause business interruptions, and acute climate risks, which may cause business interruptions as well as damage to assets.

Understanding the physical/transition risk trade-off

TCFD reports often contain a forward-looking model output for an orderly transition scenario like Net-Zero 2050, and compare it with those looking at higher temperatures, such as Nationally Determined Contributions. Using the same typical balanced portfolio, we explore the trade-off between physical risks and transition risks (see chart). 

Perhaps the chart’s first interesting observation is that the commercial emission sector, which includes both buildings and services, contributes slightly above 70% of portfolio physical risk, while carrying around the same weight in the sample portfolio². 

One could say that this exposure is “neutral” towards the physical risk budget and is positive towards the policy-risk budget, as commercial positions only contribute about 50% of policy risk. Second, even though commercial sector exposures can decrease the physical risk exposure, they still carry physical risk. Third, the difference between scenarios is significantly larger for policy risk than it is for physical risk. This implies that policy risks should be re-evaluated more often. 

Trade-off between transition and physical values at risk

Emission sector breakdown of MSCI climate VaR estimates for NGFS scenarios “Net-Zero-2050” and “Nationally Determined Contributions” on a typical balanced multi-asset class portfolio

New ways to challenge investment ideas

Climate-relevant data is much more than just greenhouse gas emissions. Forward-looking metrics can help to identify and manage the different types of climate risks found in an investor’s portfolio. However, the risks need to be well-understood. 

Climate scenarios open another long-term angle to portfolio analysis and put even more emphasis on the all-important question: what is your investment horizon?

For the near-term, scenario assumptions on policy risk are more important than those on physical risk. The latter depends more on the location of assets and can look vastly different from our shown example for less capital-light strategies that may have more geographical exposure to emerging markets.