Is your portfolio ready for the low-carbon world?

Commitments made in 2015, and progress to them, as part of the Paris Agreement will be reviewed this year at the United Nations Climate Change Conference (known as COP26) in Glasgow. Already we know the current plans do not deliver the two degree centigrade commitment, let alone the 1.5 degree ambition. Furthermore, most countries are not on track to deliver them.

In February’s Market Perspectives, we highlighted the physical effects and risks for investors, of not delivering on the above plans. With the increasingly visible physical effects of climate change, and growing public sentiment, countries and companies will be expected to take more action, and faster, to address climate change and reduce carbon emissions. This creates a corollary of transition risks, or the financial risks which could result from the process of adjusting to a low-carbon economy.

Transition risks

Transition risks are not as immediately visible as say a hurricane or moves in average temperatures. They are the more structural and systemic shifts that climate change, and efforts to address it, will have on companies and investors.

Given the potential financial risks, investors need to be increasingly aware and positioned for the implications of the actions taken to achieve climate targets. To help that process, we look at the transition risks that arise from moving towards a greener economy and strategies associated with climate change adaptation and mitigation.

Understanding the types of risk

Transition risks arise from the requirement to deliver climate targets and from the process of switching to a low-carbon economy. These are generally categorised as policy and legal, technology, market, and reputational risk. Let’s review these in turn.

Policy and legal

Policy changes will either seek to constrain contributors to climate change or promote adapting to its effects. This can range from carbon-pricing mechanisms, emissions-reporting obligations, sustainable land-use practices, phasing out fossil fuel subsidies or encouraging greater energy-efficiency.

Companies that are not prepared for these changes, and fail to mitigate the impacts in a timely manner, face considerable policy risk. Those businesses that avoid or actively lobby against these changes may face potential litigation risks from consumers, investors and governments.

Market

Market risks are created with shifts in supply and demand for certain commodities, products and services. Like the fashion for reducing plastic bags and plastic straws usage, changes in customer behaviour can rapidly affect an industry’s viability. Market risks may affect production costs, revenue mix or asset re-pricing.

Technology

Technological innovation is needed to address climate change. For companies, either development of or use of new technologies always comes with certain risks. R&D expenditure may not lead to results. Capital expenditure in the early industry leader may have to be written-off as lower cost technologies are developed.

More significantly, is the risk of not taking action to, for example change existing production to lower emissions options, which can generate greater cost and competitiveness risks.

Reputation

Finally, reputational risk stems from changing social perceptions of an organisation’s contribution or detraction to climate change. Consumers are becoming more aware about the impact to the climate of various products.

Customers and communities are more likely to demand – in some cases through strikes or protests – more commitment to the transition to a low-carbon economy from companies. Fast changing social dynamics can be extremely damaging to a company’s reputation and negatively affect their license to operate, attract talent, or profitability.

Financial implications of transition risks

The transition to a climate-resilient and low-carbon future carries both risks and opportunities that could unfold gradually or through sudden shocks. Transition risks tend to have a built-in lead time, allowing companies to plan and adjust. However, the frequency of abrupt shocks from physical risks, accelerated policy changes and sudden shifts in social expectations have recently increased.

Efforts to meet climate goals require far-reaching changes to the energy system, carbon-intensive industries and consumer behaviours. Almost all resource-intensive sectors (such as cement, glass and agrochemicals) will need to decarbonise. High-carbon sectors that fail to transition towards a low-carbon environment could end up with substantial stranded assets. While the potential value-at-risk posed by transition risks vary widely, markets have recently started to shun “polluting” industries towards more environmentally-friendly alternatives.

According to the G20 Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD), companies face a range impacts from transition risks. Examples of these are included below:

How investors can respond

In the next few years, transition risk could increase significantly. Besides the implications of physical risks, investors also need to consider how the low-carbon transition could financially impact a variety of sectors and asset types held within their portfolios. There are several proactive practices that can improve investment judgement about climate risks and opportunities.

As no company is immune from climate risk – in one form or another – scenario analysis can be the first step in assessing a portfolios risk and opportunity exposure to transition risk. This step allows to forecast the financial impact of different climate scenarios (2C-4C), and helps organisations and investors to better understand the climate transition over long term.

For strategic asset allocation, investors can assess the relative implications of climate scenarios on different geographies, asset classes and time horizons.

Assessing companies' footprint

For many investors, assessing a company’s carbon footprint is also a technique in understanding the impact of certain investments and the relative climate risk due to carbon exposure. Even though carbon footprinting has some limitations (in say consistency and scope of data), by calculating the tonnes of atmospheric carbon dioxide equivalent per million dollars of revenue for an investment, the method facilitates decision making around de-risking.

Finally, investors should also assess whether organisations and their senior executives are actively planning for climate risk and addressing their environmental, social, and governance (ESG) footprints. This can be achieved through active engagement between parties and transparent disclosure of climate-related information beyond published reports and data – in line with the TCFD’s recommendations.

Climate-change related risks can quickly add up to hundreds of billions of dollars globally. As the world accelerates its move towards a low-carbon economy, transition risks are rapidly becoming visible. The above methods enable companies and investors prepare accordingly: plan for a number of different scenarios, depending on the extent and impact of global climate change and build more climate-resilient portfolios.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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