This year’s Climate Week New York City (CWNYC) gathering came at a critical point in the global response to climate change, with the US potentially leaving the Paris Climate Agreement, while many other countries, governments and companies have reiterated their commitments to reducing their greenhouse gas emissions by 2021. Media interest and investor engagement around #CWNYC have certainly gathered momentum over recent years.
Impax was once again proud to contribute to CWNYC, and hosted a well-attended panel discussion at the start of the week on identifying, quantifying, and managing carbon risk in investment portfolios. It was pleasing that our event was so well attended with strong investor interest in the topic.
This event built on a recent series of events with Carbon Tracker, a London-based financial think tank that aims to map the transition to a sustainable economy, and ClientEarth, an environmental legal NGO focused on protecting the environment through advocacy and litigation.
Our starting point
Climate change risk is a combination of weather risk (i.e. the direct impact of climate change) and carbon risk (by which we mean the risk of owning assets that could be impaired as society imposes or adapts to lower emissions of greenhouse gases). We focus on the latter, given the longer time frame of the former, and we question whether this carbon risk is currently priced into investment portfolios. In particular, many long-term investors do not take into account near-term factors, including likely government intervention to reduce CO2 emissions, and the changing consumption patterns and business models that this would induce.
Our model starts with an estimate of future cash flow impairment for companies that have limited ability to pass on cost increases to their customers. We then uses scenario analysis to determine the net present value of this risk for each company, before using the NPV data to guide portfolio optimisation. Finally, we recommend that assets owners update their models periodically to take account of changing sentiment and probabilities of intervention.
A key aim in this work has been to identify an investment strategy that can reduce carbon risk while minimising the introduction of any additional risks. Since inception over two years ago, our recommended portfolio has maintained a tracking error of less than 0.5% vs its benchmark (we use the MSCI World Index), posting a slight out-performance.
Insights from our panellists
Henrik Jeppesen, CarbonTracker’s head of investor outreach for North America, presented research examining the implications that adhering to a 2 degree carbon budget will have on global fossil fuel reserves. 66,000 fossil fuel sources, belonging to 3,200 companies were analysed, to determine the most economically efficient fossil fuel reserves to extract before exceeding the carbon budget. Everything beyond the cap was designated non-viable in the context of a global cap on CO2 emissions.
Developments are proceeding in other areas, too. Alice Garton, a senior lawyer at ClientEarth, spoke about how the interpretation of the law in the context of climate change risk has recently been ‘flipped on its head’. Curtis Ravenel, global head of sustainable business & finance at Bloomberg, agreed with this, stating that “even though climate change risk is a political and existential issue, when you can really make it about financial decisions and fiduciary duties you are putting this into a quantitative format that has the potential to fit neatly into the existing (legal) framework.”
Over the past few years we have endeavoured to bring together economic, legal, and investment management perspectives on carbon risk to help investors understand and assess one of the most complex challenges they face. Impax is currently working to extend our carbon risk assessment methodology to the electric utilities sector. Further work is also planned to include research into basic materials and mining companies. With these additions, Impax will further enhance carbon risk assessment in investment portfolios.