The key question for sustainable investors is: how vulnerable is a company to the transition from a fossil fuel-based economy to a lower carbon one?
Understanding carbon risk in a portfolio can help investors make better decisions. Investors typically do not know the extent to which a portfolio is exposed to carbon risk. While a portfolio’s exposure to fossil fuels is a major component of its carbon risk, a much wider range of industries, approaching half the overall global market capitalization by some estimates, have exposure to carbon risk through trends like the shift to renewables or electric vehicles.
Efforts to combat climate change by reducing greenhouse gas emissions are now taking on greater urgency, especially after having lost momentum in the wake of the 2015 Paris climate agreement. The United Nations Intergovernmental Panel on Climate Change (IPCC) 2018 report concluded that the effects of climate change are more severe and more imminent than previously expected. It forecasts dire consequences resulting from a global temperature increase of 1.5° centigrade over pre-industrial levels.
Therefore, companies in fossil fuel-related industries or with carbon heavy operations are under pressure. Governments, civil society, and the private sector are mobilizing, taxing carbon, incentivizing renewable energy, even divesting from fossil fuels. Investors too are becoming increasingly aware of climate change-related risks and the need to transition away from carbon-intensive activities. Pressure is mounting on pension funds and other asset owners to more thoughtfully consider carbon risk.
Understanding carbon risk helps decision making
A portfolio carbon risk assessment can provide information on overall risk exposure and where in the portfolio the risk is located.
After assessing portfolio level carbon risk, investors can make strategic decisions to mitigate carbon risk and measure its reduction. This applies to asset managers, asset owners, and other investors. An asset manager can use carbon risk information to inform buy-sell and portfolio construction decisions, to make decisions on which companies to engage with and to communicate with clients and other stakeholders about their activities.
An asset owner or investor can use carbon risk information to better understand how climate risk affects their investments overall and as a basis for action to reduce their exposure to climate risk. This information allows fund investors to take climate risk into consideration as they monitor, compare, and select investments and managers.
To help investors specifically focus on and better understand carbon risk in portfolios, Morningstar has developed portfolio-level carbon risk scores that are based on an innovative new set of company carbon-risk ratings from Sustainalytics. Sustainalytics specializes in EGS and covers more than 10,000 companies globally. Sustainalytics has assigned Carbon Risk Ratings to more than 4,000 companies across the world.
Given the urgency around climate change, the shift to a low-carbon economy is both essential and imminent. Businesses must adapt if they will survive and thrive in a world less dependent on fossil fuels. Investors have a critical role to play, whether driven by a desire to advance the low-carbon transition, or purely by risk mitigation goals.
Analysis of carbon-intensive industries requires factoring carbon risk into the calculus. Fortunately, selecting on the basis of low carbon risk leads to quality investments. Effectively managing carbon risk is a sign of a long-term oriented, strategically run business.
This post initially appeared on Morningstar.ca
