Climate change is a risk that is increasingly taking hold of us. A recently released discussion paper by the Reserve Bank of India (RBI) on climate risk has acknowledged it as a systemic risk to the financial system. According to The Economist, the London School of Economics estimated in 2016 that global financial assets at risk from climate change were worth $2.5 trillion, and this increased to $4.2 trillion in 2019. It is imperative that investors understand and plan for these impending issues. But, how do investors identify winners and losers in transition?
The important thing to look for when building an equity portfolio is to consider how companies are preparing and investing strategically to mitigate these risks. Climate-related risks can be physical or transitional. Physical risks include severe weather events, changes in rainfall patterns, rising sea levels, etc. Infection risk includes business losses from changes in policies and regulations, the preference for climate-friendly products in the market, and the steep decline in the cost of adoption. the product. These risks can increase the cost of production and operation, disrupt supply chains, and reduce demand for carbon-emitting or polluting products and services, and thus reduce the value of existing financial assets (equity and debt). can decrease. For example, the declining cost of clean energy, along with rising carbon emissions costs, is making the businesses of companies relying on fossil-fuels riskier. There is also a decline in asset value as insurance costs will increase as the frequency and intensity of adverse weather events increase.
However, where can you get information to make the right investment choice? For one, globally listed companies and bond issuers are mandated to disclose climate change risks. For example, markets regulator SEBI’s BRSR regulation has made it mandatory for the top 1,000 companies to disclose sustainability risks and opportunities, including climate change. Therefore, be sure to look at the company’s financial reports as the first source. There are also specialized research agencies such as MSCI, Bloomberg, CDP, Refinitiv, and Morningstar that provide quantitative and qualitative information about the climate risks of corporates.
Note that while these research reports are useful for establishing a perspective on a company’s climate change issues, you should also understand the assessment methodology. Unlike credit ratings, ESG ratings vary between agencies because of differences in the choice and weighting of features as well as measurement methods. Newspapers, research reports of independent research houses and academic institutions, and magazines are some other information sources. You can also do a screening – negative and/or positive – as well as the integration of climate change risk into stock selection and portfolio construction. The simplest is negative screening that can help avoid investments in carbon-intensive sectors such as coal, oil and gas that are more vulnerable. Note, however, that climate change may not affect companies in the same industry in the same proportion—some are increasingly converting their businesses to be lower carbon emitters. They can drive innovation, reduce costs and increase profits while achieving a long-term competitive advantage.
A positive screening approach involves identifying companies that are into mitigating climate change—a strategy similar to thematic investment. It is a top-down investment analysis based on long-term and structural changes. As the economy transitions to being less carbon-intensive, there is a huge opportunity for investment in low-carbon technologies and their value chain. Topics could be clean energy, clean transportation, climate-resilient agriculture and negative carbon technologies. For example, Tesla’s stock has performed well over the past five years on the back of its electric car and clean energy business, while General Motors and Ford Motors have lagged far behind.
When performing a bottom-up analysis for choosing specific stocks, you must assess a company’s financial and operating performance from the perspective of climate risks and opportunities. When making financial adjustments, examine climate change strategy and governance practices. For example, consider two companies in an inherently carbon-intensive industry such as fossil-fuel-based combustion cars. If one of them is investing in increasingly competitive alternative products such as electric cars while the other is not, you can evaluate the long-term business impact.
It also helps to see specific metrics that are region specific. For example, ACC Cement’s CO2 emissions have dropped from 506 kg/tonne in 2018 to 493 kg/tonne in 2020, and has set an ambitious target of reducing it to 400 kg/tonne by 2030. Similarly, Asian Paints’ contribution to renewable energy increased from 35% in 2017-18 to 61.1% in 2021-22. Such metrics and targets can help evaluate companies among peers.
Labanya Prakash Jena is a Regional Climate Finance Adviser, Commonwealth Secretariat and Doctoral Scholar at XLRI, Jamshedpur. Meera Shiva is a Chartered Financial Analyst and works with early stage startups and investors. The views expressed here are personal.
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