Climate risk: An investor resource guide

Climate change is a material risk. The physical risks to assets and supply chains posed by extreme weather are expected to worsen if climate change is not mitigated. At the same time, policy actions taken to decarbonise the world economy are creating transition risk for firms and sectors that fail to adapt. If not managed well, both types of climate risk threaten to reduce economic growth, creating a less favourable environment for investment generally.

Investors need to be aware of not only how climate change affects their investments but also of the impact of their investments on climate. The notion of double materiality acknowledges that investments are both affected by climate change and can play a role in addressing (or worsening) the climate crisis. The sources listed below offer an introduction to the investment materiality of climate risk. General overviews and those aimed at specialised audiences (e.g., portfolio managers, trustees, accountants) are provided.

While many organisations have long had governance structures and processes related to environmental issues, these have typically focused on issues related to investee companies’ compliance with traditional environmental regulations. Adapting governance to address climate as a strategic issue is more recent: now, more than 75% of PRI signatories have tasked specific board members, committees or particular managerial employees with climate-related oversight.  

Climate change can be integrated into the governance of investment organisations through explicit incorporation into committee charters and employee job descriptions. This makes it possible to clarify climate-related responsibilities, the division of labour between a board (or the equivalent) and a management team, and the specific skills and expertise needed for each to exercise adequate climate oversight. Climate risks and opportunities must then be articulated, taking into account the nature of an organisation’s existing portfolio, as well as the state of climate science, public policy, and the views of beneficiaries, clients, or other stakeholders. In many cases, statements of investment policy or belief are adapted to include consideration of climate issues and subjected to board approval. Climate risk can then be fully integrated into strategic planning. To support achievement of climate goals, executive pay can be linked to performance against those goals.

About three-quarters of PRI signatories are analysing portfolio exposures to physical risks, such as increased incidence of storms, droughts, and wildfires that could damage assets or disrupt supply chains. They are also studying transition risks and opportunities, including climate-related regulations, incentives, and taxes; changes in technology; and demand shifts occasioned by the energy transformation. Many are also conducting scenario analysis as part of strategic planning.

Scenario analysis

Climate-related scenario analysis for investment portfolios is the practice of envisioning future trajectories for the development of the Earth’s climate system and estimating their potential impacts on the value of an investment portfolio. Only a minority of PRI signatories have completed this process, although it is rapidly becoming best practice as it is one of the recommended disclosures under the TCFD.

Q. How do investors conduct scenario analysis?

A. Some investors develop investment beliefs about the likely future trajectory of climate change (e.g., that a continuation of business-as-usual is likely to have severely detrimental effects). Then they decide on appropriate investment actions that should be taken in response (such as allocating capital to climate solutions and engaging carbon-intensive firms regarding business model change).

Other investors use formal scenarios developed by well-known institutions such as the International Energy Agency, Intergovernmental Panel on Climate Change, or the Inevitable Policy Response, which envision changes in policy, consumption, and business activities resulting in a certain degree of temperature rise by a certain date. In the latter approach, each company whose securities an investor holds may be examined to determine whether its future trajectory appears aligned with the development a given scenario lays out for its industry. Some methodologies also examine macroeconomic factors, providing inputs at the sector rather than the company level, and some are designed to measure portfolio-level alignment with certain temperature outcomes. The scenario analysis process can be conducted by portfolio managers or investment officers, or it can be done with the help of specialised research providers.

Q. How do scenarios vary?

A. Key differences among scenarios include:

• the levels of temperature rise they envision, and by which target date;
• how quickly and forcefully they imagine governments enacting climate-related regulation;
• whether and to what extent they imagine a target temperature being temporarily exceeded (in an “overshoot” scenario); and
• whether and to what extent they rely upon the removal of carbon dioxide from the atmosphere (using technologies that will need to be developed in the future).

Investors may choose to use only those scenarios they believe are likely or prudent, and it is common to use multiple scenarios, given the inherent uncertainties involved. 

Q. How can the results of scenario analysis vary?

A. An assessment of any given investee company’s alignment with a particular scenario may vary due to methodological choices. These may include the way data gaps are handled and the relative weight accorded to different and possibly contradictory aspects of corporate performance (e.g., climate governance vs. capital expenditures). It is important for investors to fully investigate the methodologies of external data and research providers.

Q. How can the results of scenario analysis be used?

A. Investors are using the results of scenario analysis to inform asset allocation, security selection, research processes, and stewardship. For example, after considering the future trajectories for climate change, investors might increase investment in renewable energy; divest from holdings that have higher emissions profiles than peers; investigate the vulnerability of investee companies’ supply chains to climate-related disruptions; and engage carbon-intensive firms regarding business model transitions.

At the portfolio level, investors evaluate risks to particular sectors (such as oil and gas) and asset classes (such as real estate). They also consider climate’s potential impact on a range of familiar risk types (credit risk, liquidity risk, legal risk, supply chain risk, insurance risk, operational risk and reputational risk). On the individual security level, investors are investigating how well investee companies are managing climate risk and opportunity. Moreover, many investors are comparing the materiality and priority of climate-related risks to other types of risk over a variety of time frames to be able to integrate climate issues into a comprehensive risk management system.

Q. How can climate-related risks be managed?

A. The Investor Agenda, a collaboration among seven major groups working with investors, has created an Investor Climate Action Plans Expectations Ladder to clarify expectations of investors on climate, with four tiers leading investors towards alignment with net zero emissions and a 1.5°C future. It recommends that asset managers and asset owners:

• manage systemic climate risks in investor portfolios and shift investments away from coal and other fossil fuels towards renewable energy and climate solutions in line with a 1.5°C future;
• engage with companies to drive and demonstrate real progress in line with a 1.5°C future;
• engage with governments to enact policy in line with the Paris Agreement; and
• disclose how their climate risk management activities align with the TCFD framework, while encouraging investee companies to do the same.

Governance cuts across the four areas above to ensure that all climate-related considerations are embedded in investors’ top-down governance arrangements in line with TCFD recommendations. Asset owners with external managers can query them about whether they are taking these actions as well.

Different metrics can be used to gauge a portfolio’s exposure to climate risk or opportunity, or its contribution to amelioration of climate change. Some are backward-looking (such as portfolio emissions measurements, which are based on disclosures or estimates of past emissions) while others are forward-looking (such as estimates of the implied temperature rise associated with an investment strategy).

Metrics are needed to assess progress against company-set targets regarding the level of performance that an organisation hopes to achieve by particular dates. Increasingly, net zero carbon emissions targets by mid-century or sooner are being set by both asset owners and asset managers, as well as investment consultants and other service providers. While only a minority of PRI signatories currently use metrics and targets, their adoption is rapidly increasing, including through initiatives such as the UN-convened Net-Zero Asset Owner Alliance and the Net Zero Asset Managers Initiative. These initiatives go beyond the management of portfolio risk to ensure that investment activity is aligned with the goal of a net zero economy.

Metrics are most useful when they are presented with sufficient context to make their meaning clear and their relationship to organisational strategy and risk management apparent. For example, reporting on portfolio-level carbon emissions (or the intensity of these emissions when scaled by market capitalisation or revenues) is more meaningful if a comparison to an appropriate benchmark is provided and the data is placed in the context of the organisation’s plans, if any, for portfolio decarbonisation. Trendline data including values from past years may also be useful to illustrate progress. Given that data and methodologies used to estimate climate risk are evolving, it is valuable to review metrics periodically and consider updating them when appropriate.

Q. What are some of the most commonly used portfolio analysis metrics?

A. TCFD recommends disclosure of the following seven cross-industry metrics for all organisations, as well as target-setting related to each:

1. operational carbon emissions, both in absolute and intensity terms and including scopes 1, 2, and 3;
2. carbon price assumptions, both external and internal;
3. the percentage of assets and/or activities vulnerable to physical climate risks;
4. the percentage of assets and/or activities vulnerable to climate-related transition risks;
5. the percentage of assets and/or activities aligned toward climate-related opportunities;
6. the percentage of executive remuneration impacted by climate considerations; and
7. the level of expenditures or capital investment driven by climate considerations.

On the first point, investors are encouraged to use the Partnership for Carbon Accounting Financials to report emissions associated with their portfolios and their financing activities. In addition to the items listed, some investors track and disclose sector- or industry-specific metrics, or metrics related to stewardship, such as number of corporate and public policy engagements, shareholder resolution filings, and proxy votes in support of climate progress. Some also disclose their portfolio’s degree of alignment with scenarios associated with particular levels of average temperature rise compared to pre-industrial levels.

Q. What are the methodological issues associated with measuring portfolio carbon emissions (TCFD recommended metric 1 above)?

A. There are three categories of carbon emissions. Scope 1 refers to emissions arising from company operations; scope 2 refers to emissions tied to energy purchases; and scope 3 captures emissions from the company’s supply chain and from its customers’ use of its products or services.

The voluntary nature of emissions reporting leads to inconsistency in data availability. Investors estimating portfolio emissions typically use the services of external data providers who collect data on issuers’ disclosed emissions and estimate emissions when disclosure is lacking. Investors should query data providers about these estimation methodologies, given the variety of approaches used, and should include in their own disclosures a summary of the methodology chosen.

Q. What are the methodological issues associated with metrics on carbon price (TCFD recommended metric 2 above)?

A. Carbon price assumptions may be external prices currently in effect or “shadow” (estimated) prices used for internal calculations. In either case, carbon prices should be assumed to increase over time, to reflect a decreasing carbon budget, that is, the amount of emissions the planet can tolerate each year. Carbon price assumptions should be aligned with temperature goals used in an investor’s scenario analysis. The World Bank is a valuable resource for more information on carbon pricing schemes.

Q. How do you calculate the percentage of assets exposed to physical and transition risks (TCFD recommended metrics 3 and 4 above)?

A. Some investors may restrict their definition of securities affected by physical risk to sectors most directly exposed to extreme weather, such as real estate, infrastructure, and insurers. However, extreme weather is also disrupting the production of raw materials, complicating supply chain management for manufacturers. Investors who have analysed this aspect of physical risk may have a broader definition of the securities affected. Transition risk, as well, will be defined differently depending on the climate scenarios the investor believes are most likely to unfold.

Q. How do you calculate the percentage of assets aligned with climate opportunities? (TCFD recommended metric 5 above)?

A. Climate-related opportunities can be defined in a variety of ways. The European Union’s green taxonomy and the International Finance Corporation’s green bonds framework are used by some investors, while others present their own rationales. A number of investors are now also disclosing metrics gauging the impact of their investments, including some linked to the UN Sustainable Development Goals, which include mitigation of climate change. Disclosure on any metric should illustrate the investor’s own thinking and strategic approach in sufficient detail to allow comparison with the approaches taken by others.

Q. What should investors setting climate-related targets know?

A. It is important for target-setting processes to incorporate the latest scientific knowledge and to include short and medium-term targets as well as long-term goals (e.g., a net zero by 2050 target should be accompanied by interim steps for 2025 and 2030). As noted below, many investor networks now exist for peer support in target setting and transition planning.