Itaú AM: Integrating climate scenarios into investments

ORGANISATION DETAILS

Organisation: Itaú Asset Management

Signatory type: Investment manager

HQ country: Brazil

COVERED IN THIS CASE STUDY

Asset class: Listed equity

Geography: Brazil

Itaú Asset Management considers environmental, social and governance (ESG) factors to be important long-term performance drivers for companies. We see it as part of our fiduciary duty to understand and anticipate the impacts of climate change on society, the environment, and economic sectors - and consequently on investments. We have developed a climate scenario analysis integration tool to forecast the financial impacts on companies of climate-related risks and opportunities.

Why this approach?

Our climate scenario analysis integration tool allows for more precision when assessing climate change impacts on portfolios, and therefore improves the risk and return pattern of our strategies.

There is a large number of platforms and tools available on the market that offer climate risk assessments and that estimate climate-related financial impacts in different scenarios. However, some of these tools have an industry or monothematic focus. In view of this, and in line with our philosophy of proprietary analysis, we chose to create our own methodology for integrating climate scenarios into portfolios.

The approach in practice

In our white paper on the integration of climate scenarios into investments, we go into some of the detail on how we estimate the cost of climate-related impacts and opportunities. The process starts with a materiality analysis. We have developed an industry materiality matrix that takes into consideration which climate impacts will be the most relevant for each industry. Issues considered include:

Changes in consumption patterns
Exposure to physical climate impacts
Ecoefficiency initiatives
Changes in the water cycle
Greenhouse gas emissions pricing

Following the materiality analysis, we move to modelling company performance under three climate scenarios. These are a 1.5°C rise in global average temperatures above pre-industrial levels, a 2°C rise, and a business-as-usual scenario.

Carbon prices vary significantly under the different climate scenarios considered. The scientific scenarios usually attribute a price-per-metric-ton of carbon equivalent, which dictates the viability of green technologies. However, there is a lack of consensus on the technologies that will be used in the transition, and on the required carbon price.

The table below shows the price ranges set out by the Grantham Research Institute on Climate Change and the Environment at LSE,^[1] and the Intergovernmental Panel on Climate Change^[2] under two different scenarios. They both modelled carbon prices that they predict are consistent with limiting global average temperature rises to within 1.5°C and 2°C of pre-industrial levels.

1.5°C Scenario	2030	2050
IPCC	135-6,050 USD/tonCO₂e	245-14,300 USD/tonCO₂e
Grantham Research Institute on Climate Change and the Environment at LSE	100-185 USD/tonCO₂e	220-430 USD/tonCO₂e

2°C Scenario	2030	2050
IPCC	15-220 USD/tonCO₂e	45-1,050 USD/tonCO₂e
Grantham Research Institute on Climate Change and the Environment at LSE	40-80 USD/tonCO₂e	100-250 USD/tonCO₂e

The scientific scenarios present huge differences in respect to carbon prices. In our model, we use the highest prices from the IPCC and Grantham Research Institute models.

The amounts currently charged for greenhouse gas emissions in most jurisdictions is significantly lower than the references mentioned above. In our business-as-usual scenario, we adopted carbon emission pricing levels based on a range of global prices. The chart below, taken from the World Bank’s State and Trends of Carbon Pricing 2021 report, shows that the amount charged for carbon, whether in market or pricing models, is usually lower than USD 40/tonCO₂e, with it exceeding USD 100/tonCO₂e in only three jurisdictions.

Graph showing carbon prices in different countries and cities in 2021

Example

To illustrate how we estimate the impacts of different climate scenarios on an individual company we will use a hypothetical Brazilian energy transmission company as an example.

Infrastructure transmission assets have a high exposure to extreme climate events. According to data from the Brazilian National Institute of Space Research, around 70% of failures in transmission systems are caused by lightning and storms. With the increase in the occurrence of this type of event, caused by climate change, it is likely that these impacts will be even greater in the future. In Brazil, transmission assets are remunerated based on their availability in the system, so when there are failures in their operations, their annual income is negatively impacted.

We estimated the compound annual growth rate (CAGR) for the company under the 1.5°C, 2°C, and business-as-usual scenarios. The results were:

1.5°C scenario = CAGR of 0.3% in the occurrence of extreme climate events;
2°C scenario = CAGR of 0.6% in the occurrence of extreme climate events; and
Business-as-usual scenario = CAGR of 1.5% in the occurrence of extreme climate events.

We also modelled the net present value of the impacts for the company in different climate scenarios using the following formula:

Itau - Equation

in which:

A = revenue lost due to services interruption during the base year;

B = interruption % associated with extreme weather events; and

C = variation in the occurrence of extreme weather events.

The net present value of the impacts for this company were calculated to be:

1.5°C scenario = -R$42.3 million
2°C scenario = -R$94.9 million
Business-as-usual scenario = -R$291 million

The net present value impact and CAGR metrics are useful for quantifying the predicted impact of different climate-related drivers, including carbon prices and the physical impacts of climate change.

These metrics were fed into a database, allowing us to compare the exposure of different portfolios to climate-related risks and opportunities. From our analysis, we found that companies in the Ibovespa index are more exposed to climate-related risks than to opportunities. Results show that investee companies’ business models still need to transition to a low-carbon economy.

The result is evidence of how companies need to incorporate climate change into their strategies and planning more emphatically. There is also a need for companies to report more transparently in line with the TCFD recommendations. It is important to highlight that some of the climate-related impacts presented can be transferred through the value chain, therefore reducing the impact on company balance sheets.

Future developments

It is important to note that our analysis is focused on the long term, and assumes a continuation of companies’ business models, which may end up being significantly altered due to new regulations or market demands - ultimately reducing the estimated financial impact (i.e., companies can significantly reduce their CO₂e emissions, therefore reducing the impact of carbon pricing in the long term).

If companies do end up changing their operating models or transferring climate-related costs through the value chain, the climate scenario analysis integration tool would need to be adjusted to reflect these changes. We want to develop and adjust the tool through engagements with companies and climate institutions, considering up-to-date data from the market.

We will engage with companies in relation to net-zero targets, decarbonisation strategies, and other climate-related matters. Also, when engaging with climate institutions, we will address the new scientific projections and scenarios to input into the tool.

Results

The outputs of Itaú AM’s scenario analysis have been important in engagements. The tool helps portfolio managers better understand the financial impacts associated with climate change in their investments and benchmarks. It enables the ESG specialists to raise awareness and provides them with material information about the climate resilience of portfolios over the long term.