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For many investors, climate change is their number one Environmental Social Governance (ESG) concern – echoed in this year's edition of the World Economic Forum's Global Risks Report. For a third consecutive year, environmental risks dominate the report - both in terms of impact and likelihood.

One of the key drivers underpinning those concerns is regulation. Today over 1,500 separate pieces of climate policy or legislation are in force around the world . Some impact the companies investors are invested in; others target investors themselves. In France, for example, climate-change reporting became mandatory for institutional investors in 2015.

The reasons for this raft of regulation were made extremely clear in last year's report from the Intergovernmental Panel on Climate Change (IPCC). It pointed to the urgent action needed to limit global warming to 1.5 degrees Celsius before 2030 if we are to avoid irreversible and far-reaching damage to the world we live in.

Thinking an uncertain future

So how do investors deal with the myriad challenges thrown up by climate change, navigate the complex web of legislation, and understand the consequences of different climate change scenarios?

There is no straight forward answer. But here is an approach using scenario analysis as a way to start thinking about climate change and identify not just risks, but also opportunities for investors.

The role of scenario analysis

Most investors are familiar with scenario analysis, but its application to climate change is relatively recent.

In its 2017 recommendations, the Taskforce on Climate-related Financial Disclosures (TCFD) – a working group led by Michael Bloomberg and supported by Mark Carney of which UBS is a member – explicitly stated that investors and companies undertake climate change scenario analysis.

A leading group of large scale European investors, The Institutional Investors Group on Climate Change (IGCC), formed a working group to create a five-step framework to help asset owners and managers use scenario analysis as a means of understanding how climate change can drive financial impact across their portfolios.

The IIGCC recommend a cross-functional approach: bringing together experts with backgrounds in risk management, investment and ESG, to create outcomes which are relevant to investors which they can then act on.

Ultimately, by giving investors a structured way to think about climate change, an effective scenario analysis offers a starting point from which early warning signs of climate change effects can be monitored. By observing these, investors are better placed to assess which climate scenario is most likely to unfold and position their investment strategy accordingly. In this way, they can optimize emerging opportunities while better managing downside risk.

Putting it into practice

So how could scenario analysis work in practice at a portfolio level? One example is UBS Asset Management’s Climate Aware strategy.

In 2017, UBS Asset Management partnered with a UK pension fund client to create the Climate Aware strategy, a rules-based equity strategy, deployed when researching companies and managing portfolios. The approach aims to be forward-looking and uses a probabilistic framework to capture the inherent uncertainty surrounding carbon data

First, a key building block of the strategy is the alignment of investments with a 2 degrees Celsius scenario. A quantitative model compares a company’s carbon footprint trend with the emission reduction required by the IEA’s (Institute of Economic Affairs) 2 degrees Celsius scenario. An estimate of "glidepath probability" shows how close the company is to the necessary climate change trajectory, i.e., warming of 1.5 degrees, 2 degrees, etc...

In our view, a quantitative model works best when it is combined with a range of other quantitative and qualitative information.

Qualitatively, we would assess climate disclosures and objectives, policies, and what initiatives are in place which are related to carbon efficiency.

Quantitatively, we would focus on carbon footprint, and in the case of the energy sector, the proportion of renewable energy generation versus generation from coal and companies owning coal, oil or gas reserves.

Information, including the glidepath probability, can also help identify companies that are a priority for engagement.

The value of engaging

When thinking about climate change in an investment context, engaging with companies management is an important element for investors. It offers an opportunity to directly influence company behavior.

As part of a voting and engagement program, investors benefit by seeking an improvement in companies' governance, risk management, strategic alignment, targets and metrics, as well as the overall approach to disclosure.

At UBS Asset Management, a primary focus is the oil, gas and utilities sectors, where we identify specific areas of weakness and individual companies to engage with.

Whenever possible, we align our engagement with collaborative programs that are consistent with our goals. This includes Climate Action 100+, a global initiative of more than 300 investors with over USD 30 trillion of assets under management. We also align our engagements on climate issues with our voting policy: we actively support climate resolutions which are consistent with long-term shareholder interests.

Our observations on the ground

Our engagement action has highlighted several findings.

A large number of oil and gas companies are still in the early stages of explaining their strategy for transitioning toward a lower carbon future and the implications of that strategy. Just a few are able to articulate future actions in terms of business models.

In the utilities sector, particularly in the U.S, we found multiple companies retiring coal fired power stations. Some replace them with natural gas, others have more ambitious plans for renewable energy.

Conclusion

Climate change is one of the most pressing concerns investors are facing. For investee companies, climate transition is a material consideration.

While the sense of urgency is often obliterated, investors and investees should consider action to face a rapidly evolving regulatory environment. For that, investors have methods at their disposal, and strategies exist to manage exposure to climate change within their chosen risk-return profile.

Finally, both asset managers and asset owners have the capability to drive positive long-term change by engaging with companies to influence their business models and activities as they impact on climate transition.

Michael Baldinger is New York-based head of sustainable and impact investing and Francis Condon is an Amsterdam-based sustainable and impact investing research analyst at UBS Asset Management. This content represents the views of the authors. 

This article is a modified version of an article first published on Pensions and Investments on March 25, 2019

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