Are you climate aware?

Ten index investor questions about managing climate risk

13 Aug 2020

Passive equity investors face a variety of options for bringing their index investments in line with sustainability objectives. In this paper, our SI and indexing specialists share their views on the various factors related to climate change and the potential (unintended) consequences. Read more.


Exhibit 1: 2100 warming predictions

The Climate Action Tracker is an independent scientific analysis that tracks government climate action against the globally agreed Paris Agreement aim of holding warming well below 2°C, and pursuing efforts to limit warming to 1.5°C by 2100.

Exhibit 1, "2100 warming predictions," shows projections made by The Climate Action Tracker, an independent scientific analysis that tracks government climate action against the globally agreed Paris Agreement aim of holding warming well below 2°C globally by 2100. Under baseline conditions, temperatures globally are expected to rise between 4.1-4.8°C by 2100. Under current policies, the rise is expected to be 3.0-3.4°C. An optimistic projection is 2.9°C, and if all pledges and targets are met, the rise will be 2.6-2.9°C by 2100.

Many investors are uncertain how best to align their passive equity investments with the global transition toward a lower-carbon future. A common response is divesting high carbon-output companies by investing in tracker funds that are benchmarked to ex-fossil fuel indices. But there are consequences to this choice. By excluding fossil fuel investments, the indexed investor avoids some risks but also misses opportunities: some ‘oil majors’ are among the largest investors in alternative energy.

Also, it is clear that a transition to a lower-carbon world will take time, and anyone who simply excludes those companies is unable to exert shareholder influence on the means and timing of needed changes.

We believe the more responsible approach may be for investors to maintain a thoughtful allocation to carbon-emitting companies with the twin goals of supporting positive change through proactive engagement with the companies that appear to be the least well positioned while also supporting companies that are developing new, lower carbon technologies. At the same time, the more the portfolio is re-shaped away from the index benchmark the greater the chance that the investment returns will diverge. UBS Asset Management’s Climate Aware strategy seeks to provide index investors with an innovative, rules-based strategy, designed to capitalize on the long-term transition to a low greenhouse-gas (GHG) emissions economy by investing more in companies at the heart of this transition as well as those adapting their operating models.

In 2019, UBS-AM surveyed over 600 institutional investors worldwide, representing more than €19 trillion in combined AuM about their view of sustainable investing. A majority said they believe environmental factors will matter more to their investments than traditional financial criteria over the next five years.

This paper answers the 10 questions we hear most often from investors about managing climate risk in their passive equity portfolios and how the Climate Aware strategy addresses those issues. The first three questions are listed below. Download the full paper to read more.

A: Investors, lenders and insurers don’t yet have a clear view of which companies will struggle, endure or prosper as the environment changes, regulations evolve, new technologies emerge and customer behavior shifts. Without this information, financial markets can’t price climate-related risks and opportunities effectively.

Given the uncertainties of climate change and the lower carbon transition, UBS-AM researched the role of scenario analysis as a potential tool for understanding the possible impacts on investment portfolios. In the development of our Climate Aware strategy, we have created a methodology for understanding the alignment of individual investments and a global investment portfolio with a 2˚ Celsius pathway as defined by the International Energy Agency (see Exhibit 1). The transition to lower carbon introduces two broad categories of risk: physical and transition-related risks as barriers to investment (see Exhibit 2).


Exhibit 2: Climate-related risks

Physical risks

Examples of

Examples of

Acute risks

Acute risks

Chronic risks

Chronic risks

Examples of

potential risks

Acute risks

Increased risk of extreme weather events

Chronic risks

Changes in climate and landscape, e.g. coastal areas or rain forests

possible financial implications

Reduced revenue from negative impacts on production facilities, sales and workforce

Increased operating, capital and insurance COSTS, as well as asset depreciation due to damages

Transition-related risks

Policy and legal risks

Policy and legal risks

Technology risks

Technology risks

Market risks

Market risks

Reputation risks

Reputation risks

Policy and legal risks

Imposition of mitigation policies or regulation and exposure to litigation

Technology risks

Investment and transition costs to a low-carbon technology

Uncertainty of investment decisions

Market risks

Uncertainty regarding consumer behaviour, market signals and supply chain

Reputation risks

Stigmatization of industry

Changes in consumer preferences and stakeholder expectations

Policy and legal risks

Increase in operating and/or litigation costs

Forced capital depreciation due to policies

Technology risks

Value loss of existing assets

Reduced demand for products and services

Costs of developing and procuring new technology

Market risks

Reduced demand

Increased costs from unexpected market changes in supply chains

Reputation risks

Reduced revenue due to decrease in demand, production, capital availability and employee attractiveness

Our approach applies ‘tilts’ to an equity index away from companies we believe are less likely to be in line with the low carbon economy and towards companies we see as most aligned to meet industry carbon reduction targets (see Exhibit 3). By analyzing how companies are positioned for the transition to a low carbon economy, the strategy seeks to reap the benefits of that shift. The portfolio targets:

  • At least 40% higher exposure to companies that generate renewable energy and supporting technology compared to the parent index
  • A 30% tilt towards companies most aligned to meet industry carbon reduction targets in line with the 2˚C scenario
  • 50% reduction in carbon intensity

Key features of the UBS-AM Climate Aware strategy:

  • Minimal deviations vs. market capital weighted benchmark
  • Low tracking error and low turnover
  • No (explicit) exclusions policy
  • Meaningful carbon reduction
  • Aligned to forward-looking carbon reduction targets
  • Tilted to renewable energy
  • Potentially lower performance risk
  • Low cost
  • Customizable

Exhibit 3: Portfolio construction process

Exhibit 3, "Portfolio construction process," discusses how the UBS Climate Aware strategy tilts its portfolio as compared to its target index. Its objectives are to reduce carbon by 50% from its index rate, reduce fossil fuel reserves and coal energy by 30%, increase renewables by 40%, and include a 30% tilt towards companies most aligned to meet industry carbon reduction targets.

A: Areas we assess (at individual investment or issuer level) are:

Regulation Risks: For example, the effect on costs of carbon pricing on large GHG emitting companies
Market Risks: Such as the move away from products with high carbon- and energy-intensity
Technology Risks: Such as the large scale substitution of products and services
Physical Risks: Such as the risk to fixed assets and/or supply chains
Reputational Risks: Such as the stigmatization of an industry

A: Rather than responding that carbon sensitivity is priced into valuations, we see more of a differentiated effect on valuations as the response to climate changes develops. We see the potential for winners to come from climate change leaders and innovators, renewable energy generators and service providers, electric vehicle manufacturers and materials suppliers. In our portfolio construction we control the exposure to BARRA value factors. Thus we control any unintended exposure to value or any equity risk premia.

Thinking about climate change in terms of time frame raises two clear challenges. The first relates to the fact that while climate change is generally accepted to be a long-term risk, the actions needed to tackle it are short-term. For investors this poses a fundamental problem. Put simply, existing short-term investment frameworks aren’t designed to capture long-term risks. Second, institutional investors often carry obligations of being a long-term investor, evidence suggests some equity managers hold assets for an average of just 1.7 years. That offers analysts little incentive to extend their projections.

However, recent analysis conducted by German researchers, considered the question “When does it pay to be green?” Using 68 estimations from 32 empirical studies, it focused solely on the materiality of climate change and carbon performance (Busch & Lewandowski, 2017) and came up with the following findings:

  1. There is a positive association between carbon performance and financial performance.
  2. The choice of indicators heavily determinates the strength and significance of empirical outcomes. In general, “relative emissions” are more likely to produce statistically significant results than absolute emissions.
  3. This positive correlation is significantly higher in “market-based” financial performance (e.g. Market cap or total shareholder return (TSR) than in accounting-based financial performance).

A: Only 55% of companies in the MSCI ACWI index currently report on CO2 data (see Exhibit 4). To mitigate this lack of information, we have developed a multi-vendor database for sustainable investment data, aggregating and filtering information to provide greater comparability between sectors and regions.

We approach the uncertainties of carbon forecasts and impact on prices changes/profit margins by investigating drivers such as changing regulation, engaging with company management to understand how they are orienting their businesses towards a lower carbon economy, and incorporating what we find into our analysis and investment decision-making.
 


Exhibit 4: All databases use a combination of reported and estimated data

Database

Trucost

Sustainalytics

ISS

MSCI’s Carbonmetrics

Coverage

  • 4,000+ companies
  • 10 years of data
  • Scope 1, 2 and 3
  • 30 analysts

  • 10,000+ companies
  • Scope 1 and 2
  • 120+ analysts(carbon and ESG)

  • 40,000+ companies
  • Scope 1 and 2

  • 9,000+ companies
  • Scope 1 and 2

 

 

Methodology

  • Input-output economic model: resource companies use to produce goods and services, and the related level of pollutants
  • Integrates use and emissions of over 700 environmental sources

  • Includes latest reported emissions data; for non-reporting companies, estimates data using company’s market cap, revenue, employees and environmental score
  • 80+ estimation models for non-reporting companies

  • Methodology developed with researchers from ETH Zurich
  • 150+ industry-specific models

  • When company doesn’t report data, MSCI applies one of four models:
    • Co. intensity model
    • Co. production model
    • GICS sub-industry model
    • Economic input-output life cycle assessment model

Notes

  • S&P DJ indices utilise Trucost data
  • FTSE are collaborating with Trucost to construct custom índices 

  • In addition to carbon research, comprehensive ESG research

  • EDHEC’s ScientificBeta and STOXX indices utilise ISS data

  • MSCI Low Carbon Target
  • MSCI Low Carbon Leaders
  • MSCI ex Fossil Fuels
  • MSCI ex Coal

Are you climate aware? Ten index investor questions about managing climate risk

To continue reading Are you climate aware? Ten index investor questions about managing climate risk, download the PDF.

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