Ignore climate change at your peril

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Ignore climate change at your peril

Sustainable investment continues to be in demand.

A recent study by HSBC Global Asset Management, surveying 204 UK IFAs, discovered that interest in social concerns, such as diversity, human rights, consumer protection, and animal welfare is the main reason for client demand for investments explicitly incorporating ESG issues. 

However, 34 per cent IFAs said that the single main reason impacting client demand for ESG products can be attributed to a limited understanding of ESG issues, including a non-factual view of the impact to long-term investment portfolios. 

IFAs therefore play a key role in helping investors look at the bigger picture and consider other investment risks relating to sustainability, such as climate change. Ensuring investors understand not only the investments they are making but also the wider issues impacting those investments, is key to retaining interest and engagement. 

For example, being proactive can help investors mitigate the risks associated with climate change, estimated at a loss of return of 0.82 per cent per year for developed equities. Carbon footprint analysis is one tool for understanding climate risk – but what do investors need to know to help them adopt this to support their investment decisions and what’s next? 

1. Why does climate change matter? 

Climate change represents an urgent threat to corporations, economies, society and the planet. In December 2015, over 190 countries agreed to take immediate action with the Paris Agreement, an international commitment to stay within 2 degrees C of warming above pre-industrial levels.

This goal necessitates the transition to a lower-carbon economy. The transition is already underway and set to accelerate as changes in policy and regulation, the falling cost of technology and demand are leading to fundamental shifts in sectors such as energy, auto and utilities.

Our current trajectory is closer to 4 degrees C above pre-industrial levels by 2100 if no action is taken. The physical impacts of climate change associated with this temperature increase are severe – in both social and economic terms.

The financial consequences of these physical changes are no less severe. An Economist Intelligence Unit report calculates the value at risk to global manageable assets from climate change to be $US 4.2trn, in present value terms. In many cases, regional impacts can be more pronounced.

2. What are climate-related risks?

A report by the Financial Stability Board (FSB) backed Taskforce on Climate-related Financial Disclosures (TCFD) classified climate-related risks into two major categories – physical risks and transition risks.

Transition risks relate to the impacts and costs of policy, legal, technology and market changes that will be required to mitigate and adapt to climate change. In concrete terms this will result in a higher carbon price associated with carbon emissions. 

Physical risks relate to the physical impacts of climate change. These include an increase in the frequency and severity of extreme weather events, such as droughts, floods, storms, or longer-term changes in climate patterns, such as rainfall and temperature.

These will all contribute to negative impacts on human health, ecosystems and the economy.

Companies that fail to respond to the impacts of the transition to a lower-carbon economy face financial and reputational risks, potentially harming their credit ratings and share price. How they respond and adapt their business strategies and models will be critical, and there will be winners and losers.

However, the consequences of a failure to transition are far greater.

3. What is a carbon footprint?

The Greenhouse Gas Protocol, the most widely used international accounting tool for GHG emissions, classifies a company’s direct and indirect emissions throughout the supply chain into three ‘scopes’ – direct operational emissions (scope 1), purchased electricity, steam or heat (scope 2) and emissions resulting from the activities of the company but occur from sources not owned or controlled by the company (scope 3)4. Security level carbon footprints can be aggregated to portfolio level. 

4. How can carbon footprinting help investors?
The TCFD recommended that asset managers provide the weighted-average carbon intensity, where data are available or can be reasonably estimated, for each product or investment strategy. The Task Force acknowledges the challenges and limitations of current carbon footprinting metrics but views this disclosure as a first step.

While carbon footprints do not tell us about the physical climate risks – the most important risk for some securities – it can act as a reasonable proxy for understanding transition risk, identifying the most-exposed securities. 

Investors can use carbon footprint analysis to understand the exposure of companies to the potential effects of carbon pricing and as a simple proxy for gauging climate-related transition risk, both as a standalone tool and in combination with a carbon target, as part of an investment strategy. 

5. What’s next for carbon footprint analysis? 

As disclosure improves, we expect the use of carbon footprint analysis to develop in three respects.

Firstly, we believe there will be improvements in coverage and accuracy. Carbon reporting is particularly challenging for smaller and emerging market companies and for other asset classes beyond equities and corporate bonds such as sovereign bonds.

We expect the adoption of the TCFD recommendations to accelerate both coverage and the quality of the information, making carbon data more complete, accurate and useful for investment decisions.

The requirement for the financial sector to disclose its carbon footprint is also likely to spur more comprehensive coverage and methodologies beyond equities. 

Secondly, going forward, carbon footprints are likely to be used in combination with exposure to climate-related investment opportunities (for example ‘green revenues’) to provide a more accurate exposure profile of risks and opportunities, and to determine if it is aligned with the Paris Agreement goal of holding the increase in the global average temperature to well below 2 degree C above pre-industrial levels. .

Thirdly, carbon footprints will likely be used in combination with geographic and product information, allowing investors to combine transition and physical risk information.

The implications of climate change and transitioning to a lower-carbon economy are core investment considerations – today and for the coming decades. Carbon footprinting presents a useful tool for investors to make these key decisions. 

Stephanie Maier is a director, responsible investment and Daniel Rudd is head of UK wholesale at HSBC Global Asset Management