The portfolio impacts of climate change and the transition to a low-carbon economy are reshaping how clients, who ultimately bear the risks, and investment professionals, through their fiduciary duty, are incorporating climate-related risks and opportunities into their investment processes. This article offers tips for how investment teams can bring these strategies from idea to action, based on advice shared by panellists at CFA Society Toronto’s climate change webinar series from this past winter.

Pushback from investment teams against setting up a climate change investment strategy is typically triggered by a fear that incorporating climate change considerations will interfere with their portfolio decision making. One solution is to provide teams with carbon budgets, within which they have discretion, and which are analogous to their current return objectives and risk budgets. Ensure the process is flexible enough to allow for well-documented exceptions, but do not provide so much latitude that deviations have no repercussions. Focus discussions on science-based initiatives that show how companies are reducing carbon and hitting various targets. Reframe the incorporation of climate change as part of fulfilling their fiduciary duty over longer time horizons, as they are investing across multiple generations.

Developing a robust climate change strategy can feel daunting at first.
The following tips for success may help facilitate the process

– Clearly define terms to avoid misunderstandings around vague terms like “sustainability”
– Do the work upfront to decide on approaches, targets, and available levers to reduce the need for course correction after implementation
– Educate internal investment teams on climate science and how investment risks change under different climate scenarios
– Get buy-in throughout the company, particularly among the top leadership
– Get some help by learning from peers’ best practices or engaging a consultant

Measuring climate-related risks
Measuring and managing climate-related risks requires appropriate metrics to determine baselines and track progress over time. These risks need to be expressed across all asset classes, ideally using an identical metric throughout. 

Examples of climate-related risk metrics include:
– Carbon footprinting: Data on carbon footprints is easily obtainable from various data providers and can be used to assess if holdings are leaders or laggards, identify hotspots, determine baselines for decarbonization targets, and track performance over time
– Carbon valuation, value at risk, and percent change in EBITDA (earnings before interest, taxes, depreciation, and amortization): When looking at carbon-related portfolio risks and opportunities, determine their financial impacts (e.g., costs of production, new technologies, carbon price, market supply and demand) and project these impacts on revenue
– Green-to-brown ratios: This is a transition-based metric that tracks green (energy-efficient, clean technology) versus brown (carbon-intensive) revenues
– Carbon avoided: This metric provides a quantification of the carbon emissions a holding has avoided throughout its value chain

Setting KPIs
Look to your climate change strategy and goals and select the appropriate key performance indicators (KPIs) for investment teams to achieve those goals. Remuneration can then be linked to progress on those KPIs. This approach will require buy-in from investment teams and clear expectations of what is being measured and the repercussions of those measurements.

Incorporating climate change in investment analysis and portfolio construction
Incorporating climate change includes analyzing factors such as a firm’s carbon footprint throughout the value chain; scope 1, 2, and 3 emissions (these are classifications of a company’s carbon emissions); forward-looking metrics such as company policies or plans and corporate governance to deliver on those plans; and opportunities for new products, services, technologies, and innovations to reduce emissions. The goal is to understand how the holding might evolve under various transition pathways. This includes forecasting the impact of carbon prices on different sectors and on market supply and demand. Build the cost pathway necessary to adapt through the marginal abatement cost curve for each sector. Combining this with macro factors can highlight the companies that are better placed to benefit from the carbon transition and weather the costs associated with meeting more stringent regulatory requirements. The areas of the largest risks and opportunities can be identified using heat maps.

Performing scenario analyses using a range of warming scenarios that may include higher transition risks or higher physical risks, such as a 1.5°C, 2°C, and 3°C warming, can help quantify portfolio impacts. The PRI’s Inevitable Policy Response is a great resource to find quantified impacts given the scientific urgency for reduced emissions that will inevitably lead to policy responses.

Engagement is a critical component of managing overarching systemic risks like climate change. Engage directly with management and join collaborative engagements (such as Climate Action 100+ or conduct advocacy). Encourage science-based targets, as these are key to a credible sustainability strategy. Companies that integrate science into their sustainability strategies usually possess the strategic vision and capabilities needed to achieve and maintain strong sustainability performance over time.

Although bringing a robust climate change strategy from idea to action takes effort and planning, it can help quantify the potential portfolio impacts of climate change, add value, reduce risk, and ultimately fulfill investment professionals’ fiduciary duty. 

CFA SOCIETY TORONTO’S CLIMATE CHANGE WEBINAR SERIES 

Session 1: THE CLIMATE CHANGE JOURNEY 

• Alison Loat, OPTrust (moderator)
• Meredith Jones, Aon
• Bertrand Millot, CDPQ
• Daren Smith, UTAM
  

Session 2: MEASURING CLIMATE RISK

• Joy Williams, Mantle314 (moderator)
• Karen Lockridge, Canada Post Corporation Pension Plan
• Janice Noronha, PwC
• Anna-Marie Wascher, Flat World Partners

Session 3: INVESTING FOR CLIMATE CHANGE

• Brandon Gill New, OPTrust (moderator)
• Margaret Childe, Manulife Investment Management
• Deidre Cooper, Ninety One 
• Aleksandra Njagulj, CBRE Global Investors