Portfolio Considerations: What the Latest IPCC Report and Transition Risk KPIs Reveal

Pooja Khosla, Ph.D., and Elliot Cohen, Ph.D., with FactSet partner Entelligent are co-authors of this article. 

The 2023 IPCC report on global climate change renews urgency, provides hope that it’s still possible to limit warming to 1.5 degrees Celsius, and offers solutions for climate-resilient development. 

According to the IPCC’s 2022 report, the remaining carbon budget is about 400 to 600 gigatons of CO₂ to stay within the temperature limit. At current emission rates, that amount could be exhausted in the next 10 to 15 years. Staying within the limit requires collaboration to reduce 2030 global emissions by around 45% and reaching net-zero emissions by mid-century. 

Yet the IPCC’s emphasis this time was more muted. The organization underscored a stronger hope to develop climate-resilient economies, adopt best practices in policy and technology, and develop communities far less reliant on carbon-intensive consumption—all at a greater pace and scale than what has been done so far. 

Comparing Climate Models to Gauge Efforts Across Regional Economies

As scientists, we have compared IPCC findings at a regional level with what we see from our models. The purpose is to show that economies stepping up to climate action via policy or technological breakthroughs are de-risking future losses.

We have integrated the most current scenarios from the Network for Greening the Financial System (NGFS). The NGFS scenarios are intended to help institutions better project how climate risks could affect their portfolios and financial stability.

NGFS Phase III and Entelligent T-Risk Highlights  

T-Risk, based on a patented methodology we invented, is a directional score that measures the expected return over 10 years of a securitized asset (public equities in this case) between current policies and an alternative scenario. Previously, we evaluated a single alternative scenario: Net Zero 2050 (Paris-aligned).

We have expanded the scenario space to include Nationally Determined Contributions (NDC), Divergent Net Zero 2050, and Below 2°C. Scenarios are defined according to NGFS phase III guidelines for central banks and supervisors. They reflect a spectrum of policy ambitions and reactions, changes in technology, carbon dioxide removal, and regional policy variation. They are grouped by four transition pathways: Orderly, Disorderly, Hot House World, and Too Little, Too Late (see Fig. 1).

Fig 1: T-Risk 3.0 New Scenario Options

Empirical Findings by Region and Sector 

Fig. 2 (below) shows the distribution of the T-Risk ratio for each of the four major scenarios, grouped by region. A ratio greater than zero indicates a higher expected return under current policies (business as usual), while a ratio less than zero indicates a higher return in the alternative climate scenario. If you believe the world will ultimately limit global greenhouse gas emissions and achieve a decarbonization pathway, then the securitized assets of companies with T-Risk ratios below zero are worthy investments. 

There are two key considerations with Fig. 2. First is the expectation or median of the distribution (denoted by a horizontal line at the center of each boxplot). For example, Asia/Pacific Ex-Japan has a higher expected transition risk compared to other regions. The risk is highest for scenarios with the highest level of policy ambition (Divergent NetZero and NetZero 2050), followed in descending order by Below 2°C and NDC.

In addition, note the interquartile range of the distribution (25th to 75th percentile denoted by the boundaries of the box in the boxplot. A wider range (taller box) signals a wider range of outcomes and higher volatility. Across regions, Divergent NetZero has the highest level of variation as well. Conversely, NDC—which represents the lowest level of climate transition risk from a policy perspective but likely the highest with respect to physical risk— consistently has the lowest level of variation by this measure. 

Relating Empirical T-Risk Findings to Regional Policy Variation: Economies Mainstreaming Climate Action De-Risk Future Losses 

Europe and Japan show lower transition risk across NGFS phase 3 scenarios (see Fig. 2). The purple Divergent NetZero box is aligned with the NDC box for these two regions relative to North America, Asia/Pacific Ex Japan, and Latin America. This aligns with Japan and Europe leading the sustainability race due to their political and public commitment to policies, as well as their traditions of technological innovation and regulatory frameworks. 

Fig. 2 Regional T-Risk Ratio

Source: Entelligent T-Risk Multi-Scenario   

Japan and European Union 

In Japan, the government set an ambitious target to achieve net-zero greenhouse gas emissions by 2050, followed by a pledge to increase 2030 target reductions by 46% from 2013 levels. A 2021 survey found 85% of Japanese people were concerned about climate change, with 71% in favor of setting a net zero target.

The European Union also set a target of net-zero greenhouse gas emissions by 2050 and pledged to reduce emissions at least 55% by 2030. A 2020 survey found 93% of European citizens considered environmental protection to be important, with 72% considering it "very important." 

Both regions are known for technological innovation. Japanese automaker Toyota announced plans in 2021 to introduce 15 electric vehicles by 2025. In Europe, which has a strong renewable energy sector, many companies are advancing wind and solar power. The EU accounted for 16% of global renewable energy capacity in 2020, according to the International Renewable Energy Agency. 

In both regions, there are strong regulatory frameworks to support sustainability goals. Europeans must comply with regulations on energy efficiency, renewable energy, and emissions reduction. The EU's Energy Efficiency Directive requires countries to achieve a 32.5% improvement in energy efficiency by 2030. Japan has its own set of regulations on waste management, energy efficiency, and sustainable finance, including a "plastics smart" policy that promotes sustainable consumption and production.  

Africa/Middle East 

There is lower inter-scenario divergence for the Africa/Middle East region because of its dependence on oil and gas, with some countries relying on those resources for up to 90% of total energy consumption. Shifting the energy mix in this region significantly over the next five to 10 years is unlikely.

Yet there is increasing recognition of the need to diversify the energy mix and invest in renewable energy in the long run. Several major countries in the region— including Saudi Arabia, the United Arab Emirates, and Egypt—have set ambitious targets in recent years for renewable energy deployment. There also may be substantial opportunities to promote sustainable development and economic growth longer term.

Investing in initiatives like renewable energy and sustainable water management would allow the region to move toward a more sustainable future while also creating economic opportunities. Late this year, the UAE will host the 28th United Nations Climate Change Conference (known as COP 28), with a view to building on previous successes.  

North America, Latin America, and Asia-Pacific 

A disorderly climate transition, characterized by uncoordinated and haphazard responses, is likely to result in significant risk for North America, Latin America, and Asia-Pacific. All three regions are highly vulnerable to the impacts of climate change. Critical infrastructure and supply chains could be disrupted, with the potential to cause severe economic losses. These regions also have significant exposure to carbon-intensive industries (e.g., fossil-fuel extraction), which would be affected disproportionately by a disorderly transition. 

Historically, they have been less active in setting climate targets and implementing policies akin to Europe and Japan. That could lead to significant regulatory and policy changes that NA/LA/AP are not prepared for, in turn leading to significant transition risk. 

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Co-author: Elliot Cohen, Ph.D., is Vice President for Research and Development at Entelligent. He brings 15 years of experience in energy and statistical modeling and has contributed tens of thousands of lines of production machine learning code at three tech startups, each having gone on to a successful exit. Dr. Cohen is a highly experienced data scientist with areas of expertise including ESG investing, quant strategies, risk measurement, machine learning, mathematical optimization, and experimental design. Dr. Cohen's strong technical foundation includes three engineering degrees, teaching, and postdoctoral research at Columbia University. He is also a former Fulbright Scholar and Fellow of the National Science Foundation.

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