Should You Consider Expanding Your Standard Portfolio Risk Analyses with Carbon and Climate Data?

Regulatory frameworks for environmental and sustainability factors continue to evolve—particularly in Europe. As a result, some portfolio managers and institutional investors around the world are choosing to expand their standard investment risk analyses. For example, those individuals use quantitative inputs to consider carbon intensity, efforts toward net-zero energy sources, and physical climate risks at various levels such as company, sector, industry, and region.

The purpose of this article is to offer perspective for investment decisionmakers who are considering whether to augment their standard risk management processes. Let’s take a closer look, beginning with regulatory background.

Financial Regulatory Practices for Climate

Climate risk is a growing international theme in financial regulation and supervision, with heightened scrutiny following the 2008 financial crisis. The globally focused Financial Stability Board (FSB) launched the Task Force on Climate-Related Financial Disclosures (TCFD) in 2015, the same year as the signing of the Paris climate agreement.

In the years since, the TCFD published recommendations on disclosure—addressing governance, strategy, risk management, and metrics and targets—they’ve been adopted by thousands of organizations and used in the sustainable finance and regulatory frameworks of many countries.

Climate risk financial regulation, like climate risk itself, has multiple drivers and transmission channels:

• Initiatives of bodies such as the FSB and the International Organization of Securities Commissions (IOSCO)

• Binding accords such as the Paris agreement

• Regional and national net-zero goals

• Voluntary associations such as the Network for Greening the Financial System (NGFS)

• Myriad regulatory requirements, supervisory exercises, and guidelines

Carbon Intensity

Carbon intensity refers to the amount of carbon dioxide (CO2) emissions produced per unit of economic output, typically measured as emissions per unit of gross domestic product (GDP), or emissions per unit of energy consumed. For our discussion here, carbon intensity measures the amount of carbon emissions per million of revenue.

The chart below indicates the direction of carbon intensity over the last 10 years for a broad world equity index.

There are multiple drivers for this direction, including:

• Regulatory vision based on joint commitment of governments. Some countries also impose additional scrutiny to include scenarios on climate change impact on assets.

• Requirements of market participants for increased transparency via disclosure of environmental and social impacts of investment decisions.

• Consumer pressure for climate-friendly businesses and products.

• Expectations among select investors for portfolio opportunities that may be more resilient to the physical and transition risks associated with climate change and offer the potential for long-term value.

Energy Transition Risk

Climate risk considerations could be exploited in two directions: energy transition risks and physical risks. At a high level, company actions to reduce GHG emmissions could help reduce physical threats from climate change (e.g., floods, drought, wildfires, extreme weather), however they could increase the impacts of transitioning to a net-zero economy. And vice versa, inability or slower pace in reduction of carbon emissions will ease transition impacts, however will pose additional and increased threats from physical impact from climate change.

Let’s start with a portfolio focus on transition risk as well as opportunities, based on transitioning to a sustainable net-zero economy For our analysis, we used Carbon Risk Rating, which is part of the ISS ESG¹ data packages available within the FactSet workstation for licensed users. That dataset provides a holistic forward-looking assessment of the climate-related risk of companies and asset classes; it measures the extent to which companies can mitigate transition risks based on its specific baseline carbon risk exposure.

On a scale of 0 (very poor performance) to 100 (excellent performance), the Carbon Risk Rating assesses how a company deals with industry-specific climate risks both in its own operations as well as in the supply chain. Each company is assigned a specific baseline risk and a performance assessment to managing transition risk, thus capturing both risk and opportunities. Companies are classified into four groups according to the carbon risk rating: laggards, medium performers, outperformers, and leaders.

We add this metric to a Value at Risk analysis of the portfolio, where VaR is FactSet generated risk analytic. Looking at the risk profile of the broad world index in the table below, we reveal key insights:

• Standalone risk of leaders and laggards is very close: 20-day VaR at 95% confidence level is 6.76% for leaders and 6.93% for laggards.

• Carbon risk rating is extremely low for laggards (weighted average of 18), indicating those companies deteriorate the carbon risk rating of the portfolio while bearing the same average risk as the leaders, who boost the carbon risk rating of the index (with their weighted average of 81).

• Despite similar market risk, both groups exhibit extremely different transition risk profiles. If we focused only on market risk analysis, we would omit the longer-term factor of how portfolio returns could be influenced by how companies transition to a net-zero economy.

Using the same broad world equity index, from a regional perspective we gain an additional insight beyond standard risk analyses. In the table below, two regions with the same long-term transition risk offer significantly different short-term risk/return profiles:

• Latin America and Africa/Mideast both have weighted an average Carbon Risk Rating of 47, while at the same time the 20-day VaR of 95% is almost two times higher for the Latin America region. Note in this example, simulated mean return is even lower for the higher risk profile of Latin America.

• Asia Pacific ex Japan and Japan regions have very similar weighted average Carbon Risk Rating of 50 and 51, respectively. However, market risk as measured by the 20-day VaR of 95% is much higher for Japan (7.51%) compared to the rest of Asia Pacific (5.85%). Again, the higher risk region Japan shows much lower simulated mean return (0.03%) compared to the rest of Asia Pacific (0.26%).

It is interesting when you use an asset-level risk analysis. In the standard risk return plot below, you would prefer to preserve assets in the bottom right corner as they have high return potential and comparatively low risk. And at the same time, an investor might avoid assets in the top left corner with negative potential return and high risk.

In the chart below, we illustrate how factoring in Carbon Risk Ratings across the four groups—leaders, outperformers, medium performers and laggards—offers a perspective on transition risk. That enables you to further filter the companies in the bottom right corner and preserve only darker dots in the right bottom corner of the plot.

The chart below illustrates another way to visualize climate data in risk analyses: comparing the two-dimensional risk return plot with a three-dimensional scatter plot, adding carbon risk rating as a third dimension. Darker dots represent company stocks with higher carbon risk ratings, while lighter dots depict those with lower carbon risk ratings.

Now from all the points in the front right part of the cube, which are low risk and high return companies, investors might prefer to focus only on the leaders and outperformers, which are the darkest dots in this quadrant, squared in green below:

Asset-level analysis shows both numerous companies with the same risk and return characteristics but with quite different transition risk profiles. In the table below you may find a few filtered pairs, where the 20-day simulated mean return is the same and 20-day VaR of 95% is similar or even lower for the leader group compared to the laggard group. Carbon risk rating is substantially different in each of the selected pairs.

Physical Risks

Now that we’ve discussed energy-transition risks, we will review physical risks. There are multiple analytics available, but for this review we focus on the Most Likely Physical Risk Scores for five physical hazards: drought, flood, heat stress, tropical cyclone, and wildfire. The scores are part of ISS ESG Climate Physical Risk package available through the FactSet workstation. They measure the change in an issuer's financial risk relative to its GICS sector, with 100 assigned to companies with negligible risk and 1 assigned to those with highest risk in the sector,

The analysis helps identify the potential impact of hazards in the investment portfolio. You can view assets that are more vulnerable to a particular hazard or, if you use the total physical risk score, you can identify assets that are more resiliant to physical risks than the rest of the sector.

Analyzing physical risk scores on asset level provides insight into assets whose conventional risk/return profiles are similar but are dissimilar when factoring in physical risks. For example, the table below illustrates pairs of companies from the same sectors that have very close 20-day simulated mean return and VaR 95% yet exhibit significantly different exposure to climate hazards, where Mean and VaR are FactSet generated analytics.

Two factors that determine the total physical risk score for same-sector companies are the region/location and exposure of the revenue to current and potential future hazards (i.e., drought, flood, heat stress, wildfire, or tropical cyclone).

In Conclusion

Given climate risk is a continued international theme in financial regulation and supervision, more portfolio managers and institutional investors might decide to augment their standard risk analyses with carbon and climate data. There is a long list of datasets from which to choose, along with numerous options to slice and drill into group and asset levels.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.

¹ ISS ESG works closely with its partners to provide access to a comprehensive set of high-quality ESG and climate data that investors use to do their work.

ISS ESG is the responsible investment arm of Institutional Shareholder Services Inc., the world’s leading provider of environmental, social, and governance solutions for asset owners, asset managers, hedge funds, and asset servicing providers. With more than 30 years of corporate governance expertise and 25 years of providing in-depth responsible investment research and analytics, ISS ESG has the unique understanding of the requirements of institutional investors. With its comprehensive offering of solutions, ISS ESG enables investors to develop and integrate responsible investing policies and practices, engage on responsible investment issues, and monitor portfolio company practices through screening solutions. It also provides climate data, analytics, and advisory services to help financial market participants understand, measure, and act on climate-related risks across all asset classes. In addition, ISS ESG delivers corporate and country ESG research and ratings enabling its clients to identify material social and environmental risks and opportunities.