The Intergovernmental Panel on Climate Change (IPCC) represents the most concerted scientific collaboration on climate change that informs policy decisions. The panel’s reports have provided critical insights into the physical and socioeconomic implications of a warmer climate. The Sixth Assessment Report (AR6) by Working Group 1 (the subgroup responsible for investigating the physical science basis of climate change) revealed that, unless there is an acceleration of mitigation efforts, hopes of limiting warming to 1.5°C beyond preindustrial levels would be out of reach.
These scientific conclusions impact climate policy, which will eventually translate into pressures on the global financial system. Often, these actions first manifest as reporting and disclosure requirements. Evidence of this can be seen in the number of countries requiring the use of Task Force of Climate Related Financial Disclosure (TCFD) reporting guidelines, sustainability regulations in Europe, and many other new regulations.
There is a responsibility on both the sell side and buy side of the financial system to work toward adoption and mitigation. Much as their influence appears to dovetail, it is understood that the demand side holds a bit more sway over the supply side in this instance. The buy side has always been a major factor in the direction of the global economy because of the overall power of consolidated funds. This means that the direction and momentum of climate considerations and disclosures ought to be a primary concern of pension funds, mutual funds, hedge funds, insurers, and all other asset owners.
Asset managers, who often act as agents for the asset owners, must also understand the risks to themselves and their clients. In turn, they must educate their clients on the climate risks of their investments. Asset owners themselves need to know the risks and they are demanding it from their asset managers.
The Carbon Disclosure Project (CDP) has shown that the financial sector is underrepresenting the extent of climate-related risk in portfolios by approximately $1 trillion (USD). On average, each institution’s portfolio emissions are about 700x greater than its direct emissions. This means that the greatest impact in the financial sector lies specifically in the investments held by the buy side rather than in their operational activities, as would be the case for the companies in which they invest.
While regulators want the financial industry to disclose its climate risks according to proposals such as TCFD and legislation like the European Union’s Sustainable Finance Disclosure Regulation (SFDR), the buy side would remain data handicapped without similar climate-related disclosures by the companies in which they invest. Therefore, it is crucial for both asset owners and asset managers to exert pressure on the companies in which they hold investments to provide these disclosures.
To be useful and fulfill the desired use cases (e.g., comparing new and traditional financial disclosures), the investee companies’ climate-related disclosures must follow standardized processes. Additionally, they must produce commonly recognized and accepted metrics such as those recommended by the TCFD.
For their own TCFD disclosures and those to be required from companies, buy-side participants must commit to understanding what the disclosed metrics mean.
Measured in tons carbon dioxide equivalent (CO2e) per million dollars of revenue (tons CO2e/$M revenue), weighted average carbon intensity measures how much emissions it costs to generate $1 million of revenue over a certain period. For companies, this can be used to measure carbon cost and ultimately generate a turnover for a business segment. It generally covers their Scope 1 and Scope 2 emissions but should ideally include Scope 3 when possible.
This seeks to measure the absolute CO2e of all applicable greenhouse gas (GHG) emissions from overall productive operations. The most common method of allocating these amounts is the equity method. Here, the proportion of ownership represents the proportion of total carbon emissions accounted for by an investor.
One major benefit of this method is accounting for total carbon emissions in a way that prevents double counting or unclaimed emissions. With this metric, participants at the buy side must consider whether coverage of greenhouse gases is extensive enough to capture all a company’s activities. This is important because even minute quantities of some GHG, like sulfur hexafluoride (SF6), can have significant global warming potential (GWP).
In the most basic sense, the concept of carbon footprints for individuals refers to the carbon cost of living. For corporations, it is the carbon cost of operations as measured by CO2e/$M invested. Companies with large carbon footprints in the climate registry are known as brown, while those with smaller footprints are known as green. However, the carbon footprint metric alone is not sufficient to make sound investment decisions; average revenue per ton CO2e is a derivative metric that can provide an even better perspective.
Carbon intensity is one of the most comparative metrics because it measures efficiency. It is especially suitable for intercompany comparisons as well as time-based comparisons of a given company. For investors committed to engagement with their investee companies, measuring changes in carbon intensity metrics over time can indicate whether agreed-to changes are being implemented and yield results. Although it has the same units (tons CO2e/$M revenue) as the weighted average carbon intensity, the carbon intensity metric is measured differently.
This represents the value of capital assets at risk in companies. To interpret this metric properly, asset owners and asset managers must understand the relationship between the operations of the companies in which they’ve invested and the physical and transition risks of climate change. This requires an elevated degree of transparency and an understanding of the value chain that is distilled in an asset owner’s portfolio. The buy side should be justifiably interested in which assets or business segments are at risk of stranding or obsolescence, as well as how that may impact the growth and profitability of their holdings.
The average revenue per ton CO2e allows buy-side participants to process the carbon footprint as an asset with an expected negative return and whose reductions should be maximized. This metric demands that buy-side participants consider CO2e in inverse. This is critical if buy-side participants are to make positive investments towards the reduction of CO2e, rather than just engaging in the passive avoidance of CO2e.
This view allows investors to capitalize on the opportunities inherent in CO2e reduction; it also helps diversify and reduce their climate risk over time. In addition, this metric enables a forward-looking vetting system to CO2e emissions considerations.
T-Risk assesses climate transition risk exposures for a given climate transition pathway or temperature target. It shows the direction and momentum of company adjustments for climate resilience in terms of their returns, costs, revenues, and any other relevant indicator. This measure provides buy-side participants with the insights to assess the alignment of their investee companies in comparison to the targets that they have set.
While reviewing these metrics in company TCFD reports is crucial, there remains a great deal of value for the buy side to derive from understanding how these metrics and others play out in their portfolios.
This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet. The information contained in this article is not 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.