The Reality of Transition Risks for Investors: Part I

Today there are more reasons to feel optimistic about our transition toward a low-carbon future than there were a year ago. The U.S. has rejoined the Paris Agreement and the Biden administration has expressed commitment to becoming a leader in the fight against climate change. Global emissions dipped by more than 6% in 2020, albeit due to a global pandemic, and major countries, including India, are trying to “build back better” by focusing on green stimulus. However, the global community is still not on track to meet the Paris Agreement’s commitment to limit warming to 1.5℃.

In theory, if carbon emissions and global development were decoupled and a scientific optimum was the sole goal, a more ambitious temperature target would have been set. Instead, we have a painstakingly negotiated a consensus-based commitment to limit global warming to 2℃, with a target to reach 1.5℃ by the end of the century (the Paris Agreement). However, the non-binding Nationally Determined Contributions (NDCs) submitted every five years by each of the parties are insufficient and have never been consistent, with a 2℃ let alone a 1.5℃ pathway. Therefore, investors must prepare their portfolios for a warmer world and apply pressure to rapidly decarbonize.

The Motivation for Net Zero

“Net zero” is an exciting prospect and an effective catchphrase, but we must first understand the motivation for it. The pathways described by the Intergovernmental Panel on Climate Change (IPCC) for achieving the 1.5℃ goal requires net-zero CO2 emissions by 2050, and net-zero greenhouse gas emissions by 2070. Reaching net-zero emissions does not guarantee that we will achieve the 1.5℃ target. Timing matters, and in this case, the faster, the better.

Net-zero greenhouse gas emissions refers to putting no more warming gases into the atmosphere than are being removed. However, CO2 has a long lifetime in the atmosphere—over 300 years—before it naturally and chemically decomposes. A unit of CO2 emitted today will remain in the atmosphere and cause warming for several generations. Just imagine the atmosphere as a full bathtub with the drain open and the faucet running. If you can open the drain enough to release as much water as the faucet is depositing into the tub, you have achieved net zero, but you are still sitting in a tub full of hot water. Even if you close the tap, you still have to wait for it to slowly drain—for 300 years. Time to grab your direct air carbon capture bucket!

Breaking Down Climate Change Risk

Even if we miss the 1.5℃ target, the pressure to decarbonize will remain as any warming above that level is already too much. The world is already at a 1.0℃ warming, and nations and individuals are actively experiencing damages from extreme weather, drought, and sea level rise. As these stressors continue to worsen, the pressure will mount to transition faster and deeper, placing businesses and investors at the steep end of transition risk.

Transition risk is one of two major components of climate change risk. The other is physical risk. As a collective, nations and businesses are all exposed to both, but the degree of exposure and the resultant cost will manifest unevenly.

While nations will be running anxiously to stave off the severity of physical risks, businesses will be looking at how to protect the value of their assets, and indeed their very business model, from the cascade of changes resulting from carbon mitigation, including but not limited to—a price on carbon, the end of fossil fuel subsidies, renewable energy credits, shifting consumption patterns, and rapid technological advancement.

Being able to recognize and incorporate transition risk is crucial to effectively understanding the changes in enterprise-specific risk and how they generally interact. A business’ resilience to the carbon transition that’s already underway depends on this.

It’s Not Over at Net Zero

The net-zero by 2050 goal is a goalpost on the way to net-negative. Direct removal will be necessary to effectively slow warming, and more ambitiously, to halt and ultimately reverse it. Hence, transition risk is sure to linger longer than 2050.

Business models must be realigned to survive the transition; not only to hold up under the anticipated public scrutiny for net-zero targets. The realignment must be done with the intention of bolstering businesses’ resilience for a prolonged, tumultuous change in the socioeconomic and ecological status quo. In the same vein, investors must begin to assess their portfolios through the lens of prolonged resilience. We need processes here that are just and inclusive.

Divestment is a popular, soothing, and relatively easy solution but it does not address all the challenges that come with portfolio decarbonization. From 1988 to 2015, 100 companies were responsible for 71% of global emissions; all were in the energy sector. Real solutions to decarbonization must involve a motivation for all companies, especially these companies responsible, to reduce emissions drastically and quickly and reward those who do, if we really intend to bend the temperature curve. This rate of carbon reduction, what we will call the “transition gamma,” should be the fulcrum of any climate sustainability strategy.

Investing Strategies

Sustainable and just transitions require that we focus on investing strategies that are sector and region inclusive—without losing sight of the fact that we would be better off as a low-carbon world today, rather than tomorrow. It really is a race and companies should be looking to run fast. Investors, on the other hand, should be looking at who is running the fastest in their attempts.

How can you do this for your portfolio?

• Prepare for transition and physical risks associated with a variety of climate scenarios. The desired 1.5℃ scenario but also the more likely 3℃ and 4℃+ scenarios. This is a key recommendation by the Task Force on Climate-Related Financial Disclosures (TCFD); it is now critical to gauge sector and portfolio return performances for multiple climate pathways. The energy sector, while obviously carbon intensive today, is not one to ignore. Energy production and consumption as well as energy prices are very sensitive to the socioeconomic and technical shocks associated with climate change mitigation and adaptation. In our next article, we’ll explore the scenario analysis recommendations by the TCFD and what that means for investors.
• Give attention to the transition gamma. Leverage corporate carbon disclosures to quantify real emissions reduction trajectories of the securities in your portfolio—rather than their stated temperature targets—to guide reductions in emissions associated with your portfolio. It is very important that investors consider short-to-intermediate measurement standards to integrate emission trajectories. A system that can guide quarterly checks and rebalances to ensure that investment portfolios are on the path of maximum carbon reduction potential will be ideal.

Conclusion

It is true that we want society to move towards carbon mitigation. However, it is also very important that investments are well prepared for climate resiliency and adaptation. We need a solution for investors that is aligned with both their financial and environmental goals. A crucial point in the discussion around transition risk for portfolios is the topic of transition gamma. In the third part of this article series, we’ll delve deeper into the underlying concept and what investors stand to gain by incorporating it into their carbon reduction strategies.

Entelligent’s Pooja Khosla, Vice President of Client Development, and Nana Yaa Asante-Darko, Client Relationship Administrator, also contributed to this article.

This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet. The information in this report is not investment advice.