Long-term portfolio decarbonisation: how to assess climate risks beyond ESG

Date

September 2016

Date

September 2016

The carbon and climate change risks arising from fossil fuel exposure within an investment fund are far broader than the traditional risks captured within a company’s standard environment, social and governance (ESG) assessment.

The successful negotiation of the Paris Agreement in December 2015 has created a global impetus to limit increases in warming to 2^oC. At the same time it has set the far more ambitious target of aiming to limit warming to 1.5^oC by 2050. Both of these targets require strong action from the public and private sectors in establishing clear, science-based targets that provide solid country and sectoral pathways to deep decarbonisation.

Short and long-term steps taken by investors towards portfolio decarbonisation will provide much needed market signals to the private sector regarding their company’s response to climate change.

From understanding emissions to decarbonisation: Australian action

In many respects portfolio decarbonisation is easier said than done. There is no formal global or domestic framework advising on how funds can properly calculate portfolio emissions and their exposure to risk, to then pursue portfolio decarbonisation. The Task Force on Climate-Related Financial Disclosures¹, the Climate Disclosures Standards Board² and the United Nations Environment Programme Finance Initiative (UNEP FI)³ have all worked to develop framework guidance on the disclosure of climate change and carbon risks – but none of these provide a long-term, structured approach to decarbonisation.

This has not stopped many international and domestic investors and finance providers, committing to action. Under the Montreal Pledge a number of Australian investment funds, including Australian Ethical Investment, Hesta, Catholic Super, Local Government Super, VicSuper – amongst others, have stated commitments to pursue portfolio decarbonisation. Each of these organisations will have to determine their own, best-fit approach to decarbonisation.

Assessing climate risk in an investment asset

In order to properly assess the risks associated with a particular investment asset, investors can do one of the following:

An independent company assessment based on publicly available information - including public information on their emissions performance and ongoing approach to managing climate change
Engagement with the company to get a better idea of action in respect of climate change and carbon management.

How to move from commitment to measurable success?

Investment funds serious about decarbonisation can build on both existing independent analysis and engagement approaches to drive meaningful change.

Assessing meaningful emissions coverage

Understanding the absolute emissions and emissions intensity compared to peers, and the emissions trajectory of a potential investment cannot be a minor consideration. The Portfolio Decarbonisation Coalition makes a recommendation that the boundaries should be set for emissions coverage – which includes current emissions and long-term emissions exposure⁴.

A major concern in establishing the emissions profile of a particular investment or asset is ensuring a robust basis for all numbers used. There are a number of potential sources that help establish the emissions profile of a particular organisation or asset, each with their own set of limitations:

The National Greenhouse and Energy Reporting (NGER) legislation provides a robust and verifiable framework for establishing scope 1 and scope 2 emissions⁵ from Australian companies, however the information is limited to Australian operations
CDP⁶ requires all reporting companies to disclose their total global emissions (scope 1, scope 2 and scope 3) however as there is no standard approach for emissions calculation specified in the CDP guidance document, there is a risk that company data is not directly comparable
There is currently no robust dataset that incorporates current emissions and emissions intensity with an emissions forecast for a company, which is particularly relevant for mining, and oil and gas companies with long-term fossil fuel reserves.

As a result, the best approach for investors is to use a combination of available information to develop their own emissions models, including forecast emissions projection, about a company or asset’s emissions performance. This should not only be compared against the peers of an asset, but also against the required contribution of the sector to meeting the global emissions reduction targets.

Compare committed performance against global requirements

The point above is an important one. The long-term financial performance of a potential investment asset will be dependent on both the projected carbon budget of their particular sector, and how the company asset is able to perform within this carbon budget against their peers.

If companies have a long term emissions reduction and/ or carbon management strategy in place, this needs to represent a fitting contribution to a 2^oC world. As Science Based Targets (SBTs)⁷ evolve, this will provide a verifiable way to assess whether a company is making a genuine contribution to global emissions reductions.

Review year on year performance

A key component of working towards portfolio decarbonisation targets will be ensuring companies with carbon reduction targets in place are tracking towards the achievement of these targets. Ongoing engagement with investment assets will play a major role, but also needs to be accompanied by independent verification of company/ asset performance against their target or a publicly available climate change or carbon reduction strategy.

In addition, year-on-year engagement should consider updates on global sectoral carbon budgets to reassess the medium-long term position that a particular asset has within a 2^oC world.

The investment sector and its contribution to reducing global emissions

Much has been said about the important role that short and long term investors and lenders can play in driving sustained emissions reductions. Energetics has previously written articles considering whether climate risk is the ‘black swan’ for investors and the global carbon risk disclosure movement.

The impacts of climate change can bring about lasting reputational, operational and corporate governance issues for a corporation. More importantly the impacts of climate change can create major risks for the ongoing financial performance of a company. Consider, for instance, the rapid deterioration of the performance of Peabody Energy and Arch Coal⁸ and the subsequent class actions bought forward by their pension fund members. In both of these cases depressed commodity prices had a major impact on the company’s stock price. Both companies maintained employee retirement plans which invested heavily in the company stock. The claims suggested that trustees of the employee retirement plans had breached the trust of their members by failing to consider the impacts of investing primarily in company coal stocks; noting the current risks attached to the fossil fuel sector.

These cases highlight not just how pervasive the risks of climate change are to the continued successful performance of a company, but how in some circumstances the impact of these risks can be transferred to a related trustee or investor group.

For investors, implementing a staged approach to portfolio decarbonisation that considers the full impact of climate change risks on an existing or prospective investment, can limit investor risk exposure.