Climate Risks: Time to Factor the Most Fatal Risk in Your Portfolio

Part II: Call for the Investment Professionals

Why the Call?

The Climate Clock is ticking fast and in the face of the dearth of data and disclosures, the challenges to come across the new and fluid expectations of clients are multiplying. The physical and transition risks are certain to materially alter and affect the portfolio management process. The new and involved nature of risks and their level of integration may pose a systemic-risks to the overall markets (particularly oil & gas, utilities, automotive, etc.) jeopardizing the risk-return profile. The invested asset classes may perform sub-par, yielding sub-optimal returns; for example - the intensified flood and dry spell (physical risks) on hydropower projects. The flaw in accounting, financial modelling, and valuations, risks investment decisions, bugging off the investors. Therefore, it is a pressing moment for all investment professionals to contemplate the climatic variables for the creation of green portfolios that produces sustainable returns. Approx. one-third of the global investors have formally committed to a net-zero portfolio i.e. (net zero emission of GHG) by 2050. Regulatory impositions (Transition risks) for higher fuel standards, clean energy, etc. could be daunting for financial institutions, while Physical risks may be more severe following 2050. Fund Managers have the challenge to meet the risk-return objectives of investors at such climate constraints. Not only the risks but the return opportunities brought in by climate change in the field of renewable energies, green finance, clean tech, etc. should also be factored.

Insight to the Fundamental Theories of Climate Change:

1. Carbon Budget: The climate modelling determines the Carbon budget which is the total amount of remaining carbon emission (CO₂) that human can emit which will not result the global average surface temperature to exceed above 1.5^OC or 2^O The 2021 IPCC Report states with 67% probability that the remaining carbon budget for curbing the global temperature at 1.5^OC is 400 GtCO₂ i.e. 400 billion tonnes CO₂ and 1,150 GtCO₂ for curbing the temperature at 2^OC. Report anticipate the remaining carbon budget for 1.5^OC would be finish by 2030, suggesting the quick action on reduction of GHGs.

2. Carbon Price / Tax: Carbon price is the price charged for emission of GHG/CO₂ and an incentive provided to control such emission. It aims to lower the emission of GHG/CO Carbon price can be implemented either through a Carbon Tax (cost per ton of emission) or through the Cap-and-Trade System which allows carbon credit trade. Approx. 30% of global emission are priced under these approaches at an average of $6 per ton of CO₂. Stern and Stiglitz 2017 Report forecast the carbon price to range $50–$100/tCO2 by 2030.

3. Carbon Border Tax: In 2019, European Commission, in its efforts to control the carbon leakage and achieve the carbon-neutrality, proposed the Carbon Border Adjustment Mechanism (CBAM), i.e. the Carbon border tax. Any carbon-intensive products imported from the country having no carbon pricing mechanism or green economy policies will be levied the carbon border tax.

4. Carbon as an asset class / Commodity: Under the Carbon credit concept, nations/companies/individuals (receiver) are given the limit to emit the CO₂/CO₂e GHG. For instance, one credit allows the emission of one ton of CO₂/CO₂e GHG. Receivers with excess carbon (i.e. unused) can sell the carbon to others (for carbon offset) like an asset/commodities/options in a carbon market/exchange. The objective is to lower the GHG/CO₂e emission by incentivizing the lower user of carbon and penalizing the higher carbon user, thus allotment of carbon credit is reduced over time. A study (2012 - 2019) finds that the annualized return and sharp ratio of carbon composite are higher than traditional asset classes (equity, bonds, etc.) despite higher volatilities. The inclusion of carbon asset in the portfolio is likely to provide diversification benefits due to its lower correlation with other asset classes.

Note: In 2021, Nepal committed to Forest Carbon Partnership Facility (FCPF) to implement the activities under the ‘Reducing Emissions through Deforestation and Degradation’ (REDD) mechanism, enabling Nepal to sell the carbon stock at $5 per ton of CO₂ emission.

5. Green Finance: The objective is to finance the projects that promote the green economy i.e. more sustainable economic development with lower carbon. The market of green finance, which rose tremendously, has exceeded $3.5 trillion already. More than half of this size is comprised by Green bonds alone, Sustainability bonds, and Social bonds each approx. 20 % size, while Sustainability-linked bonds (SLB) and Transition bonds are the least issued.

6. Green Swan: Probability does remain in climate modelling not to factor the climate events, consequences, and severity exhaustively, thus potentially producing the black swan events; rare, unpredictable events with systemic impacts. The concept of Green Swan emerged to find systemic solutions or solutions that tap into the positive exponentials of climate-related Black Swan events. The Bank for International Settlement (BIS) in coordination with various other governments and organizations conducted the third edition of the Green Swan Conference “Getting real with tech and the transition” on May 31 - June 1, 2023.

7. Rework to the Accounting and Auditing Standards: The assumption, judgment, and estimation in various parts of accounting like recognizing revenues and expenses, determining the provisions amount, depreciation, asset fair value, etc. could require frequent revision. The assumption of going concern, audit planning, sampling, etc. may change along with the responsibilities of auditors and management. Clients, investors, and regulators may seek more financial disclosures.

8. Soundness of Business Valuation: Valuation is influenced more by subjective and judgemental factors; valuator comprehension and assumptions of the integration between the business cash flows and the climatic variables greatly affect the present value of the company/stock. Valuation models (including the Real Options) may not appropriately factor in the climate scenarios, risk premiums, cash flows, etc. 

9. Increased Climate and Other VaR: Climate VaR helps the Investment professional to assess the financial losses on their portfolios due to exposure to climatic events. These forward-looking metrics model the various unfavourable scenarios (including the favourable), perform stress testing, and value the portfolio. Not only Climate VaR, but all kinds of VaR like market, credit, operational, liquidity, etc. will shoot up as the consequence of physical and transition risks. These VaR figure helps the company in taking the optimum climate risk exposure.

10. Construction of Climate Hedged Portfolios: Not a perfect hedge but climate risks could be managed with systematically constructed decarbonized and/or aligned portfolios. Portfolio should try include the asset with negative carbon beta that weight more to those assets whose performance correlate more to the climate change. The investment in different hemispheres of the earth could help trim the investment risks because losses in one region could be redeemed by another. Such portfolio has negative/low risk premium and higher return expectation. They value more when climatic risks resurface more.

Closing Note: 

The main challenge is the lack of data and disclosure about the climatic events in the company’s report itself. Despite these constraints, evidence do persist on pricing of the physical and transition risks in equity, bonds, credit, real estate, etc. market. The Climate Disclosure Project (CPD) reports that over 515 institutional investors with a combined asset worth US$ 106 trillion have requested for a company’s disclosure on climate change and over 8,400 companies representing over 50% of global market capitalization have reported accordingly. Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosure (TCFD) provides the standard disclosure contents. The practice of ESG, socially responsible investing, etc. are not new. Investors have started discounting carbon-intensive companies, and stranded assets while premiums are paid for green bonds, climate-hedged portfolios, etc. These kinds of practices are less evident in developing countries. The Economist Intelligence Unit (EIU) in 2015 estimated the net present value costs of climate change to be at least $4.2 trillion. United Nations Environment Programme (UNEP) estimates the costs of adaptation to climate change in developing nations, upper side, to exceed US$ 500 billion annually by 2050 while IPCC estimated the amount to be above US$ 1 trillion annually. UNEP report also states the need for International Adaptation Finance to the extent of US$ 340 billion per year to the developing countries by the year 2030. However, only US$ 28.6 billion in Adaptation Finance flowed in 2020; nearly ten times Adaptation Finance Gap.

(Contributed by Jeewan Pun. Pun is a former CFA Charter-holder and Certified FRM, currently serving as the Head of Research and Product Department at Garima Capital Limited.)

READ PART I OF THE SERIES: Climate Risks: Time to Factor the Most Fatal Risk in Your Portfolio; Part I: Understanding the Climate Change Risks