A number of investors choose to sell investments in fossil fuel producers. This reduces the CO2 emissions of the investment portfolio but only partially protects the investors against the risks of the climate transition.
The climate transition is more than CO2 reduction. In fact, our own research shows that less than 10 percent of the impact of the transition is due to the current carbon footprint of companies. We look at all future changes related to climate transition, from every part of a company, and in every sector. The impact on the value of companies, investments and ultimately the investment portfolio is then determined. By emphasising the management of all risks of the climate transition, the return and risk objectives are served, in addition to reducing CO2 emissions.
Need for progress is great
In 2015, governments from around the world joined forces in Paris to tackle climate change at a conference commonly known as COP21. This made climate an important issue for investors as well. At the same time, pension fund participants became more critical, action groups started to stir and engagement with companies intensified.
In 2019, more than 50 financial parties, together with their umbrella organisations, signed the financial sector’s commitment to the Climate Agreement in the Netherlands. This Climate Agreement aims to cost-effectively reduce CO2 emissions by 49 percent by 2030 compared to 1990. In the meantime, a number of investors have chosen to distance themselves from investments in producers of fossil fuels. In this way, the CO2 emissions of the portfolio are directly reduced. However, this has not yet removed all transition risks.
At the moment, COP26 is taking place in Glasgow. This conference is seen as a crucial moment for the world. It will take stock. What progress has been made since 2015 to combat climate change and what (new) commitments are being made? Countries have been asked to come up with ambitious targets for CO2 reduction by 2030. The need is great.
The new UN IPCC report clearly shows that the climate is warmed up by humans. The impact of climate change is becoming increasingly severe worldwide in the form of extreme weather conditions such as drought, storms and floods. A faster transition to a CO2 neutral world is necessary to avoid the worst climate risks.
Transition changes business models
Companies are faced with the clean task of adapting to this new world. The transition has great potential to create value, but could also lead to significant losses for companies.
Research suggests that the 100 most emitting companies could lose 43 per cent of their market capitalisation by 2025. As leading investors, pension funds will therefore need to be aware of the effects that the climate transition has on these companies. Financial markets are shifting as transition policies, technology and consumer behaviour will structurally change profitability and business models.
Climate Transition Value at Risk
To manage this transition risk, a yardstick is needed to measure it. A measure that integrally measures the financial impact of climate change is “Climate Transition Value at Risk”, or CTVaR. This measure uses detailed, bottom-up scenarios to assess the impact of changes in policy, technology, industry and consumer behaviour, then models the financial impact of a climate transition on the future cash flows of individual companies and investments. This provides investors with a concrete tool to determine the actual impact of the climate transition on investment portfolios.
Common climate measures such as measuring the current carbon footprint and focusing on compliance with reporting standards (TCFD) help identify outliers, such as fossil fuel producers. It says little about the price of investments or the financial risks associated with the transition. Companies in low-emission sectors are rewarded in the usual measures while all other relevant information about the financial transition risks these companies face is ignored. CTVaR measures the extent to which a company is revalued based on a full climate transition. In this way, CTVaR identifies companies that can be leaders in the climate transition.
The good news for investors is that the CTVaR measure is also being used to construct an investable index, the Climate Transition Index. This CTI index removes the following shortcomings of current climate indices:
- all relevant information regarding the climate transition on the value of companies and investments is included;
- The information is forward-looking, in-depth and based on the path to a CO2 neutral world rather than a methodology based on historical / current CO2 emissions;
- The index takes into account the wide range of policy and system changes for different goods, services and commodities in line with the objectives of the
Paris Agreement
A faster transition to a carbon neutral world is needed to avoid the worst climate risks. The new CTI indices offer investors an innovative and readily available solution to better manage climate risks.
A CTI index seeks to reduce the negative financial impact of falling valuations due to companies having a negative CTVaR. At the same time, opportunities can be seized from listed companies that are well positioned for the climate transition. In this way, investors are enabled to simultaneously reduce the CO2 emissions of their portfolio, obtain sufficient returns and limit risks. Of course, this also benefits investors who have made the choice to sell investments in fossil fuel producers.