CFA Institute examining how financial sector can help mitigate climate change
The Chartered Financial Analyst Institute is looking to more deeply examine the financial industry’s role in mitigating climate change.
In a new report, the CFA Institute examined how investors can engage with the issue of climate change. It noted a recent survey of its members found 40 per cent of respondents incorporate climate change information into the investment process. In past research, the institute found 75 per cent of a select group of C-suite executives believe climate change is an important issue. The disparity between these two percentages would suggest there’s an appetite for more data and disclosure on issues of climate risk from issuer companies, according to the report.
As for tools the financial sector can use to improve the situation, the institute said it supports carbon pricing. “Putting a price on carbon emissions that considers the negative externality of climate change creates an incentive for the invisible hand of the market to move economies away from burning fossil fuels.”
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The report also noted that carbon price expectations should be included in analyst reports. “A realistic market price on carbon will send a price signal that analysts need in order to properly value the externalities that come with greenhouse gas emissions.”
Calling for investors to push for improved disclosure and climate metrics from portfolio companies, the institute suggested both investors and investee companies work together to establish what metrics are relevant when assessing a company’s strategy for handling climate change. It also recommended that both investors and investee companies look to the future potential physical effects of climate change to ensure data, disclosures and scenario analyses are robust enough.
“Scenario analysis, one of the most useful tools for incorporating climate change research into the investment process, applies probabilities to different possible outcomes and decision trees. Investors and analysts can use it to imagine a number of possible different futures in an attempt to assess risk.”
Further, the report said education within the investment profession is still required and suggested that investors continue to engage with policy measures to ensure concurrent efforts are being made in public and private spheres.
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It also included several case studies on how investors can engage on climate change issues with their portfolio companies.
“At Aberdeen Standard Investments, we are particularly interested in transition stories from companies that can demonstrate that they have embarked on a journey to decarbonize their operations,” said Petra Daroczi, the company’s investment analyst in fixed income and environmental, social and governance, in her submission to the report. “Our assessment follows a three-step process: screening, carbon risk assessment and evaluation of strategy. This framework enables us to objectively measure the viability of decarbonization and its implications for the company, as well as [for] investors.”
She provided the example of an Asian utility company using 100-per-cent fossil fuels for its power generation. In that scenario, the company stated its ambition to move away from carbon-intense coal to use more natural gas and renewables.
Daroczi described a framework whereby the company is first screened, examining absolute, relative, and expansion thresholds to discern whether the company is in alignment with the two degree celsius warming limit on climate change in the Paris Agreement.
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“For example, absolute triggers, such as the overall [carbon dioxide] the company emits, are useful for identifying which companies will be among the largest emitters. On a relative basis, we can identify if a material portion of a company’s operations are in coal-fired power generation. The expansion threshold aids in understanding whether a company has committed to further investing in coal-fired assets. In our framework, we flagged [the company] for breaching the relative basis threshold because it was generating more than 20 per cent of its power from coal.”
The next step is to assess carbon risk, she wrote. “Here we take a deep dive into the characteristics of the operator’s physical assets, such as location, operational lifetime and fuel mix profile. These elements provide us with important information on several levels. The location tells us whether the company operates in a jurisdiction that has existing or proposed plans for carbon taxation, for example. Asset lifespan tells us about stranded asset risk — the longer a plant’s operational lifetime, for example, the higher the risk that it will not be economically viable to exploit it in the future.
“We also consider the plant’s emission profile, including absolute emissions and emission intensity, because the more CO2 a company emits, the higher the potential for future carbon tax costs. Finally, financial metrics also play a key role in our carbon-risk assessment because ultimately we want to understand whether the company has the ability to limit the effects of increased costs (carbon tax, costs of complying with stricter environmental regulations) on profit.”
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The final step of the framework is to examine the viability of the company’s plan to decarbonize, said Daroczi. The examination delves into C-suite oversight to find out whether key performance indicators related to decarbonization are meaningfully tied to executive compensation. Then it assesses how well the company communicates with investors on the issue, whether by sustainability reports or disclosures in line with robust reporting guidelines.