Beyond footprinting: How can investors manage carbon risks in their portfolio?

Institutional investors are facing increased pressure from customers, regulators and civil society to become more responsive to the threat of climate change. Over the last few years, there have been several developments that encourage investors to integrate risks associated with climate change into their decision-making (see timeline below). In addition to the impact of their investment, they need to address the effect climate change will have on their investment. This will manifest in both physical risk – through floods, draughts, extreme weather events, etc. – and carbon risk (also referred to as transition risk).

The shift to materiality

Current practices revolve around the impact of investment on climate. This is primarily done through portfolio carbon footprint measurement and fossil fuels involvement screening, which then form the basis of efforts to decarbonize portfolios. Here investors typically opt to either divest from high-emitting companies, or to increase the level of engagement to encourage carbon reduction strategies.

However, there are limitations to this model, not least the shortcomings of carbon footprint data. Not all companies report, and even where data is available, it is not always comparable given the prevalence of different carbon accounting methods. Equally, there is the challenge of double counting within a portfolio as the direct carbon emissions of one company can be the indirect emissions of another. As a result, investors are left with inconsistent data points that do not necessarily support carbon risk management and investment decisions.

Carbon risk case study: Cars versus planes

The emphasis on materiality argues that not all tons of emitted carbon are equal. This is evident when looking at a comparison of the automobile and airline industries. Sustainalytics has created a Carbon Risk Rating that measures companies’ exposure to and management of transition risk. By comparing these scores with emissions data, it is clear that although own operations of airlines are easily ten times more carbon intensive, car manufacturers actually experience higher risk.

The primary reason for this difference is automobile manufacturers face significantly higher regulatory pressure. The industry has seen several breakthroughs in recent years, and the growth of electric vehicles is seen as a viable low-carbon alternative. Airlines, however, do not yet have the same replacement options, with no commercially-viable and scalable low-carbon alternative to kerosene. As a result, airlines only have limited options in how to manage carbon risk, and therefore face lower pressure to reform.

Managing a low-carbon transition

For investors to navigate the transition to a low-carbon economy in a progressive but non-disruptive manner, they need to consider more than the footprint of their investments. Regulators have shown more of an appetite to enforce disclosures about climate change, and there is broad acceptance within the investment community that the shift to low-carbon will be accompanied by a range of risks and opportunities. With the help of carbon metrics focused on materiality, investors will understand which companies are more financially at risk from this transition, in turn facilitating a superior investment strategy.