Will climate change risk impact your share portfolio?
SMSF investors need to query whether the stocks they are holding have greenhouse gas emissions, and to what level.
In 2009, governments around the world committed to limiting global warming to no more than two degrees centigrade above pre-industrial temperatures. Scientists believe that temperatures beyond this level threaten catastrophic climate change. In this article, we discuss the issue of global warming and explore the impact that climate change will have on investment portfolios.
Economies need to undergo significant structural change
As part of this commitment to lower the world’s temperature, economies need to change. The global economy needs to make structural changes to ensure that global warming is limited to less than two degrees centigrade by 2050, and Australia will need to significantly reduce its emissions by more than 90%. Among its trading partners, Australia is one of the least greenhouse gas efficient economies, and its 2030 target will leave it with about the same efficiency that Europe, Japan and Korea had back in 2010. The structural changes required by economies clearly represent opportunities and risks to investors, and mean that investors should be considering the impact of climate change on their investments. This includes individual companies’ carbon targets, as well as the carbon footprint of a portfolio as a whole.
Are we investing dangerously?
By analysing the carbon footprint of an investment portfolio (e.g. emissions per dollar invested) investors can make an informed assessment about the climate change risk across their portfolio, and will be able to monitor how this risk is managed over time. Carbon emissions can be broken down into three broad categories. Scope one emissions are direct emissions from owned or controlled sources. This may include stationary or mobile combustion from fossil fuels. Scope two emissions are indirect emissions from the generation of purchased energy such as electricity, steam or other sources of energy. Scope three emissions include a number of different sources of greenhouse gas emissions including employee commuting, business travel, third-party products, distribution and logistics.
Figure 1 shows the scope one and two emissions disclosed in the MSCI World Index, demonstrating the bulk of risk lies in three or four key sectors (utilities, materials, industrials and energy). Compare this to the benchmark weights in the index where these sectors account for more than 40%. While at first glance it would appear that divestment may solve the issue of climate change risk within portfolios, it is not quite so clear-cut, and there are a number of important factors to consider.
Figure 1: Reported scope 1 and 2 emissions represents -5.5 billion tonnes CO2-e.
Source: MSCI World Index as of 30 June 2015.
Understand the real risk within portfolios
To fully understand the real risk of climate change inherent within a portfolio, there are a number of important factors to consider. Firstly, there is significant discrepancy in the data collected. Currently, within the MSCI World Index only around 65% of companies publish their greenhouse gas emission data, and collection can vary between companies. Secondly, double counting provides considerable complexity in measuring the risk; for example, emissions from an electric utility can also be accounted for through another company’s electricity usage. Thirdly, while it’s important to consider operational emissions, as investors, we are interested in a company’s equity exposure.
If a company owns 50% of an operation, it is only exposed to 50% of the emissions – whether it operates the facility or not. All of these factors can have a significant impact on trying to assess the risk of climate change within a portfolio. In assessing the risk associated with ‘stranded assets’, the Carbon Tracker Initiative has projected that between 60-80% of coal, oil and gas reserves of publicly listed companies is ‘unburnable’ if the world is to have a chance of not exceeding global warming targets. This would mean that many carbon reserves would need to be written off as financial losses. In our view, potentially stranded reserves do not necessarily impact a company’s value. In assessing the likelihood for stranded assets, the key factors to consider are a company’s relative emission intensity of fossil fuel, and position on the cost curve within its industry.
Building greater resilience
SMSF investors need to think about how regulatory and policy options that governments implement will impact their portfolios. If this involves a price on greenhouse gas emissions, then investors need to query whether the stocks they are holding have greenhouse gas emissions, and to what level.
They also need to consider the ability of those companies to pass through these costs to the consumer. As discussed, there is much complexity in assessing these risks (taking into account a number of metrics), and it is important that the correct due diligence occurs in building greater resilience within portfolios.
About the author
Dr Ian Woods joined AMP Capital in December 2000, and since that time has focussed on how the issues of sustainability and ESG relate to financial investment and the investment risks. Dr Woods’ background is in environmental and risk consulting both in Asia/Pacific region and Europe.