Sustainable finance

How material is climate change for the financial community?

In November 2015 The Bank of England governor, Mark Carney, delivered a stark warning detailing the various risks global markets and the financial community face as a result of a changing climate. He called climate change the “tragedy of the horizon”. Earlier this year the World Economic Forum stressed the same point. Climate change and related issues are in the top five most impactful risks and top ten most likely risks for the global economy. With such calls requesting clear and rapid action, it seems interesting to take a look at how material climate change is for investors and the broader financial community.

Financial community leaders are pushing for action

On the international stage, the opinion among top financial leaders seems to clearly point that climate change is a priority. A dozen voluntary initiatives exist to date. For example 120 international investors with a total of $10 trillion committed under the Montreal Pledge to disclose, report and reduce the carbon intensities of their investment portfolios. More recently 63 stock exchanges around the world committed to push companies listed to disclose climate change data.

In parallel authorities are also pushing for more transparency. For instance since August of 2016 [1], institutional investors in France (more than 800 organizations) are required to disclose the amount of green investments in their portfolios and how their investment strategy contributes to the mitigation of climate change.

Climate change materiality through the lens of available data

Several independent reports seem to point in the same direction. Companies taking into consideration climate change whether on its own or as part of a larger ESG set of criteria, are more likely to outperform those that do not.

A recent study by Mercer estimates the impact of climate change on returns via modelling. It concluded climate change, under the scenarios modeled, will inevitably have an impact on investment returns, so investors need to view it as a new return variable. As an example average annual returns from the coal sub-sector could fall by anywhere between 18% and 74% over the next 35 years, with effects more pronounced over the coming decade (eroding between 26% and 138% of average annual returns). Conversely, the renewables sub-sector could see average annual returns increase by between 6% and 54% over a 35 year time horizon (or between 4% and 97% over a 10-year period).

Another research found that companies with low Scope 3 emissions intensities significantly outperformed those with high Scope 3 emissions. In addition this trend remained statistically significant even when other risks were accounted for. More interestingly, Scope 3 seemed to be a far more statistically relevant and therefore better indicator of returns than Scope 1 and 2 emissions.

However what is the story on the ground?

How much of the international momentum and conclusive information to date actually has an impact on the ground? To have a sense, we looked at fourteen major Canadian financial institutions listed on stock exchanges and that have submitted a climate change disclosure as part of the Climate Change Disclosure Program of CDP. CDP is one of the primary sources of information on how companies manage climate change.

We considered the climate-related risks and opportunities that were reported by each company. Then we looked at how these institutions rated each risk in terms of likelihood and impact to their business. Here is one of the findings of our analysis, which covered a variety of areas.

Figure 1 represents the highest rated risk reported by each company on a risk matrix. The more the rating approaches the bottom left of the diagram, the lower the risk is considered to be for a company. On the other hand, the closer to the upper right corner, the higher the risk is. Companies that reported climate change to not be material at all received a rating of zero.

As can be seen in Figure 1, the majority of companies in our sample reported at least one climate related risk that is considered more likely than not to materialize in the foreseeable future. This confirms there is a general high awareness on the financial consequences of climate change. When looking at the foreseeable impact on business, our sample is divided in two equal halves. One half considers climate change consequences on assets and business to be significant (right-hand side of the chart), while the other half considers them to be low or not material in the foreseeable future.

We reached a similar result when performed the same analysis for opportunities as can be seen in Figure 2. Half of the sample considers there are low or no opportunities, while the other half believe the low carbon economy transition and climate change adaptation can constitute valuable business opportunities.

This finding points out there still is a significant portion of the financial and investment community that either does not believe the low-carbon transition will happen or that ignores or underestimates the many negative ripple effects to which investment portfolios are exposed. Considering there are literally hundreds of financial institutions on the Canadian market managing life insurances, investment funds and pension funds it seems imperative to ensure as many as possible acquire the capability to integrate climate risk it in their investment decisions.

Our own experience on the ground confirms that only a minority of leaders have a comprehensive understanding and approach to climate risk which includes an actual estimate of the carbon intensity of their investment portfolios.

Conclusion

Going back to our initial question, it seems a disconnect may exist between the message brought forward by international leaders and supported by historical data and the perception of the broader investor community.

We believe this gap lies somehow at the heart of the approach most companies have in identifying material issues. In most cases, companies fill out a materiality matrix by asking relevant internal and external stakeholders to raise issues that they consider to be material to the companies and then to assign a severity score to each one of them. The materiality matrix summarizes all the topics and their relative importance in the eyes of stakeholders. While an excellent first step, it seems that climate change, as other long term and complex issues, does not always receive a weighting aligned with the objective evidence. Indeed materiality assessment is based on individual perceptions that are highly dependent on the regional context and level of awareness, whereas climate change needs to be looked at through scientific evidence.

The world of finance has relatively recently joined the table of stakeholders concerned over climate change, with those most concerned being the insurance and re-insurance sectors. Most other players in the finance chain are naturally more inclined to short term considerations. Therefore they seem to have yet to fully grasp that the extent to which the world is set to change in the next decades is not manageable through business as usual processes and tools. Monitoring of carbon emissions detained in a portfolio and how issuers identify climate risks and adjust their strategies should be fundamental tools in every fund manager’s decision making tool box going forward. Doing so, not only will they respect the fiduciary duty towards customers and ensure consistent risk adjusted investment returns, but also act as enablers of the efficient transition to a low-carbon economy – our only plan for a prosperous future.