Climate change transition and stranded asset risks can come from a complex mix of factors including carbon regulation, adapting to physical impacts, technological change and evolving consumer preferences. These shifts will be major influences on the investment performance of some sectors and countries. Below is a brief summary of the third Climate Change Whitepaper – Climate Change Transition Risks and Opportunities.
Business transition risks and opportunities refers to the market impacts driven by the economic, policy, technology and social changes stemming from the transition to a net-zero carbon economy. It is the most complex and contested of the risks and opportunities associated with climate change because it involves predications about the future interaction between these significant forces.
The key questions for investors when considering climate change transition risks are:
- Which companies and assets will have to make the greatest and most difficult changes during the transition to a net zero carbon economy and which are best positioned to provide solutions?
- Which companies and assets will be impacted most, both positively and negatively, due to the worsening physical impacts of climate disruption?
- What assumptions and methods of analysis need to be tested to ensure the above is being properly incorporated into investment decision-making and ownership practices?
Transition risk has started to take place for some companies and sectors. The Energy Sector Case Study shows how these risks and opportunities are playing out for the electricity sector as an example.
Investors can employ various strategies to incorporate transition risks in a manner that makes sense for their asset class or investment style.
Including transition risks in assessments of companies and their assets
The way transition risks will affect companies and sectors will vary depending on how and where they do business. Companies in the same industry can have vastly different challenges.
For example, Canadian-based aluminium manufacturer Alcan International (part of Rio Tinto) uses hydroelectric power and produces lower-emissions aluminium than many of their competitors who rely on emissions intensive coal powered electricity. While from a carbon emissions perspective this positions Alcan well, these facilities may face challenges from the physical impacts of climate change if it disrupts the flow of water into hydroelectric facilities.
These nuances mean sector or country level assessments may be overly blunt and penalise those companies best positioned to contribute to and benefit from the transition to a net-zero carbon economy. A company-level assessment framework allows investors to better understand and manage company specific transition risks. Scoring methodologies can be developed which allow these risks to be assessed across a portfolio..
Frameworks such as the one we described in our 'Climate Change Whitepaper' or as has been developed by Moody’s, can be used to better understand these issues. Incorporation of physical risks and additional factors for some highly exposed industries, similar to those used in our stranded assets framework, could also be considered. These need not be excessively complicated and can often be achieved by considering existing information in different ways. For example, traditional quality metrics like debt-to-equity as a proxy for adaptive capacity.
Integration is key to successfully managing transition risks and opportunities
Ultimately, to be sustainable and effective, investors need to develop processes and frameworks that are consistent with their investment beliefs and that integrate seamlessly with their investment processes.
For some investors performing bottom up company analysis is not possible, in which case the growing number of ESG research providers who offer ratings that capture transition risks may be a viable alternative. These ratings can be a helpful tool, however they do remain a relatively new area for providers which will require further development and industry engagement.
Test balance sheet, income and cash flow assumptions
Financial assumptions for companies exposed to transition risks should be carefully scrutinised as not all transition risks are obvious.
For example, while car manufacturers will need to alter their production processes to switch to electric vehicles, downstream impacts from this change could be even more significant. This is because electric vehicles have fewer parts and require minimal servicing compared to internal combustion engines, this in turn will have impacts for car servicing and spare-part sales. What on the surface may seem like a balance sheet consideration may in fact be more material in P&L and cash flow statements.
Similarly, tightening pollution standards will shift the financial position of some companies. Following new mercury standards for US power stations introduced in 2012, a number of plants chose to close rather than upgrade to meet the new standards. For some, this brought forward costs associated with site remediation, which may not have been fully reflected on company balance sheets.
Conversely, many companies can achieve significant savings through energy efficiency, changing production processes and investment in lower cost clean energy alternatives.
Understand changing demand for goods and services
Demand is and will continue to change in unexpected ways for different products and services. Applying a climate change lens can help test the assumptions behind forecasts, particularly where they are not consistent with Paris objectives or other drivers of transition risk. For example, the IEA has consistently underestimated the adoption and penetration of renewable energy technologies despite their exponential growth rates.
The broader drive towards green finance further supports these business strategies as Green Bonds and other financing structures are developed to fund these activities, at the same time high carbon alternatives face higher costs of capital.
Read our Climate Change Whitepaper for more investor strategies.
Long-term investors, like the companies they invest in, are faced with the challenges of making decisions in this rapidly changing environment. Developing assessment frameworks and challenging assumptions will help investors make better decisions. Engagement with investee companies will set clear expectations and ensure they are being met. While advocacy with governments and other stakeholders is needed to shift the financial system so that it can play its full role in delivering climate action.
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