<!-- Swiftype Variables -->

Opinion

Carbon risk, not climate risk

Quantifying carbon risk in investment portfolios

President Trump's decision to withdraw from the Paris climate agreement will not derail the global commitment to reducing global carbon emissions. More than 190 countries remain focused in their efforts to limit temperature rises to 1.5 degrees Centigrade above pre-industrial levels with China and other Asian countries now set to lead the charge.

Government intervention to reduce pollution is typically based on taxation, "cap and trade" schemes or standards. In the context of policy to mitigate climate change, investors should focus on "carbon pricing" as a proxy for these policy instruments.

There are strong indications that today's prices of energy stocks do not account for the risk of government intervention. Although not linked to climate change policy, the recent catastrophic collapse of the prices of coal stocks appears to illustrate poor investor understanding of the rapid buildup of the supply of shale gas, which undermined coal prices significantly.

Measuring the carbon emissions produced from a business' activities as a proxy for its financial exposure to carbon price is too simplistic. First, there is no true consensus on a methodology for calculating this. Second, this approach typically takes no account of the pricing power of the underlying company, meaning that using this method to guide portfolio decisions might actually increase risk.

An alternative approach is required. Estimating how much of today's asset values are "at risk," and modeling an optimal level of reallocation from the most exposed companies, while also demonstrating that reallocation to companies active in energy efficiency markets limits the introduction of new risks. This approach reflects climate change risk as measured today and provides a framework for managing this issue in the future.

Investors should first concentrate on listed companies engaged in the exploration and production of fossil fuel assets. As suppliers of globally traded commodities, these companies are unlikely to be able to pass on the full effect of carbon pricing to their customers or to adjust their revenue or asset base quickly enough to avoid this exposure. In contrast, companies further down the energy value chain, for example gasoline refiners, utilities or airlines, typically face much more complex market structures — many can pass a portion or even all of their cost increases onto their customers in the form of higher prices.

A simple model of each fossil fuel sector shows the introduction of carbon pricing will raise retail prices, depress wholesale prices and reduce supply/consumption, leaving some assets stranded and impacting cash flows for those who remain in the market.

Neither "full divestment" of all fossil-fuel stocks (and potentially other companies) nor "do nothing" is rational. Is there a way of using well-established investment management tools to establish a logical approach that not only reflects today's risks, but also is flexible enough to evolve as climate change investment risk changes?

Using a scenario approach to carbon pricing, the "value at risk" for those companies in the MSCI World Energy index that are potentially affected can be calculated and sold. The divested sum can then be reallocated to a basket of energy efficiency stocks. These stock prices are typically correlated more closely with the retail price of energy (which is expected to rise with carbon prices) than with the wholesale price of energy (which is expected to fall).

Two possible scenarios for divestment are:

• Graded divestment: reallocate capital from companies with a reduction in value higher than 10%; reduce exposure to the remaining companies in proportion to their value reduction;

• Full divestment: reallocate capital from all coal and oil producers in the index toward energy efficiency stocks.

Reallocating to renewable energy companies might appear to be an alternative approach. However, the sector is dominated by a small number of large-cap names and investing in this limited group could introduce additional risks, particularly stock-specific risk and the risk of regulatory change.

The FTSE Environmental Opportunities Energy Efficiency index represents an attractive basket of stocks for reallocation. With around $1 trillion of aggregate market capitalization, there is plenty of scope for small and midsize investors to adjust their portfolios.

Over the past two years, the full divestment option has outperformed the "do nothing" MSCI World index with limited impact on tracking error. However, while the full divestment scenario currently beats the MSCI World by more than graded divestment does, the latter is the more rational approach.

Because such a "smart carbon" portfolio represents only a partial sell-off of many fossil-fuel stocks, investors who engage with companies and seek to persuade them to change strategy will still have a seat at the table. This would enable investors to seek additional information from fossil fuel asset owners in order to improve their risk analysis. They should also engage with regulators to mandate further disclosure of this information, and continuously refine their assumptions and modeling of this issue in order to adjust their positioning as to the quantum, timing and likelihood of carbon pricing.

In time, it is likely the market values of all stocks will incorporate climate change risk. However, investors who position themselves ahead of this change should outperform.

Ian Simm is CEO of Impax Asset Management Ltd., London. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.