Seeking Alignment with
Climate Change
May 22, 2023


Investors undertake vigilant monitoring of physical, transition and greenwashing risks as they calibrate their ESG investments

Driven by the imperative of climate change, the world is lurching away from fossil fuels and toward a carbon-neutral future. This period of transition poses significant risks for institutional investors, who must continuously adjust their portfolios as countries, companies and markets forge ahead to reach the holy grail of net-zero carbon emissions.

ESG: Seeking Alignment with Climate Change Webinar

This discussion by leading asset managers and index providers will highlight a multi-faceted approach to climate risks, how to evaluate companies on their ESG credentials and ability to navigate the climate transition, current advances in data and disclosure and, importantly, upcoming regulatory efforts to watch.
Chris Hackel
Head of Sustainable Indices
Thomas Kuh
Head of ESG Strategy
Morningstar Indexes
Jennifer Boscardin-Ching
Client Portfolio Manager,
Thematic Equities Team
Pictet Asset Management
Margaret Dorn
Senior Director,
Head of Sustainability Indices
S&P Dow Jones Indices
Wednesday, May 24, 2023
2:00 p.m. ET

Physical and transition perils

According to Azadeh Sabour, senior vice president of climate solutions at Morningstar Sustainalytics, there are several key risks driving investors’ responses to climate change. The first, she said, is “the physical risks that are causing, and have the potential to cause, damage to assets and infrastructure, which can result in increased costs and reduced productivity. These risks are creating an urgent need among investors to forecast the effects of climate change on their portfolios so they can manage exposure to physical hazards, such as floods, sea-level rise and hurricanes, and then mitigate the investment risk.”

The second risk, she added, is “the transition risks such as increased costs due to shifting technologies and from carbon pricing and policy shifts. As the transition accelerates, companies that do not aggressively transition might have reduced access to capital and insurance because they will be deemed too risky.”

Other risks for companies, Sabour added, include reputational risks from changing customer perspectives; liability and legal risks associated with diluted net-zero targets and the potential for greenwashing; and compliance risks from the “alphabet soup” of mandatory climate reporting and disclosure standards.

Investors are asking Morningstar for “relevant climate data, research ratings and indexes so that they can identify transition and physical risks, make more informed decisions when evaluating corporate net-zero claims and then manage their investments appropriately to mitigate those risks,” she said. “As a leading service provider, we offer the expertise, skills, and the data and analysis that asset owners and asset managers require. Our job is to provide the scale so that we can support their risk-mitigation efforts with information and products that they can’t develop on their own.”

Jennifer Boscardin-Ching, client portfolio manager for environmental thematic investing at Pictet Asset Management (Pictet AM), elaborated on transition and physical risks. “Transition risks are risks to companies or businesses that arise from the inability to shift or adapt to an economy that is decarbonizing or transitioning toward net-zero,” she said. “An example is the risk of write-offs, asset impairment or early retirement of existing assets due to policy changes or product substitution, which could happen to fossil-fuel-intensive industries. Another is the increased costs related to carbon pricing, which we’re seeing in Europe via the [European Union’s] Emissions Trading System, where carbon-heavy industries are going to have to pay a price for the carbon they’re emitting.”

Physical risks, Boscardin-Ching added, “are related to assets or operations that are negatively impacted by extreme weather events or systemic changes, such as factories being subjected to increased flooding events, or maybe a more vulnerable electricity grid due to increased heat stress. The financial world is starting to pay more attention to these risks.”

Another area of focus for investors is the impact of credit risk related to climate change on sovereign debt, according to Edo Schets, head of climate for core product sustainable finance solutions at Bloomberg. “Sovereign bond investors should think about accounting for climate risks on the country level,” he said.
“G-20 countries have set their own targets for net-zero emissions, and now they’re aligning their policies to those targets. Countries that have gaps with some of the targets they’re setting face physical and transition risks like ecosystem deterioration, drops in crop yields, wildfires and coastal flooding, all of which can significantly affect national economies as well.”

Read: 360° of Climate – Indices for Every Objective

Carbon pricing scenarios

Margaret Dorn, head of ESG indices – Americas for S&P Dow Jones Indices, pointed to the risk of exposure to higher future carbon-pricing scenarios that many companies face. Investors need to understand the potential earnings at risk from carbon pricing — also referred to as carbon earnings at risk — a topic that increasingly comes up in her conversations with investors.

“Investors want to know how vulnerable companies, and the companies in their portfolios, are to current and future carbon-pricing scenarios,” she explained. “They want to understand and assess the potential impact on a company’s earnings today if the company has to pay a future price for their greenhouse gas emissions, and to better understand and manage the risk associated with those changes in carbon pricing.”

Institutions vary in terms of where they are in their climate journey, Dorn continued. “Some have a very in-depth understanding of the implications and risks of climate change, while others are still uncovering what those risks may be. So being able to quantify such risks is becoming increasingly important.”

Essentially, “as with any kind of analysis, your outputs are only as good as your inputs, so the quality of your data is crucial,” Dorn pointed out. Trucost, S&P Global’s environmental data arm, has developed robust data sets that examine carbon earnings at risk as well as physical and transition risks. “This is incredibly critical for us as index providers, because these robust data sets are what will enable us to address the constantly evolving demands of climate-related indexing,” she said.

Investors want to know how vulnerable companies, and the companies in their portfolios, are to current and future carbon-pricing scenarios.
Margaret Dorn
S&P Dow Jones Indices

Tackling greenwashing

Institutions are being more vigilant in how they identify greenwashing by their asset managers as well as the companies in their portfolios. Plan participants and regulators will hold them accountable if their managers and portfolio companies aren’t walking their own talk about sustainability.

Boscardin-Ching described the approach at Pictet AM thematic investing as a multistep process of analysis and engagement. In the first step, she said, “we conduct an initial negative screening to exclude companies whose activities are causing significant environmental or social harm, such as those companies that violate the United Nations Global Compact principles. After that, we conduct a much more in-depth ESG evaluation to check a company’s third-party ESG ratings and identify any potential controversies. We exclude companies with high levels of controversies. Finally, we integrate the ESG profile into a company’s fundamental analysis, which informs our portfolio construction.”

For Pictet AM, she added, “engagement and proxy voting can be one way to help deliver positive impact to the companies we own. As active managers, we have to be able to say that the companies that we invest in are credible. After a company enters the portfolio, our engagements are based on our ability to influence the company and the extent of positive impact that our engagement would generate on the company’s stakeholders and on its long-term fundamentals.”

Read: Transparent ESG metrics power smarter fund investments

Index transparency

Bloomberg’s Schets said that as a data provider, one of the firm’s goals is “to support our clients who need to avoid greenwashing. We speak to a lot of clients who are concerned about it and don’t want to do it. But it can sometimes be difficult to know if you’re doing the right thing. So we provide all the transparency we can around reported data and make clear to clients what’s real and what might be, let’s say, ‘marketing.’ We help them make the right decisions.”

In addition, he said, “if a company sets a carbon target, we provide analytics to see whether the company is doing what it says it wants to do. For example, the analytics might compare the company’s carbon target with third-party carbon pathways that say something about where the company could or should be at a certain point in the future. Our data highlights if a target is science based and if the company has linked executive compensation to its achievement of the target.”

S&P DJI’s Dorn emphasized transparency as well. “A lot of the concerns around greenwashing come down to transparency and understanding an investment strategy’s sustainability objectives,” she said. “An index can help to solve some of the questions simply because it’s the nature of what an index is designed to do, which is to be a transparent, rules-based tool. And that rules-based construct is what allows investors to have a clearer understanding around what the index’s objectives are and what it seeks to measure.”

For example, S&P DJI’s Paris-aligned and climate-transition indexes “have a very clear and transparent mandate around the particular climate and sustainability objectives that have been built into the index methodology. S&P DJI climate indices offer a spectrum of target outcomes with different levels of carbon reduction, exposure to fossil fuel reserves and tracking error,” Dorn said. [See graph below.]

Selected Outcomes of S&P DJI's Climate Indices
*Note: Index levels data from July 29, 2017 to July 29, 2022. Tracking error provided for the S&P 500 Net Zero 2050 Carbon Budget (2022 Vintage) Index is the 63-day tracking error. Weighted average carbon intensity data as of July 29, 2022. Bubble area denotes fossil fuel reserves reduction. The S&P 500 Carbon Efficient Index was launched Oct. 22, 2018. The S&P 500 Net Zero 2050 Paris-Aligned ESG Index and S&P 500 Net Zero 2050 Climate Transition ESG Index were launched June 1, 2020. The S&P 500 Net Zero 2050 Carbon Budget (2022 Vintage) Index was launched July 25, 2022. All data prior to index launch date is back-tested hypothetical data. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance.

Source: S&P Dow Jones Indices LLC.


There are obvious and not-so-obvious places to find promising climate-related investments

The climate transition presents many attractive investment opportunities. While some, such as renewable energy, are on everyone’s list, others are less obvious.

As Pictet AM’s Boscardin-Ching pointed out, “Renewables are often the first thing we think about regarding opportunities or technologies to mitigate climate change. But when you look at the entire investible universe for climate change mitigation and adaptation, there’s a wide range of opportunities in addition to renewables. Every industry in the world is trying to reduce emissions and meet their emissions-reduction targets. Demand is rising for any kind of products that can help industries run more efficiently.” [See visual below.]

Clean Energy Transition Investment Opportunites
Source: Pictet Asset Management, 2023

One of the key levers to addressing climate change is electrification. “Harnessing clean energy sources requires massive electrification, such as the shift away from combustion-engine vehicles and toward electric vehicles, replacing gas heaters in buildings with electric heat pumps, and integrating electrification and distributed energy resources into the grid,” she said. “We think an underappreciated area in the electrification story is the semiconductor industry, which provides the enabling technologies for electrification. Electrification, in our view, is going to become one of the strongest demand drivers for semiconductors in the coming decade. Power semiconductors are particularly crucial, as they are needed throughout the clean energy ecosystem — from renewable energy, such as solar inverters, to electric vehicles and smart grids.”

“Only a handful of companies around the world can create and produce equipment for semiconductor manufacturing,” Boscardin-Ching continued. “They have very high technological and scale barriers to entry and admirable profit margins. Add to this a significant uptick in demand for their products and you’ve got a compelling long-term investment story.”

Another promising sector is environmental consulting companies, she said, “whose services are needed for big projects that will have to meet complex requirements for climate mitigation and adaptation. They have very robust project backlogs and are experiencing a strong increase in demand for their services.”

Read: Rethinking climate change mitigation

Follow the transition

Chris Hackel, head of sustainable indices at Bloomberg, said, “Trillions of dollars are currently being allocated to the energy transition globally, and there are major regulatory tailwinds as well. The U.S. has the Inflation Reduction Act, which offers billions of dollars in tax credits for clean energy and low-carbon technologies over the next decade or so. Europe has the European Green Deal, a set of policy initiatives whose big-picture goal is to make the European Union climate neutral in 2050.”

When you look at the entire investible universe for climate change mitigation and adaptation, there’s a wide range of opportunities in addition to renewables.
Jennifer Boscardin-Ching
Pictet Asset Management

“Electric vehicles are a clear example of this opportunity,” he said. “The transportation sector has been one of the most successful so far in reducing emissions because of the growth in electric vehicle sales.”

Bloomberg’s indexes include a variety of either low-carbon or transition themes, “everything from decarbonizing to wind, solar, biofuels, clean energy [and] renewables,” Hackel said. The firm has also created a carbon-transition sovereign index by developing a “methodology that assesses governments’ progress toward the Paris Agreement goals,” and it is working on a carbon-related commodities index as well.

Survivors and thrivers

Thomas Kuh, Ph.D., head of ESG strategy at Morningstar Indexes, said, “We believe there will be survivors and thrivers in the face of increasing physical and transition risks. The survivors will be those that invest in and execute an aggressive transformation that positions them to prosper in a low-carbon economy. The thrivers are the innovators who develop climate-related solutions to help the survivors make meaningful business-model transformations to reach their net-zero objectives. Allocators of capital that want to align their investment strategies with forward-looking climate goals need help identifying the thrivers and the survivors. That’s where investment research providers can add value.” [See graph below.]

Industries with strong carbon transition risk management
*Note: A company with a management score over 60 is categorized as one with strong management of low carbon transition risk. The analysis of companies across our research universe shows that most industries are in the lower range of average management scores (scores between 40 and 50). Source: Morninstar Sustainalytics. For informational purposes only. Each of the industries listed comprise more than 2% of representation in the universe.


Index providers are developing specialized and custom products to meet current — and future — institutional demand

As asset owners’ demand for climate-related data and indexing has boomed in recent years, index providers have responded with increasingly sophisticated products. Some have developed more specialized indexes that can help investors measure their portfolios’ sustainability in new ways — and they continue to explore new approaches.

Carbon budgeting

S&P DJI broke new ground when it launched the S&P 500 Net Zero 2050 Carbon Budget Indices in mid-2022. This series of benchmarks “reflects net-zero alignment in a simple and innovative way by looking through the lens of a global carbon budget intended to keep global warming at or below 1.5 degrees Celsius. The budget then can be applied to the S& 500 and other broad market benchmarks,” Dorn explained. “The same approach for reducing greenhouse gas emissions for the planet can also be applied to finance tools like an equity benchmark.”

The carbon-budget index series is also designed to align with the net-zero assessments established by the Intergovernmental Panel on Climate Change, or IPCC, on the achievement of the Paris Agreement targets, Dorn added. “We believe this is unique among indices. Each index in the series aligns with the IPCC approach by allocating a carbon budget across index constituents based on their total Scope 1, 2 and 3 emissions, as calculated by S&P Global Trucost. While many climate-focused index products are forward-looking and incorporate multiple frameworks, constraints and objectives, the sole focus [of the carbon-budget indexes] is to align with a carbon budget while [also] limiting index-construction impacts.”

Forward-looking metrics

Hackel of Bloomberg said that investors are actively seeking index solutions that address specific portfolio needs. “We’ve heard from some [clients] who want to invest in different sectors based on the need for an accelerated or slower emissions-reduction path. They want to make overweighting or underweighting decisions using this specific criterion.”

“We’ve also heard,” he said, “from many investors who want to incorporate more forward-looking metrics, like companies’ science-based emissions targets or the revenue at risk for companies that don’t make the transition fast enough. Investors can use those metrics as tools to identify companies that are most successfully managing the transition.” Bloomberg is also engaging with investors who want to be thoughtful about how they can apply climate themes across asset classes beyond equities and corporate bonds, such as sovereign debt, municipal debt and commodities, among others.

Trillions of dollars are currently being allocated to the energy transition globally, and there are major regulatory tailwinds as well.
Chris Hackel

A holistic view

The investors with whom Morningstar is engaging “want to take a holistic view of climate and environmental, social and governance” investing, Kuh said. The firm is developing benchmarks using the Low Carbon Transition Rating developed by its Sustainalytics team and plans to incorporate its ESG Risk Ratings into those benchmarks.

“In addition, investors are very interested in a number of what we consider to be climate-adjacent issues, like biodiversity,” Kuh said. “Some investors seek a benchmark that focuses exclusively on biodiversity issues, but others are looking to incorporate biodiversity data into the construction of a benchmark that covers a broader range of climate-related factors.”

Morningstar expects that investors will increasingly take climate-adjacent issues into account in their ESG investments. “Institutions that have a conviction about these issues will likely put their core investments into passive products, so the development of these holistic benchmarks is important to enable institutional asset owners to implement their sustainable-investment and climate-related investment policies.”

Read: A New Tool at the Table: Understanding Low Carbon Transition Risk by Industry and How Companies Are Managing It



The strong momentum for climate-based investing is expected to accelerate

Institutional investors are bullish on the long-term prospects for climate-based investing. According to a 2022 survey by the Morgan Stanley Institute for Sustainable Investing, 83% of the asset owners they surveyed around the globe have already implemented or plan to implement sustainable-investment strategies.1 By all accounts, the outlook is bright.

“Climate-related investing is set to grow and will likely accelerate as policy shifts continue to speed up the pace of decarbonization,” said Sabour at Morningstar. “We expect reported data and disclosure will become more standardized and the availability of research insights about corporate activity will rise. As a result, more climate solutions and decarbonization technologies should become available and increasingly adopted.”

She also pointed to a shift in investors’ focus. “Previously, they concentrated on measuring and reporting on the carbon footprint of their portfolios, but their needs are fast evolving to more holistically measuring and managing the transition and physical risks. They want to integrate climate-related signals into mainstream financial analysis and investment decision-making, and they need to identify and manage their climate-related risks to meet their fiduciary obligations.”

Meaningful transformation

The net-zero commitment and accelerated regulation are creating significant tailwinds for climate-aligned investing, Sabour added. “Net-zero’s going to require meaningful business-model transformation akin to the Industrial Revolution. The transformation will require ambitious and aggressive decarbonization, likely through strengthened policies and supported by meaningful investments. This can’t be overstated. Regulation is moving faster, particularly in Europe, and there’s a push for standardized disclosure on sustainability and climate factors by both investors and corporates. That should create more transparency on climate action — or the lack thereof.”

To Dorn of S&P DJI, “Climate-related investing is a very fast-moving world. The prospects for climate-related strategies are constantly evolving, as is the conversation around them and the new types of data being constructed to address the issues investors are facing.”

Laser focus

“As we see it, the quest for net-zero remains the biggest driver,” Dorn added. “We’re still having a lot of discussions with customers working to align their investments with a 1.5 degrees Celsius-warming scenario. It’s driving many of the advancements that we’re making and the climate-related index strategies that we’re developing, both for the near- and mid-term.”

Allocators of capital that want to align their investment strategies with forward-looking climate goals need help identifying the thrivers and the survivors [in the face of physical and transition risks].
Thomas Kuh
Morningstar Indexes

Demand for climate-related investment strategies is extremely robust, especially in Europe, noted Bloomberg’s Hackel, with traction in Asia and the U.S. as well. “In just the last year and a half, there’s been a tremendous number of launches of new climate and clean energy exchange-traded funds. Our clients have created funds and ETFs using our low-carbon and net-zero benchmarks, our green-bond indices and various thematic indices with hydrogen, wind and transition metals.”

“We’re also seeing more asset owners and asset managers,” he noted, “who are interested in broadening their climate-investing approach beyond equities or corporate bonds and into sovereign or aggregate bond indices, as well as other asset classes, like commodities. The prospects are very strong.”

Policy and data forge ahead

Boscardin-Ching at Pictet AM views supportive government policies and cheaper technologies as key factors powering climate investing over the long term. “The level of government funding to address climate change is unprecedented,” she said. “In the U.S., the Inflation Reduction Act allocates almost $370 billion to energy and climate programs over the next 10 years. There are similar policies in Europe, most notably the European Green Deal.”

“We’re also excited about the innovations that have made climate change-related technologies and products economically viable,” she added. “That wasn’t the case even a few years ago. The average energy cost for solar power generation, for example, has decreased by 80% in the past 10 years, with a similar pattern for other types of renewable technologies, such as offshore wind. Lithium-ion battery prices have come down about 88% over the last decade.”

“Historically, these technologies relied on government subsidies or regulatory mandates to drive demand and growth,” Boscardin-Ching continued. “But due to a fundamental shift in their competitiveness over about the past five years, using these technologies is now cheaper than using fossil fuels in many regions of the world, even without subsidies or dedicated policies. This creates huge demand for climate solutions, which will further accelerate climate investments.”

12022 Sustainable Signals survey, Morgan Stanley Institute for Sustainable Investing.
Strong ESG ETF growth in Europe
Note: Funds created as of Q1 2023. We include ESG, values-based and sustainability-themed ETFs. It includes rebranded funds and therefore numbers include historical assets prior to rebrand that may not be ‘ESG.’ AUM is calculated by summing up share class assets.

Source: Bloomberg Intelligence