A Financially Material Measure for Managing Transition Risks
This research piece was co-authored by Rachel Teo, Head of Sustainability and Total Portfolio Sustainable Investing; Wong De Rui, Vice President, Sustainability Office and Total Portfolio Sustainable Investing; and Lloyd Lee, Vice President, Investment Insights Group at GIC.
- Climate-related transition risks are rising with increasing government commitments to fight climate change, as well as technological progress in green solutions. Carbon taxes are a key policy lever for governments to curb emissions and fight climate change. Hence, investors will need robust metrics and tools to assess the impact of carbon taxes, a critical transition risk factor, on companies’ earnings and investors’ portfolio returns.
- Unlike other carbon metrics, such as carbon footprint and weighted average carbon intensity (WACI), carbon earnings-at-risk (CE) offers a more financially material and forward-looking risk measure for carbon pricing that can also be incorporated directly into companies’ valuation analyses. This enables investors to estimate the portfolio’s value at risk due to carbon prices.
- The future trajectory of carbon prices is uncertain. We recommend employing CESA (Carbon Earnings-at-risk Scenario Analysis), which combines CE with a scenario analysis approach for assessing CE at the total portfolio level and identifying specific areas of vulnerabilities within the portfolio for deeper due diligence.
- Our analysis finds that the carbon price impact varies widely across climate scenarios, ranging from 0% to 14% for a global equities portfolio tracking the MSCI All Country World Index. In a Failed Transition scenario where policymakers do nothing and carbon prices regress, companies face lower carbon costs and higher profits from today’s carbon price levels. On the other hand, in a Net Zero scenario, where policymakers implement ambitious climate policies, including higher carbon prices, to contain global warming to 1.5ºC, companies will incur higher carbon costs if they do not adopt more sustainable business practices.
- Carbon prices can have a material and long-lasting adverse impact on companies’ profitability and investment returns. Investors need to identify the industries and companies driving these downside risks in the portfolio, engage with companies to understand their strategies for mitigating these risks, and assess their credibility for delivering on these mitigating strategies.