How to build an equity portfolio that can address climate-related risks

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Climate change is a risk that is hurtling down fast upon us. The recent release of a discussion paper by the Reserve Bank of India (RBI) on climate risk acknowledges it as a systemic risk to the financial system. The London School of Economics estimated in 2016 that the value of global financial assets at risk from climate change is $2.5 trillion, and this rose to $4.2 trillion in 2019, as per The Economist. It is imperative that investors understand and plan for these impending issues. But, how do investors identify winners and losers in the transition?

The key thing to look for when building an equity portfolio is to consider how companies are strategically preparing and investing to mitigate these risks. Climate-related risks can be physical or transitional. Physical risks include severe weather events, changes in precipitation patterns, rising sea levels, etc. Transition risk covers business losses from change in policies and regulations, preference for climate-friendly products in the market and a drastic decline in the cost of adoption of these products. These risks could swell the cost of production and operation, disrupt supply chains, and reduce demand for carbon-emitting or polluting products and services and thus decrease the value of existing financial assets (equity and debt). For example, the increasing carbon emission costs, along with the decreasing cost of clean energy, are making fossil-fuel-dependent companies‘ businesses risky. There is also asset value erosion as insurance costs would jump whenever the frequency and intensity of adverse weather events increase.

Yet, where can you get the information to make the right investment choice? For one, listed companies and bond issuers globally are mandated to disclose climate change risks. For instance, market regulator Sebi’s BRSR regulation has made it mandatory for the top 1,000 companies to disclose sustainability risks and opportunities, including climate change. So, be sure to look at the company’s financial reports as the first source. There are also specialized research agencies such as MSCI, Bloomberg, CDP, Refinitiv, and Morningstar that provide quantitative and qualitative information about the corporates‘ climate risks.

Note that while these research reports are useful for establishing a view on the company’s climate change issues, you must also understand the evaluation methodology. Unlike credit rating, there is a divergence in ESG rating among agencies due to differences in the choice and weightage of attributes as well as measurement methods. Newspapers, research reports of independent research houses and academic institutions, and journals are some other information sources. You can also do a screening —negative and/or positive—as well as integration of climate change risk in stock selection and portfolio construction. The simplest is negative screening that can help avoid investing in carbon-intensive sectors such as coal, oil, and gas that are more vulnerable. However, note that climate change may not affect companies in the same industry by the same proportion— some may be rapidly transitioning their businesses to be less carbon-emitting. They can drive innovation, reduce costs and boost profits, while gaining a long-term competitive advantage.

A positive screening approach involves identifying companies that are into mitigating climate change—a strategy similar to thematic investing. This is a top-down investment analysis based on long-term and structural shifts. As the economy is transitioning to be less carbon-intensive, there is a huge investment opportunity in low carbon technologies and their value chain. The themes could be clean energy, clean transportation, climate-resilient agriculture, and negative carbon technologies. For example, Tesla’s stock performed spectacularly well in the last five years on the back of its electric car and clean energy business, while General Motors and Ford Motors stocks lagged far behind.

When doing a bottom-up analysis to pick specific stocks, you must assess the company’s financial and operating performance from the perspective of climate risks and opportunities. When adjusting the financials, examine the climate change strategy and governance practices. For instance, consider two companies in an inherently carbon-intensive industry such as fossil-fuel-based combustion cars. If one of them is investing in progressively competitive substitute products such as electric cars while the other is not, you can evaluate the long-term business impact.

It also helps to look at specific metrics that are sector specific. For example, ACC cement’s CO2 emissions decreased from 506 kg/ton in 2018 to 493 kg/ton in 2020, and it has set an ambitious target to reduce this to 400 kg/ton by 2030. Similarly, renewable energy contribution to Asian Paints’ total electricity consumption increased from 35% in 2017-18 to 61.1% in 2021-22. Such metrics and targets can help evaluate companies among peers.

Labanya Prakash Jena is a regional climate finance advisor, commonwealth secretariat, and a doctoral scholar at XLRI, Jamshedpur. Meera Siva is a chartered financial analyst and works with early-stage startups and investors. The views expressed here are personal.

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