Climate Emerges From the Shadows

While the world has focused on the pandemic, actions on climate and advances tied to its investment impact have continued to move forward.

Since early in 2020, the world has been preoccupied with the pandemic, but the negative effects of global warming have remained apparent, from historic wildfires in Australia and America’s Northwest to the most active Atlantic hurricane season in history. Meanwhile, concern has continued regarding deforestation in the Amazon and a general lack of progress and ambition among many countries in seeking to reach key carbon emission goals.

That said, various developments point to increased momentum on climate action. Under the Paris Agreement of 2015, nations from around the world pledged to curb carbon emissions in order to limit the increase in global temperature to 2°C above pre-industrial levels, with a preference to keep it below 1.5°C to avoid extreme environmental harm and economic dislocation. To do so, more countries have moved forward with pledges of net-zero emissions (removing as much carbon as they generate) in coming years. South Korea, China and Japan are among the latest nations to do so, all targeting roughly mid-century deadlines to realize that lofty goal. Meanwhile, the election of Joe Biden laid the groundwork for the U.S. to reenter the Paris Agreement, creating potential for more unity in addressing long-term climate challenges, while many countries are anticipating more emphasis on green technology as they recover from the current pandemic.

The Struggle to Reach ‘Net Zero’

Global Net CO2 Emissions Pathways (Gigatons per Year)

¹ Assumes CO2 emissions grow from 2018 to 2050 at the same rate as the Current Policies Scenario in UNEP’s Emissions Gap Report 2019 (1.1% CAGR).
² Assumes countries decarbonize beyond the same annual rate that was required to achieve their INDCs between 2020 and 2030. Other GHG emissions are also to be reduced by more than 50% in pathways limiting global warming to 1.5°C.
Source: World Economic Forum, IPCC, UNEP Emissions Gap Report, Climate Watch, Boston Consulting Group analysis. Data as of December 2019.

Important regulatory changes are also taking place at the regional and local levels. Both the Federal Reserve and European Central Bank are contemplating the inclusion of climate in assessing financial system risk. The United Kingdom is proposing to mandate the implementation of the governance and disclosure requirements of the Task Force on Climate-related Financial Disclosure on public and private companies, and the Bank of England Prudential Regulatory Authority plans to “stress test” U.K. insurers for climate risk in 2021. Europe continues to impose more stringent emission caps on automakers. In California, Gov. Gavin Newsom signed an order ending the sale of new gas- and diesel-powered consumer automobiles by 2025, while several car companies recently entered into an agreement with the state on meeting more stringent emission goals.

Meanwhile, companies are coming under increasing pressure from investors to disclose their carbon impact, and to seek ways to reduce or eliminate their contributions to warming. About 80% of S&P 500 companies have set emission-reduction or energy-use targets,¹ although their commitment and follow-through have been variable at best. As for portfolio managers, our industry is increasingly taking a more proactive tack, not only in the context of portfolios invested for “impact,” but as acknowledgment that climate could hold meaningful implications for economic and business health, and thus investment risk and return potential over time. These efforts have increasingly garnered the attention of clients, who, as noted in the last issue of Investment Quarterly, have been moving funds into sustainable/ESG portfolios at a record pace.²

In short, much has happened on climate during the crisis, and we anticipate more activity as the world evolves to view warming as an urgent rather than distant problem, even as the task of mitigation become more daunting with every new day.

Research, Disclosure and Engagement

As an organization, we are committed to disclosing and limiting our own climate impact, and to working together with other organizations to encourage achievement of meaningful goals in accordance with the Paris Agreement. In the context of portfolios, we feel it’s very important to come at climate with eyes wide open, and to make decisions based on data, analysis and research, to accurately assess the potential effects on sectors and portfolio companies. As part of this assessment, we want to understand what managements are doing about their exposure, and, in many cases, we may use engagement to help them address these risks.

All of these ideas and efforts fit within the broader context of our Environmental, Social and Governance approach, which postulates that material ESG risk can have a potential effect on the long-term health of companies. In the context of social impact, for example, reputational risk associated with diversity may have a more significant effect on a consumer company than an industrial wholesaler. Among environmental risks, liability from toxic waste disposal will typically be higher for a chemical company than a software concern.

Specifically relating to climate, how can a portfolio manager clarify the degree of material risk associated with climate exposure—whether to reputation, physical assets or business growth? There are many ways to approach this challenge, but we recently introduced an analysis tool that we believe can help to more accurately quantify the potential business risk to companies, drawing on third-party ratings, big data and, most importantly, the views of our research analysts across asset classes and geographies.

Pinning Down Climate Impacts

Taking a step back, we believe that climate change is likely to affect businesses in two major ways:

1. Physical impact. Extreme weather events, wildfires and floods, as well as longer-term trends such as higher sea levels, are likely to disrupt supply chains and threaten the viability of property and other assets.
2. Transition risk. Efforts to slow climate change through carbon taxes, regulation, “green” government spending, transitions to cleaner energy and adjustments to consumer behavior could have significant effects on business prospects and create new risks and opportunities for investors.

Certain businesses are clearly exposed to climate change. Automakers face higher expenses as they seek to develop viable electric cars, as well as regulatory fines and restrictions if they do not do so. Airlines may face pressure should air travel be curbed or regulatory costs increase due to their heavy reliance on fossil fuels. Meanwhile, a manufacturer of solar panels or wind turbines could benefit from shifts to alternative energy driven by climate goals.

On the other hand, a cruise line might not seem particularly vulnerable, but may be exposed due to long-term investments in ships sailing waters with increasingly stronger and more frequent hurricanes. Such extreme weather could increase the physical damage suffered by the cruise lines, and the costs of insurance and risk mitigation, as well as discourage travel in some geographies.

Our analysis tool encapsulates such observations. As a first step, it incorporates the temperature change that we think the world’s governments will allow over time (for example, the Paris Agreement’s 2°C goal). The model introduces the current “carbon footprint” of each company, and its ability to adapt to a changing regulatory and physical landscape, all based on the combination of external and internal resources noted above.

At a high level, the tool provides some valuable observations. For example, while some companies are less exposed than others, for most companies there appears little upside from physical risks.

“Transitional risk” is more nuanced and represents a wide range of potential outcomes—from extreme downside (for airlines or major oil companies) to extreme upside (for turbine or solar energy companies). In between, the results could be less predictable. For example, if temperatures are allowed to go higher, solar companies won’t see as much business, but car companies may be able to sell more traditional vehicles even if they have to move factories away from floodplains.

Focus on Fundamentals

We believe such information is highly valuable for analysts and portfolio managers, permitting them to more accurately price securities, and identify more resilient businesses for client portfolios. However, much still depends on the qualitative assessments of many factors affecting both broad environmental developments and specific company/issuer prospects.

For example, consider the California wildfires. Since 2015, California has experienced 15 of its 20 most destructive fires in history, as a result of droughts, higher temperatures and shorter winters.³ This has made it more difficult for utilities to manage their credit risk, especially in light of the state’s “reverse condemnation” law, which holds them responsible for property damage regardless of fault. The state has created a special insurance fund and liability caps to limit exposure, while the companies have been taking constructive steps to reduce wildfire risk.

Still, continued temperature increases are liable to worsen conditions. For our analysts, assessing the size and scope of a utility’s territory, as well as its progress on safety issues, is crucial. Similarly, some towns and cities have seen high levels of damage from fires, which has both increased costs and reduced sources of revenues—often but not always on a temporary basis—making fire exposure and resilience important considerations in understanding municipal financial prospects in California.

Indeed, across asset classes, careful assessment of climate (and, in this case, fire) exposure may help avoid dangers and, in some cases, open up opportunity tied to market mispricing. Conducting an analysis of each situation in light of unique circumstances around specific companies is at the core of many research threads that occur simultaneously throughout our research organization.

Engagement in Climate Strategy

Beyond quantitative tools and traditional fundamental analysis, we believe that, for active managers, taking the additional step of engaging with portfolio holdings can help reduce risks tied to climate, as is the case in the context of other ESG-related issues like board diversity or executive compensation. As an organization, we prefer ongoing dialogue with companies where we can encourage best practices, but often make our voice heard in proxy votes and occasionally more public advocacy.

A key first step, in our view, is simply maintaining sufficient disclosures on key ESG issues. Although many large companies release meaningful climate-related information, many do not: Of about 7,000 that report their emissions to CDP (a global environmental disclosure nonprofit), most offer only limited data, as shown in the accompanying display. Having that information in hand could help investors make more informed decisions about valuation—in some cases for the better. For example, we’ve found in certain instances that companies have not effectively highlighted improvements in their business on climate, and we have counseled them on how to more effectively communicate what they have achieved.

Uneven Disclosures on Climate

% Responses From 6,937 Companies

¹Do not disclose/only disclose partial emissions data.
²Say there is no facility/source of Scope 1 or 2 emissions excluded from disclosure.
³Have any form of emissions reduction target.
⁴Have reduced emissions versus last year.
Source: World Economic Forum, CDP data (2018), Boston Consulting Group analysis.

Where companies are moving to reduce carbon footprint, we have encouraged them to do so more aggressively, and to also adopt “science-based” targets tied to the Paris Agreement’s long-term goals. A technology company, for example, may have substantial energy needs, whether for cloud-based computing or indirectly through component suppliers. Greater reliance on alternative power sources, and ensuring best practices along the supply chain, can make a meaningful difference in seeking to achieve climate goals, a message that we reinforce in our engagements. Increasingly, we are asking companies not only to commit to transitioning their business model to “net zero” by 2050, but also to lay out interim targets that will demonstrate how they are going to get there.

Making Hard Choices

In some cases, climate risk is so daunting that it merits a “line in the sand” beyond which our investment teams will rarely go. Given the outsized impact of thermal coal on climate, for example, our mutual funds avoid mining companies with more than 25% of revenues from thermal coal, or utilities that are expanding coal-fired power generation. Within this outer bound, our Emerging Markets Debt team has taken a gradual approach to exclusion, allowing companies a chance to adapt as team requirements become even tougher over the next couple of years.

More broadly, the task of assessment and action in portfolios is one of nuance: How fast is a company moving on climate? To what degree is it exposed to risk, whether from physical damage, regulatory blowback or reputational damage? How might strong climate stances or business positioning relative to climate help prospects over time? For an “impact” or “sustainable” strategy, the wrong answers may close the door on investment. However, for others, the risk/reward dynamics will be weighed in the context of securities pricing, growth prospects, balance sheet quality and other characteristics. In either case, climate is now firmly ensconced in investment process, with many more refinements yet to come.