Carbon Risk Strategies to Manage the Unknown

How can investors prepare for disorderly carbon pricing scenarios?

Investors have entered a period of uncertainty; collaboration and climate activism may be the safest strategy for them to deal with it.

The more investors help to create a stable net-zero transition, the less they will need to react to disorderly and disruptive events which could have severe outcomes for their portfolios.

Both, today’s rising carbon prices and various future scenarios give investors an indication about how fast they need to adapt their portfolios.

Thierry Roncalli, Head of Quantitative Research at Amundi, says: “The risk of a carbon tax or disorderly transition to a green economy is so significant that asset prices will be impacted sooner or later.”

ESG Investor looked at the potential of a rapidly rising carbon price under a disorderly scenario last week. This week, we talked to experts about a variety of strategies that investors can apply to manage such risks.

The strategies range from evaluating stranded asset risks and investee companies’ transition plans to integrating a carbon price and factor in portfolio management and engaging with companies.

Proactive investors are joining initiatives such as the UN-convened Net-Zero Asset Owner Alliance to shape and create a more certain future by applying net-zero investment strategies.

Steven Sowden, Senior Investment Consultant at Mercer, explains investors should first understand their goal: are you trying to bring about a transition; or is it about avoid losing a lot of money if it occurs?

More passive investors will have a stronger focus on their ability to flexibly adapt to different future scenarios.

“Considering the level of uncertainty, it is likely not about choosing one strategy, but to prepare a series of strategies and be prepared to execute them when the corresponding scenario manifests,” say Willemijn Verdegaal and Lisa Eichler, Co-Heads for Climate & ESG Solutions at Ortec Finance.

Selecting well-prepared companies

Richard Mattison, CEO of S&P Global’s Trucost, explains that “the shift to greening the economy is happening faster, potentially, than people might think”.

“Seventy per cent of big US utility* companies, according to our analysis [of the 30 largest], have deep decarbonisation targets,” he says.

He recommends investors start integrating carbon pricing in their strategies to understand its impact on cash flows of investee companies.

Considerations include the extent to which a company could become a stranded asset, says Mattison, as well as the impacts of a carbon price or sustainable finance incentives on cash flows, such as green revenues, and cost of capital.

To this end, Trucost calculates for example a regional carbon price risk premium for companies and aggregates this to a portfolio level.

Broadly speaking, the direction of travel is to move out of high-carbon emitting and into low-carbon companies over time. But it is more difficult to decide what to do with the companies in the middle of the spectrum, concedes Mercer’s Sowden.

“One of the questions we’re looking at is which sectors are going to be most disrupted?” With these stocks, “it’s a balancing act”, he says. The opportunity of these companies depends on their positioning in the transition and relatively cheaper value.

To manage these ‘in-between’ stocks, the credibility of a company’s net-zero transition and its willingness to engage with investors play both a role.

Given the uncertainty over which of the firms will successfully implement their transition plans, Sowden says that investors will track and monitor companies’ progress.

Modelling transition pathways

To support its clients, Legal & General Investment Management (LGIM) has been modelling low-cost and efficient transition pathways which optimise climate risk.

“That doesn’t involve divesting whole sectors,” says Nick Stansbury, LGIM’s Head of Climate Solutions.

“It means you have to pick the right companies within each sector to minimise that risk whilst maintaining the best possible available diversification benefits to this investor,” he adds.

Stansbury says that certain areas, such as biofuel, technology, some minerals and mining companies, some land use companies, may also deliver a degree of hedging in a portfolio against a rising carbon price.

“Many of these areas demonstrate positive rather than negative characteristics as an investment, as regards to a rising carbon price,” he explains.

In a World Resources Institute and UNEP FI paper titled ‘Carbon Asset Risk’, the authors write that shareholders can “assess where [carbon asset] risks are concentrated and seek opportunities to diversify this risk across their portfolio, either within sectors or across sectors”.

It adds that “shareholders seeking to manage carbon asset risk can develop new investment performance benchmarks with lower carbon risk in order to attribute returns to this as a separate risk factor across their portfolio”.

Carbon factor strategies

Amundi’s Roncalli says that there are many ways to reduce or hedge carbon risk in a portfolio.

He manages the carbon risk of an investment portfolio using also carbon beta, a market factor called the brown-minus-green factor, which is long on brown stocks and short on green stocks.

For each stock, the carbon beta is the sensitivity of the stock return in relation to the brown-minus-green market factor; i.e. the sensitivity priced by the market towards ‘global carbon risk’.

Carbon beta is essential, Roncalli says, because it evaluates how the market views the carbon risk of a stock, rather than emissions of companies for example.

“Carbon betas may be viewed as an extension or forward-looking measure of the current carbon footprint,” he explains.

“Due to the complexity of measuring and monitoring CO2 emissions, at Amundi, we begin to incorporate a carbon beta/market-based approach with a CO2 emission/fundamental-based approach. A blended approach makes it a bit easier to understand Scope 3 emissions and compare companies across multiple sectors,” he notes.

Paul Smith, Consultant for climate change at UNEP FI, however suggests that, while a range of risk metrics exist, they “should not be dependent on market pricing as both transition or carbon and physical climate change risks do not fully price in climate risk”.

“Mercer’s TIP Factor and Amundi’s Carbon Price Threshold are important contributions to this discourse,” he notes.

“Investors need to be aware of how different assumptions around policy, behavior, technological development and climate change impacts could affect the transition pathway and sensitivity analyses should ideally incorporate an element of each of these factors,” adds Smith, who also encourages investors to consider ‘alignment metrics’.

“Managing climate risk is increasingly important, but being aware of portfolio alignment [with a net zero target] will help to identify how an investor can actively contribute to meeting international climate goals,” Smith explains.

Positioning for different futures

Ortec Finance models different scenarios for investors to enable them to position their portfolios for different futures while also evaluating how aligned they are with a net zero trajectory.

The firm’s approach focuses on capturing the impacts of both physical and transition risks on the economy and financial markets, including how those climate risks affect GDP, interest rates, inflation and outputs of different sectors.

“Some sectors will suffer—think of stranded assets – and some will thrive. We translate the impact on the real economy into financial metrics, for example into average returns of different types of assets,” Verdegaal and Eichler say.

They add that investors will have to step out of their comfort zones. Past risk decision-making models will no longer be enough to manage risks and opportunities in the years to come.

“More so than any other time, we expect that the successful investors will be those who both minimise losses and maximise their exposure to opportunities in the short, medium and long term,” they say.

Net-zero investors who are active in collaborative initiatives may also decide to directly influence policy making to ensure that foreseeable and transparent climate policies will be enacted in time before a disorderly transition unravels.


*Please note that this article was updated and the word “utility” added.

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