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From Macro to Micro

Emilio Barucci, Professor of Financial Mathematics at Politecnico di Milano, says more advanced and sophisticated climate risk models are needed to support ESG investing.

ESG investing focuses on investment processes and products that take into account the ESG features of stocks, bonds and mutual funds. The growth of ESG investing, in terms of assets under management, is driven both by investors, whose activities are affected by factors not limited to economic performance, and therefore to the risk-return trade-off, and by regulation aiming to promote sustainable investment and financial products as part of the green transition.

The relationship between ESG and economic performance

The three pillars of ESG look quite different along two dimensions at least. First of all, the indicators capturing ESG features are different in nature. While it is difficult to measure a company’s ethical performance or corporate governance, which is coming under increased scrutiny, the extent to which an organisation meets its environmental targets can be quantified considering Scope 1, 2 and 3 emissions, the amount of green energy used and other metrics. The quality of data and their evaluation is a crucial issue, which, at QFinLab – the Quantitative Finance Lab of the Department of Mathematics at Politecnico di Milano – we are addressing through our ESG Corporate Data, which focuses on companies listed in the Italian stock exchange. The initiative aims to provide a repository of ESG data for the Italian market with reliable information and an annual report exploring key trends in the ESG transition.

The connection between the three dimensions of ESG and economic performance, moreover, is not well-established. This point is crucial, as a simple approach to ESG investing based, for instance, on the exclusion of certain sectors from the investment process – an approach very popular a few years ago – is no longer viable, in that it is in contrast with the mandatory duty of asset managers. A more suitable approach, which requires investors to estimate how the ESG profile of a company impacts its future economic performance, should aim to integrate ESG factors into the asset management process. Organisations, in other words, are grappling with the issue of double counting, in the sense of economic and ESG performance, which is not an easy challenge to address.

The multiple facets of climate risk

From an investment perspective, climate risk deserves special attention. It comes in two different forms: physical and transition risk. Physical risk refers to the damage that a company may suffer because of natural disasters. In terms of financial stability, this type of risk may not be particularly relevant in the short run. Some regions can be affected by floods or drought more frequently than others, but the potential economic loss is often limited and does not trigger systemic risk, except in the case of small developing countries, including islands, whose GDP is more vulnerable to natural disasters. In the long run, the effects of physical risks could become much more significant at both the national and macro-regional levels, as the frequency and magnitude of natural disasters increase. Consequently, the physical impacts of climate change may soon pose a systemic risk.

Transition risk concerns the path to sustainability, eg towards a climate-neutral economy. Uncertainty about future environmental policies has significant drawbacks in terms of asset valuation, as it affects payoffs, such as dividends and the probability of default of the issuer. It is challenging for investors to evaluate how transition risks might impact a company’s value. Such risks could even threaten financial stability if a specific sector (eg mining, energy, or automotive) is significantly affected by new policy initiatives, such as potential bans on plastics or internal combustion engines.

Addressing climate risk is a complex task, as it involves dealing with cumulative processes, such as the increase of global temperature and of the share of CO2 in the atmosphere, with long-lasting consequences. Moreover, the relationship between these processes and the economy has not been fully explored yet. Although scientists agree that most of the 1.3°C temperature increase from the pre-industrial era is due to human activity, and mainly to CO2 emissions, the public debate is marked by conflicting opinions that make it difficult to take policy and economic decisions on the future direction of the green transition as well as investment decisions.

Indeed, there is no time series data helping to build a model. While there is little doubt that climate change and the related policies will exert an influence on companies’ operations and profitability, the extent of the impact is still uncertain.

The importance of scenario planning

Financial evaluation is a forward-looking exercise. The development of macro scenarios that take into consideration global warming, the energy mix supporting the green transition, relevant policy initiatives and technological advancements plays a crucial role. Several pieces of analysis contribute to the creation of these macro scenarios, chiefly among them those provided by central banks, eg those belonging to the Network for Greening the Financial System. The challenge we are currently facing is how to transition from the macro scenarios to an evaluation of the economic performance of a single company. This problem is difficult to address, given the numerous components involved and the complexities associated with the development of a model capable of harmonising technological, business and policy factors.

A further complication is that the forecast horizon related to the performance of a company is usually short, whereas the ecological transition requires to make long-term predictions. This means more work is needed to successfully move from macro scenarios to an in-depth analysis of individual companies. In particular, further information at micro level is necessary. Setting higher standards of disclosure for companies in the sustainability sphere is a step in the right direction, but more sophisticated models are required to build scenarios for the activity of a single business.

A look into the future

Uncertainty around the green transition has significantly increased over the last couple of years on account of rising geopolitical tensions. The war in Ukraine fuelled the competition between the two blocs led by the US and China. This may render the global economy more fragmented, with potential drawbacks to the green transition. Remarkably, these themes are becoming increasingly important in the context of the relations between developed countries, which were responsible for most of the CO2 emissions in the past, and emerging countries, which are now the main contributors to CO2 emissions. A fragmented and uncoordinated approach to the Conference of the Parties, the series of conferences annually organised by the United Nations, for instance, would be detrimental to the transition process, hindering the evaluation of finance companies.

To conclude, climate risk is becoming more central to asset management and finance. Besides influencing regulation and investors’ activity, it affects the economic performance of both companies and countries. The macro models currently available still provide very few insights at the level of the individual organisation. The development of more advanced and sophisticated models, incorporating climate risk – in the twofold form of transition and physical – technological advancements and policy initiatives, to forecast economic performance should therefore become a priority.

Creating such a comprehensive model is a task very difficult to perform. To this end, two main issues must be addressed. First, we need to identify the relationship between climate change (eg, temperature, climate vulnerability) and economic activity at the micro level (e.g., building, company level). Second, we need to model the transition path, which is influenced by both policy decisions and technological innovation. Constructing a scenario that captures the interplay of these two drivers is a very challenging task. More research is needed to support ESG investing appropriately.

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