A Four Step Process for Modelling Climate Risk

Climate change is among the most important long-term challenges facing investors today. If at some point in the future global demand for crude oil falls as other cleaner energy technologies improve, how do you value an oil block, for example? 

Similarly, how does a prospective investor value those new technology assets? These questions illustrate both the risks and opportunities presented by climate change, and explain why climate scenario modelling has now moved beyond simple risk management to become a genuine strategic imperative.
 
To navigate this ever-changing environment, investors need a way to assess the disruptive or opportunistic effects of climate change, including the range of business and financial impacts.
The Taskforce on Climate-related Financial Disclosures (TCFD) report in late 2016 highlights the issue clearly. It gives four key recommendations representing core elements of how organisations operate: governance, strategy, risk management, and metrics and targets, all of which are fairly high level.

However, we think strategy is the most significant one because this is where investors can use scenario analysis to evaluate and adjust their portfolios in light of climate change.
Investors can consider scenario analysis as a four step process:

• Outline the potential ways to analyse scenarios
• Categorise risks and opportunities within the framework
• Model the analytical factors
• and finally manage the portfolio implications and investment strategy.

Setting up scenarios

The first step is to set up the transitional risk, and physical risk scenarios, though much of the work has already been done.
Transitional risk represents markets and technology shifts, reputation, and policy/ legal. Physical risk represents chronic changes in climate which impact the firms into which investors allocate capital. Scenarios modelling anything from a 1.5°C to 6°C increase in global temperatures are already publicly available.
 
However, it is important that investors considering available scenarios match the same transitional and physical risk scenarios into their analysis and, crucially, understand how both transitional and physical risks influence each other.

Categorising risks and opportunities

The TCFD framework will, for the first time, provide a multidimensional approach to assessment. Market and technology shifts concentrate on reduced demand for carbon-intensive products and commodities, increased demand for low-carbon, energy-efficient products and services, and new technologies that disrupt markets.

The TCFD framework will, for the first time, provide a multidimensional approach to assessment

In addition, reputation as well as policy and legal risk, can also impact investors’ portfolios.
Finally, physical risk is of equal importance to transitional risk, as climate change can increase business interruption and effect operations/supply chains, consequently impacting profits and asset valuations.
Investors should realise that climate change is not only a risk, but also an opportunity, as the movement towards a greener economy will lead to some firms and sectors having a competitive advantage. 

Modelling analytical choices

Giving investors a toolkit to model scenario analysis is an important part of encouraging climate-related disclosures.

The scenario analysis report from the TCFD highlights three major considerations: parameters, assumptions and analytical choices.

Parameters include existing modelling components used by investors such as the discount rate, however the introduction of additional parameters is key.
Investors should include macroeconomic and demographic variables, both of which would be impacted by climate change. 

Giving investors a toolkit to model scenario analysis is an important part of encouraging climate-related disclosures

The assumptions investors should take into account are also addressed, such as future policy
implementation, technological developments, the energy mix, and the price and inputs of commodities.
 
Transparency is needed by investors, and includes outlining their time horizons, and also supporting data and models.

Traditionally investors have integrated some of these considerations such as the discount rate; however, the TCFD report goes further, in providing a comprehensive set of considerations that incorporate climate change risk and opportunity in a detailed and methodical approach. This means investors can ensure scenario analysis is a fundamental strategic imperative, rather than an arduously complex risk management tool.

Managing portfolio implications and strategy

The primary aim of climate-related scenario analysis for investors is to protect their portfolios against the risks of climate change, while simultaneously gaining exposure to the financial benefits of transitioning to a low carbon environment. This goes beyond just a simplistic carbon footprint and is about aggregating the impacts at a portfolio level.

Five strategies can mitigate the negative implications and benefit from potential opportunities: green bonds and thematic funds/indices, negative/best-in-class screening, strategic asset allocation, portfolio rebalancing and optimisation, and critically, engagement.

In recent years, there has been considerable growth in green finance, including green bonds, sustainable indices and thematic funds.

Cumulative issuance in the green bond market has grown almost 15 times since 2012, with more than $200 billion of green bonds issued to date.
 
A new innovation in the market has been the rise of ethical equity-linked green bonds, and BNP Paribas has played an active role in such issuances by supranationals.
 
As both the green bond market and sustainable index fields mature, investors will be better able to manage their portfolios to reallocate capital that could potentially benefit from the energy transition.
Negative/best-in-class screening allows investors to rebalance the risks and opportunities arising from climate change by first removing companies or sectors that negatively impact the environment, and then selecting the best performers within a sector using ESG criteria.

Strategic asset allocation is another way to manage portfolios, as investors weigh certain industries that strategically benefit from the energy transition, such as renewables.

When managing climate risk and opportunities, investors may consider a rebalancing strategy to optimise their portfolios. For example, BNP Paribas Securities Services has conducted modelling that shows how a low-carbon beta portfolio optimisation strategy can track MSCI ACWI at around 100 basis points, while achieving a 64.7% reduction in CO2. In this case, over a three year period the optimised portfolio outperformed the index by 1.3%.

Securities Services carbon scenario analysis

Investor engagement with companies is essential to encourage an alignment of corporate strategy towards the low-carbon economy. This can be achieved through partnerships, with key analytics providers bridging the dialogue between investors and corporates.

BNP Paribas recently did this on the European Climate Care Index. The selection is certified on a quarterly basis by VigeoEiris, which sends engagement letters to certain companies in the index to assess their energy transition strategy.

For investors, managing climate risk, both transitional and physical, may seem abstract. But in light of the TCFD recommendations, scenario analysis can become an extension of existing valuation and risk modelling, by introducing additional parameters, assumptions and analytical choices into the process.

As a result, both the risks and opportunities of climate change can be assessed, and investors can manage their portfolios accordingly.

^{This article was originally published in Environmental Finance Magazine on 17th May 2017}