Thought Leadership (English only)

Climate change: redefining the risks

Climate change will be a defining theme in the global economy, industry and financial markets. We are concerned that our industry has focused more on urging action and marketing products than on developing robust analysis and risk management. We introduce Carbon VaR as a new tool to quantify and manage climate risks.

14/09/2017

Andrew Howard

Andrew Howard

ESG可持續性研究主管

Climate change will be a defining theme in the global economy, industry and financial markets. We are concerned that our industry has focused more on urging action and marketing products than on developing robust analysis and risk management. We introduce Carbon VaR as a new tool to quantify and manage climate risks.

Earlier this year, we published the Climate Progress Dashboard, a new approach to measuring the pace of progress in mitigating the extent and impact of climate change. While the dashboard can help investors determine the current status and direction of climate action, it tells us a little about how to manage risks for a portfolio or individual stocks. Standard analysis includes carbon footprints and fossil fuel exposure, but these measures are too simplistic to analyse the complexities of climate change properly. Alongside the Dashboard, we have therefore developed a number of other analytical tools. Carbon Value at Risk (Carbon VaR) is a major advance in helping investors measure the threat to their individual portfolios.

Introducing Carbon Value at Risk

Carbon pricing looks likely to remain a key element of government climate policies for some time to come, with implications that will become much bigger as prices inevitably climb from the low levels of recent years. Large and widespread effects on competitiveness, cash flows and value are almost inevitable.

Most of our industry has not progressed far in examining, measuring or managing these risks. Carbon footprints remain the dominant measure of exposure, but at best provide an incomplete and at worst a misleading picture of the risks carbon pricing presents. We have developed an alternative measure, Carbon Value at Risk, which provides a systematic and objective guide to the risks to portfolios by analysing the effect of higher carbon prices on companies’ earnings and value.

With Carbon VaR, we can model the effects of higher carbon prices on industry profit pools, combining the impact of rising costs and indirect supply chain pressures, how both will be passed to the customer through higher prices and the consequences for customer demand. While simplified, it reflects a realistic view of the ways industries work, which measures like carbon footprints don’t even attempt.

Applying Carbon VaR to global equity markets highlights the scale of the risk. Our modelling shows that around 20% of the cash flows global companies generate could be lost if carbon prices rose to $100/tonne.

On the other hand, there is no significant correlation between individual companies’ Carbon Value at Risk and the carbon footprints investors look at most often. There is a danger that investors in low carbon investment products will find themselves more exposed to climate risks than they expect.

In the end, our modelling informs but cannot replace the judgement of experienced sector analysts able to bring their knowledge of industries and companies to the table. Carbon VaR helps identify risks by measuring the threats that companies face, but its strength lies in its integration into decision making rather than as a standalone criteria. As a result, just as we caution against viewing high carbon footprints as universally bad, we suggest that high carbon VaR is simply one element of analysis to be considered alongside other analysis and valuation.

More emissions are being priced, but costs are yet to rise

Carbon pricing has expanded significantly over the last 10-15 years. The number, stringency and economic impact of carbon markets have increased significantly. Of the main ways to put a price on carbon, emissions trading schemes (ETS) represent two thirds, with carbon taxes making up the balance1.

 

Click here to read the full report


1 In emissions trading schemes, governments impose caps on total emissions by requiring companies to submit allocations for each tonne of CO2 equivalent they emit, thereby allowing market forces to establish prices for those emission allocations. This ensures that allocations are used by the companies that value them most highly. Carbon taxes typically impose direct taxes at a fixed price on companies’ emissions.

 

Important Information
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
This material including the website has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.