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How Asset Owners and Managers Assess Climate Resilience

Prepared by Sunita Rajakumar, in consultation with S&P Global

Net zero campaigns have already attracted over 2000 supporters globally including largest investors and banks. Paris alignment is potentially the most important assessment for ensuring companies in a portfolio are aligned to a 2 or 1.5 degree trajectory and this is critical if we are to achieve the ambitions outlined in the Paris Agreement.

The investment process starts with the view of a framework like the Financial Stability Board's Taskforce on Climate-related Financial Disclosures (TCFD), applying the transition risk analysis, estimating the carbon-related earnings at risk and assessing Paris alignment by applying the physical risk analysis, understanding the results and then using the information for a TCFD-based or sustainability assessment.

Then the assessment on a portfolio level of transition and physical risk again starts with carbon footprinting, assessing a portfolio's carbon footprint, across scope one and the emissions bought into the organization ie scope two and scope three emissions, in particular first tier supply chain risks.

In particular, understanding how the energy mix in the portfolio compares to International Energy Agency (IEA) standards and expectations is crucial, because when providing a view on how investments are aligned to the achievement of a two-degree warmer world, a large part of that will depend on the energy mix.

Analysis can also lead to an implied temperature range of the business or portfolio using the science relied on by the United Nation's Intergovernmental Panel on Climate Change (IPCC) and science-based targets recommended approaches, which should underpin the assessment of the credibility of companies’ commitments. The likelihood and quantum of stranded assets are a very important baseline assessment of where climate exposure is.

Asset owners and managers need to understand the risk of shock to the portfolio of carbon pricing by assessing each individual company and the unpriced carbon cost at the location of operations of the company, then aggregating those operations around the world to the company level and input a dollar amount that is the portfolio’s exposure. This means a scenario needs to be developed of a carbon price which is needed to achieve a two-degree warmer world at different points in time, across sectors and countries.

When aggregating company analysis up to a portfolio level, it is important to review not a snapshot or an assessment at a specific point in time but across a period of time [how the companies performed over a period that reflects its recent trajectory] and then the forecasts, strategy, targets and efforts that will improve its trajectory.

Meanwhile, physical risks should be assessed with reference to multiple identified hazards, for example heatwaves: there is already deep analysis from the scientific community on how heat waves will affect the world, which can be applied to every asset individually, aggregated up to the company level and then again to a portfolio level and finally, compared to a benchmark, to understand if a portfolio has greater exposure to wildfire than the benchmark, the materiality of that risk exposure and a sensitivity-adjusted score to how sensitive is that assets exposure to that hazard.

Finally, scenario analysis is needed to benchmark assets whether compared to peers or indices [eg Paris-aligned carbon transition index series, low carbon efficient index series] to establish if investments are relatively more climate resilient.

Moving forward, asset owners and managers need to consider how they are:

I. Reporting internally [to investment committees, boards of directors] about risks throughout the organization to ensure awareness of levels of resilience, including how that position will change according to strategy to reduce climate exposure, for example by assessing the risk of unpriced carbon costs.

II. Reporting externally of climate risks is usually aligned with the TCFD and has become a bigger priority, as more companies are incentivized to report externally both carbon footprint and transition risks.

III. Engagement of asset owners or asset and portfolio managers could be as simple as identifying the outliers in sector exposure for high climate risk and establishing if that portion of the mandate is an exposure that the owner or manager is prepared to accept or a risk they are aware of. Active investors are engaging their stakeholders using analytics to analyze their portfolio from the perspective of how net zero outcomes are going to be achieved. Net zero is not just about offsetting emissions but there needs to be a significant and credible efforts to ensure a low-carbon trajectory.

Essentially, the owner or manager needs to be able to clearly articulate how they are intending to achieve results which are aligned with the decarbonization which the world has committed to, how changes to the portfolio could achieve that performance, which in turn will lead to attribution and understanding the impact that investment strategies have to positive outcomes.

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