How to build a stock portfolio that can cope with climate-related risks

Climate change is a risk that is rapidly falling on us. The recent publication of a working paper by the Reserve Bank of India (RBI) on climate risk recognizes it as a systemic risk to the financial system. The London School of Economics estimated in 2016 that the value of global financial assets at risk from climate change is $2.5 trillion, and that value rose to $4.2 trillion in 2019, according to The Economist. It is imperative that investors understand and plan for these impending issues. But how do investors identify the winners and losers of the transition?

The key thing to look for when building an equity portfolio is to consider how companies prepare and invest strategically to mitigate these risks. Climate-related risks can be physical or transitory. Physical hazards include severe weather, changes in precipitation patterns, sea level rise, etc. some products. These risks could inflate production and operating costs, disrupt supply chains, and reduce demand for carbon-emitting or polluting products and services and thus diminish the value of existing financial assets (equity and debt). For example, the rising costs of carbon emissions, as well as the falling cost of clean energy, are making the business of companies dependent on fossil fuels risky. There is also an erosion of asset values, as insurance costs would increase whenever the frequency and intensity of adverse weather events increase.

Yet, where can you get the information you need to make the right investment choice? On the one hand, listed companies and bond issuers around the world are required to disclose climate change risks. For example, market regulator Sebi’s BRSR regulation has made it mandatory for the top 1,000 companies to disclose sustainability risks and opportunities, including climate change. So be sure to check the company’s financial reports as your first source. There are also specialized research agencies such as MSCI, Bloomberg, CDP, Refinitiv and Morningstar that provide quantitative and qualitative information on corporate climate risks.

Note that while these research reports are helpful in establishing a view of the company’s climate change issues, you also need to understand the assessment methodology. Unlike credit rating, there is ESG rating divergence between agencies due to differences in the choice and weighting of attributes as well as measurement methods. Newspapers, research reports from independent research houses and academic institutions, and journals are other sources of information. You can also perform screening – negative and/or positive – as well as integrating climate change risk into stock selection and portfolio construction. The simplest is screening negative which can help avoid investing in carbon intensive sectors such as coal, oil and gas which are more vulnerable. However, note that climate change may not affect companies in the same industry in the same proportion – some may quickly transition their operations to be less carbon-intensive. They can drive innovation, reduce costs, and increase profits, all while gaining a long-term competitive advantage.

A positive screening approach is to identify companies that are working to mitigate climate change, a strategy similar to thematic investing. It is a top-down investment analysis based on structural and long-term changes. As the economy becomes less carbon intensive, there is a huge opportunity for investment in low carbon technologies and their value chain. Topics could be clean energy, clean transport, climate resilient agriculture and negative carbon technologies. For example, shares of Tesla have performed stellarly over the past five years thanks to its electric car and clean energy business, while shares of General Motors and Ford Motors have lagged far behind.

When performing a bottom-up analysis to select specific stocks, you need to assess the company’s financial and operational performance from the perspective of climate risks and opportunities. When adjusting financial statements, consider climate change strategy and governance practices. For example, consider two companies in a carbon intensive industry such as fossil fuel combustion cars. If one of them invests in increasingly competitive substitute products such as electric cars while the other does not, you can assess the long-term business impact.

It is also useful to look at specific measures specific to a sector. For example, ACC cement’s CO2 emissions fell from 506 kg/tonne in 2018 to 493 kg/tonne in 2020, and the company has set an ambitious reduction target of 400 kg/tonne by 2030. Similarly, the contribution of renewables to Asian Paints’ total electricity consumption increased from 35% in 2017-18 to 61.1% in 2021-22. These metrics and goals can help benchmark companies among their peers.

Labanya Prakash Jena is a Regional Climate Finance Advisor, Commonwealth Secretariat and PhD student at XLRI, Jamshedpur. Meera Siva is a Chartered Financial Analyst and works with startups and early stage investors. The opinions expressed here are personal.

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