November 2023 / ESG
As climate risks intensify, investment analysis must rise to the challenge
Addressing the challenge of integrating climate change dynamics into investment decision-making.
- We believe climate change is set to have a material impact on investment performance across geographies and asset classes.
- Data availability has historically been a notable headwind to analyzing climate change-related risks and opportunities.
- While the challenges around climate data are not insignificant, the good news is that there is progress.
Any successful asset manager needs to identify and analyze large systemic changes and the corresponding risks and opportunities they could bring. These types of changes are often driven by technological advances and/or regulation. We believe climate change represents a large systemic change set to have a material impact on investment performance across geographies and asset classes. Given the complexity of climate change dynamics, blending them into investment decision‑making requires not just the capacity to derive the data and insights, but also the systems and processes to integrate them into the analysis.
At T. Rowe Price Associates, Inc., our approach combines fundamental analysis (by analysts and portfolio managers), thematic and topical research (by in-house environmental, social, and governance (ESG) specialist teams), and our proprietary Responsible Investing Indicator Model (RIIM) analysis—which includes an assessment of issuers’ net zero status. It also integrates appropriate stewardship measures that seek to align with clients’ investment objectives.
Given its materiality to investment performance, climate factors and their level of materiality are considered across our investment platform; however, the investment implications can vary depending on the client’s mandate. Most of our clients have given us a mandate to deliver financial performance—in these cases, consideration of climate factors is for the purpose of delivering better financial performance. This requires insights into how corporate and other issuers may perform under a variety of climate-related scenarios, ranging from adherence to evolving regulatory demands to their capacity to conduct business in a changing environment. More specifically, this might include how they plan an orderly transition to net zero or how they are preparing for a hotter world where physical adaptation of business activities becomes necessary.
At the other end of the spectrum, a small but growing number of clients have dual mandates that include specific sustainable objectives alongside financial performance. Their sustainable objectives might include meeting net zero or greenhouse gas (GHG) reduction targets, excluding securities linked to fossil fuel production, or voting decisions that are not predominantly driven by financial materiality. In these cases, the analysis of climate factors will be the same, but the strategy may take a different approach to stewardship and divestment.
In both cases, our analysis of climate factors is benchmarked against a 1.5°C net zero pathway. To achieve this, the base case scenario implies a 50% reduction in greenhouse gas emissions by 2030 and achieving net zero by 2050. The pathway to net zero also must be science-based, which means that offsets can only be used for hard-to-abate emissions.
The challenge of quantifying climate
For many years, we have discussed data availability as a notable headwind to analyzing climate change-related risks and opportunities. The bottom line is that data remain lagged and underreported but have been improving steadily. To evaluate an issuer’s climate change exposure, an investor needs a mix of quantitative and qualitative inputs. We believe that the Task Force on Climate-Related Financial Disclosures (TCFD) reporting standard captures the required information very comprehensively, which is why we have long advocated that our investee companies adopt this reporting standard. TCFD standards have now been absorbed by the new International Sustainability Standards Board that is gaining support from regulators around the world.
One of the most critical data inputs for climate analysis is the greenhouse gas emissions footprint of an issuer. While other data inputs are also very relevant and important, we believe that most investors view reporting of Scope 1–3 greenhouse gas emissions as the base of the climate analysis pyramid (see Chart 1). As the reporting of climate scenario metrics across portfolios is starting to become more common, we feel it is important that the end investor (i.e., our clients) understands the robustness of the underlying data. As such, we have provided a snapshot of greenhouse gas emissions data availability for the MSCI World Index, a developed market benchmark that spans geographies.
Climate analysis pyramid
Scope 1 and 2 represent the direct GHG emissions of a company. Reporting of these emissions is pretty good for the companies within the MSCI World Index. For 2021, 85% of MSCI World Index constituents reported Scope 1 and 2 greenhouse gas emissions (compared with 52% five years prior). Furthermore, high emitters are more likely to report, as 94% of the MSCI World Index’s constituents’ aggregate emissions were reported in 2021. The drop seen in reported emissions in 2022 (see Chart 2) is a function of companies having not yet reported their year-end 2022 data. With more and more regulators starting to require greenhouse gas emissions disclosure, we expect to see continued improvement in the number of companies reporting, as well as in the timeliness of reporting.
MSCI World Index total GHG
(Chart 2) Emissions—Scope 1–2
Chart 2 illustrates the aggregated GHG emissions of the current constituents of the MSCI World Index (there is no adjustment for benchmark weight). Over the past 10 years, absolute aggregated Scope 1 and 2 emissions have fallen by 2.4% CAGR,1 well short of the 7% per annum decline required to be in line with a 1.5°C pathway. However, when evaluating the MSCI World Index on an intensity basis2 using a weighted average approach, we see a decline of 7.1% CAGR over the past five years (Chart 3).
MSCI World Index total GHG
(Chart 3) Emissions vs. GHG intensity—Scope 1–2
The data picture is very different when it comes to Scope 3 emissions. As these are the emissions that are not under the company’s direct control, they are more complex to measure and comprise 15 different categories—not all of which will be material to a particular issuer. Measurement typically relies on estimating standards and tools developed by organizations such as the Greenhouse Gas Protocol. These standards guide companies to put the most effort into accurately estimating the Scope 3 categories that are most relevant for their business and to use broader estimates for the other categories.3 Our own analysis takes a similar approach, and where there are enough data to analyze Scope 3 emissions, we focus on the data for the specific emissions categories deemed most relevant for each industry. Chart 4 illustrates the various categories, with the darker shading representing the categories deemed most material for each industry.
Scope 1–3 emissions materiality assessment by sector
Percent of companies in MSCI World Index reporting Scope 3 emissions by source
Evaluating net zero pathways
In assessing a company’s net zero status, we view best practice as adopting a science-based net zero target, aligned to a 1.5°C pathway that covers Scope 1–2 and the most relevant Scope 3 emissions. If a company has these targets validated by the Science Based Targets initiative (SBTi),4 it gives us confidence that it is adequately addressing its material emissions—not simply relying on carbon offsets (balancing actual emissions by investing in projects that reduce or store carbon elsewhere) when emissions should, in fact, be mitigated.
Our net zero analysis goes beyond simply identifying whether a company has a net zero target in place; it also includes a company’s short- and medium-term GHG reduction targets and a view on the credibility of its emissions trajectory. It is underpinned by the principles established by the Paris Aligned Investment Initiative Net Zero Framework. The range of targets and pathway factors we look to quantify are illustrated in Chart 6. According to our scoring system, the company in this illustration is assessed as being “committed” in its journey toward net zero for Scope 1–2, but is “not aligned” when taking into consideration Scope 3 emissions. Higher gradings are possible depending on the extent to which a company has either achieved net zero or the degree to which its emissions targets are aligned to that objective.
Criteria for issuer net zero targets
Our analysis culminates in a net zero profile for each issuer, providing essential climate information for our investment analysts and portfolio managers to evaluate. A sample profile and data inputs are illustrated in Chart 7.
Illustrative net zero profile and data inputs
Ultimately, the imperative to embed analysis of climate-related data into investment decision-making continues to intensify. The systemic challenge posed by climate change means that we need to understand and evaluate the financial risks and opportunities it creates for the issuers we may invest in on behalf of our clients. For some clients, the requirement goes beyond the need to achieve financial performance, as they target distinct sustainability objectives that govern how we construct and manage their portfolio. And while the challenges around climate data are not insignificant, the good news is that there is progress, and our platform has robust systems and processes in place to accommodate it.
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