Scoping out carbon risk: Investors must take a holistic approach

Extreme weather events and high biodiversity losses worldwide show the potentially devastating effects of climate change that lie ahead. For investors, aligning portfolios with climate protection has become a fiduciary duty. To make the right investment (or divestment) decisions, investors need a full picture of a company’s contribution to the fight against climate change.

Corporate climate strategies are improving, but overlook important aspects

Many companies aim to reduce their carbon emissions. Roughly 5,800 firms regularly report their climate-protection strategies, emissions and energy consumption to the CDP. At the end of January, 208 firms, including the Kellogg Company, Pepsi-Co, Pfizer, Procter & Gamble, and Sony, pledged to set emissions-reduction goals backed by scientific evidence.
But such ambitions often overlook fundamental aspects of climate risk. Firms often use inappropriate or inadequate criteria and system boundaries. This may result in them limiting only direct global greenhouse gas emissions (Scope 1) and indirect energy-related emissions (Scope 2), which represent a company’s direct carbon footprint. Indirect emissions (Scope 3), defined as ‘emissions that are a consequence of the operations of an organisation, but are not directly owned or controlled by [it]’, tend to be neglected. Emissions released in the upstream extraction and processing of raw materials along the supply chain, as well as during transportation and distribution, and in the use and disposal of products, can constitute as much as 90% of a company’s overall carbon footprint.
Portfolio managers often examine isolated climate-related indicators, such as direct carbon footprint and revenue data, meaning they obtain only a limited understanding of a company’s exposure to carbon risk. In addition, investors should look at whether a company is developing positively from a negative starting point, or stagnating at a specific level. They must also consider whether a firm’s claim to have ‘low’ or ‘falling’ emission levels may owe primarily to divestments of critical company units. And they should ask company management whether targets or calculated savings are based on a ‘business-as-usual’ approach, and thereby will not result in lower emissions.

Climate performance of companies: some results

oekom research has developed an evaluation methodology that measures the way companies manage their carbon risk, on a scale from 0 (worst) to 100 (best).The average Carbon Risk Rating in our universe is 28.06. This is fairly poor, though there are variations by sector. For example, ratings of utilities range from 1 to 83. The industry average of 36.5 is fairly high, compared with other sectors. There are several reasons for the spread. Utilities face an immediate and direct exposure to climate risk, but also have the power to minimise it. They can do this by choosing the energy sources they use to generate heat and electricity. Regulatory constraints also require many utilities companies to deliver minimum climate protection. This accounts for the high share of companies we rate at 20 or higher. Finally, extensive use of renewable energy by some firms raises the average.
Among the leaders are Meridian Energy, with a score of 79, and Iberdrola, which we give a rating of 72. Meridian Energy, a New Zealand-based power producer, only uses hydropower and wind energy sources. It also plans to reduce emissions further.
The poorest performers contribute to climate risks, by maintaining coal as an energy source, failing to adequately invest in renewable energy, not setting emissions reduction goals, operating plants inefficiently or using unsound infrastructure.
There are also variations in utilities companies’ scores between countries. French and German firms have relatively high average scores, at 42.5 and 39.2 respectively. US, Australian and Canadian firms typically score less than 25.

Outlook

Transformation processes are creating corporate winners and losers in the battle against climate change. Utilities firms can boost climate protection by switching to renewable energy sources, operating efficient plants, and avoiding CO2, natural gas and methane emissions.
Taking a retrospective view of a firm’s direct carbon footprint is insufficient for both companies and investors alike. Risk and performance assessments must be undertaken across the entire value chain to develop robust corporate and investment strategies. Forward-looking strategies should further the transition towards a low-carbon economy. Aligning investors’ goals with that of climate protection is essential if they wish to avoid substantial falls in portfolio values.

Jaspreet Duhra is a Senior Manager for Client Relations at oekom, and head of the firm’s London office. Julia Haake is its Director of International Business Development and head of oekom’s Paris office.