One of the key challenges for investors is understanding how the transition to a low-carbon world might impact asset valuations.
With significant changes to the current macro environment, we have seen dramatic moves in financial markets due to the ongoing Covid-19 pandemic and the economic fallout. Amidst this, ESG tilted indices have outperformed the wider market and governments have sought to incorporate climate considerations into their ‘green’ recovery plans.
The nature of climate risk – large, potentially non-linear and with uncertain time horizons – makes assessing a company’s resilience for transitioning to a low-carbon world especially difficult. Whilst most company valuations may bounce back from their current levels in the medium term, we should be on the lookout for those using the current environment as a catalyst to transition to a more sustainable footing.
Indeed, the Task Force on Climate-related Financial Disclosures (TCFD) is explicitly recommending that companies use scenario-based analysis to estimate how various pathways might impact the future value of companies. This is critical for individual business resilience but challenging at the portfolio level where we are looking across the impacts of multiple sectors, activities and markets.
Developing an approach to explore the different low-carbon transition pathways at the company level can help investors better understand the risk exposure across asset classes and tailor specific engagement questions to get a sense of the resilience of a company’s business in a systematic way.
HSBC Global Asset Management has analysed the impact of 10 different climate scenarios across a range of companies globally. The scenarios were based on two main drivers of the low-carbon transition: climate policy and regulation, and the cost and performance of technology designed to reduce emissions. The analysis identified relative ‘climate winners and losers’ acrossall scenarios, on over 2700 global companies (including emissions-intensive sectors) modelled on the MSCI All Country World Index.
- No New Action: A baseline reflecting existing climate policies and estimated technology cost trends with no further policy changes
- Paris NDCs: Incorporates the potential effects of announced policies, including Nationally Determined Contributions (NDCs) made for the Paris Agreement in 2015
- Below 2DS: Explores implications of a climate target below 2ºC, using more stringent policy than the 2DS Balanced Transformation scenario
- 2DS Balanced Transformation: Assumes globally coordinated action in 2020 to limit global warming to 2ºC above pre-industrial levels by 2100
- Late Action: Rests on the same assumptions as the 2DS Balanced Transformation scenario but with globally coordinated action delayed until 2030
- Lack of Coordination: Based on the same assumptions as 2DS Balanced Transformation but instead of coordinated action it presupposes that carbon prices diverge between regions – converging to a single global carbon price by 2100
- Renewable Revolution: Assumes that the costs of both solar and wind equipment fall faster than expected
- Room for CCS: A future where carbon capture and storage (CCS) becomes cost-competitive with renewables faster than expected
- Efficiency Boost: Increased uptake of energy efficiency measures across all economic sectors, resulting in reduced energy use for a given level of GDP
- EVs Unplugged: Presupposes an aggressive reduction in the cost of electric vehicles (EVs)
The analysis is interesting, in that it has revealed not just those sectors most impacted by climate-related transition risks and opportunities but importantly the differences in valuation or credit rating impact between companies in the same sector, and the degree to which these impacts differ between different scenarios. Understanding the sensitivities to different scenarios enables investors to better understand the resilience to different pathways and those scenarios that challenge companies.
While, predictably the coal sector has the most significant negative mean impact under most scenarios, we see the largest range of positive and negative impacts across all scenarios in concrete and cement companies.
Oil and gas, automobile manufacturers and renewable manufacturers are most sensitive across different technology scenarios. While, coal, concrete and cement, as well as iron and steel companies, are most sensitive across policy scenarios. Clean tech companies stand to gain value in most Paris aligned climate scenarios, but returns are sensitive to differences in technology costs.
What should investors look out for?
Climate risks are very different from other investment risks and the current backdrop is one where there is both limited detailed company level disclosure on the impact of climate transition scenarios, and the disclosure there is, seems to imply limited impacts. While some companies do refer to costs, there is little discussion of the need to change business models – we know, however, that most companies will need to actively plan for transition and physical climate-related risks.
It is therefore important for investors to be able to scrutinize the scenario-related disclosures of companies in order to have meaningful conversations with them about governance, strategy, metrics and assumptions, scenario choice, risk management and metrics and targets. Systematic scenario analysis is a great place for them to start.
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