As the global economy moves toward decarbonisation, investors can harness new indicators to measure the potential risks and opportunities arising from climate change.
If you’ve ever wondered how to assess companies based on the risks and opportunities related to climate change, five key metrics—absolute carbon emissions, carbon intensity, emissions reduction targets, carbon earnings at risk and climate change revenues—can help, according to a new report from Morgan Stanley, jointly issued by its Institute for Sustainable Investing and the Portfolio Solutions Group at Morgan Stanley Investment Management.
For investors, it’s now critical to assess the threats that climate change poses to assets and the impact of changing policies on corporates in the urgent transition to a low-carbon world. Economic damage from climate change-related natural disasters, such as hurricanes, wildfires or heatwaves, has risen sharply in the past 40 years.1 Between 2016 and 2018, climate change-related weather events caused more than US$630 billion in losses worldwide.2 Meanwhile, global financial regulators increasingly treat climate change as a systemic financial risk: Last year, the Network of Central Banks and Supervisors for Greening the Financial System identified climate change as a unique source of structural risk affecting the financial system.3
Climate Disasters and Related Losses Have Risen Sharply in 40 Years
For their part, many companies and governments have committed, by 2050, to achieving net zero emissions, a state in which the amount of carbon produced is offset by the amount removed from the atmosphere. This milestone is critical to ensuring that the Earth’s average temperature increases no more than 1.5˚C above preindustrial levels, which the Paris Agreement defined in 2015 as necessary to substantially limit the impact and progression of climate change.
“There is real and growing interest in climate change from an investor perspective, and decarbonisation is a complex topic that’s increasingly important,” says Matthew Slovik, Head of Global Sustainable Finance at Morgan Stanley. “Key metrics provide a comprehensive way for investors to think about climate change in their portfolios.”
As the world moves toward decarbonisation, investors, especially stockholders, can look at the following five indicators to evaluate companies through the lens of climate change, according to the report.
- Carbon emissions: A point-in-time measurement of absolute carbon emissions from a company’s direct and indirect activities.
- Carbon intensity: A measure of emissions efficiency, using revenue to normalise and compare emissions across companies of different sizes.
- Emissions reduction target: Akin to earnings guidance, a forward-looking indicator of a company’s ambitions to reduce its carbon emissions—increasingly assessed based on the breadth, quality and associated plans to achieve the target.
- Carbon Earnings at Risk (CEaR): Akin to value-at-risk, the estimated present value of future earnings loss, based on the projected price path of carbon and a company’s current emissions.
- Climate change revenues: The percentage of a company’s revenue tied to positive or negative climate impacts—which may be scored based on underlying products and services linked to climate change.
“Even if asset owners or asset managers want to embark on a path of decarbonisation, in practice this is impossible without effectively measuring the processes and outcomes that investors aim to manage,” says Rui De Figueiredo, Co-Head and Chief Investment Officer of the Solutions and Multi-Asset Group, which oversees the Portfolio Solutions Group at Morgan Stanley Investment Management. “This has been a key challenge for market participants from a data and methodological perspective and this provides a framework for investors to effectively advance a decarbonisation agenda.”
How can you use these metrics? Much as portfolio strategies are defined by sector, style or geography, these measurements can help investors define and articulate a clear decarbonisation strategy. Each indicator on its own presents a limited view: The first two metrics, which measure a company’s direct and/or indirect carbon emissions and carbon intensity, are point-in-time or backward looking, but they can help investors whose goal is to choose lower-emitting sectors or securities.
Meanwhile, forward-looking indicators can reflect proactive decarbonisation goals and provide a more complete assessment of climate change impacts. Some companies—about half globally across sectors—have set public targets for reducing carbon emissions,4 which portfolio managers can consider as guidance on future direction. While companies’ commitments to reduce emissions aren’t binding, pressure is mounting from investors, regulators and consumers for corporations to set interim emissions goals and to reach their milestones, according to the report.
About Half of Companies Have a Public Emissions Reduction Target
MSCI ACWI Universe as of 12/31/2019
Another indicator, CEaR, estimates a company’s future potential earnings loss, based on the projected shift in the price of carbon, which will be driven by underlying factors including the transition to renewable energy from fossil fuel energy, as well as policy changes such as carbon taxes or requirements to purchase permits, known as carbon emissions trading schemes.5 A company’s geography and sector significantly determine its CEaR; for example, emerging economies that may rely upon fossil fuels are generally expected to have lower carbon pricing to account for universal energy access, while developed economies will have higher pricing because of emissions to date.6
Investors can also look at a company’s revenue streams to determine how likely it is to gain, or falter, as decarbonisation progresses. Companies tied to renewable energy or battery storage, for example, could be positioned for upside potential, while those reliant on fossil-fuel-based energy sources may be exposed to greater risk, as the economy and markets necessitate lower carbon emissions.
As technological innovation, shifting consumer preferences, changes in market prices and new policies drive the transition to a low-carbon economy in coming decades, it may be incumbent on investors to use an ever-evolving set of climate metrics, along with traditional measures of financial performance, to holistically assess companies.
- Carbon emissions: The carbon dioxide equivalent of the six major greenhouse gases. As defined by the 1997 Kyoto Protocol, the six greenhouse gases contributing most to climate change are carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6).
- Scope 1 Emissions: Direct carbon emissions from owned or controlled sources.
- Scope 2 Emissions: Indirect carbon emissions from the generation of purchased energy.
- Scope 3 Emissions: Indirect emissions (not included in Scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions
- Decarbonisation: A systematic effort of companies and governments to align with a low-carbon economy by reducing carbon emissions.
- Net Zero (Emissions): A state in which any carbon emissions produced are offset by removing carbon from the atmosphere. Reaching net zero emissions by 2050 is critical to limiting average global temperature rise to less than 1.5˚C above preindustrial levels.
For more on decarbonisation, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.
1 NatCatSERVICE, MunichRe, March 2018.
3 “A Call for Action: Climate Change as a Source of Financial Risk,” Network for Greening the Financial System, 2019 (https://www.banque-france.fr/sites/default/files/media/2019/04/17/ngfs_first_comprehensive_report_-_17042019_0.pdf; accessed on 10/30/2019)
4 ISS-ESG, MSCI ACWI index, Morgan Stanley analysis.
6 See, for example, the Report of the High-Level Commission on Carbon Prices co-chaired by Nobel Laureate Joseph Stiglitz and Lord Nicholas Stern, https://www.carbonpricingleadership.org/report-of-the-highlevel-commission-on-carbon-prices.