Research Note

Identifying climate risks and opportunities for investment

By Chris Georgiou

From corporate governance and board composition to loan portfolio credit quality, new approaches utilising passive and active steps are driving the change in how to approach environmental, social and governance integration along with reporting across jurisdictions.

There is a growing confidence that environmental, social and governance (ESG) integration can help identify long-term successful companies by improving the long-term risk-return dynamics, meaning that sustainable investment (SI) and the extra work entailed, can actually serve to mitigate risks. In fact, over the past two years, global sustainable investments grew by 34% to $30.7 trillion.

Passive ESG indexes are growing in popularity with sustainable investments matching conventional returns

Sustainable investment is the allocation of capital to companies which are working to combat environmental destruction, climate change and support clean technologies while promoting corporate responsibility. Sustainable investing generally includes an investment process that uses ESG to evaluate investments or to assess the societal impact of investments.

According to a report by independent research firm Morningstar, the number of sustainable funds increased by nearly a record 50% to 351 in the United States totalling $161 billion by the end of 2018. Assets under management totalled to $89 billion for the most comprehensive sustainability criteria with $5.5 billion in net inflows.

While exchange-traded funds (ETFs) are approaching parity with open-end funds in the sustainable funds universe, passive funds now constitute about 30% of the sustainable funds in the US with net new funds rising faster than flows into active funds, according to Morningstar.

As for the performance, sustainable funds outperformed the rest in 2018, with 63% of sustainable funds finishing in the top half of its category. Based on the Morningstar research, sustainable equity funds held up better than traditional peers.

UBS (Union Bank of Switzerland) Asset Management goes beyond third-party scores and currently employs 30 equity analysts, 25 fixed income analysts and 10 ‘dedicated’ system information (SI) research analysts to build an explicit structure called ‘concentrated alpha’ that ranks and integrates ESG into investments. It encompasses idea generation, period review and reactive review which involves selling positions or engaging with the company that has dropped its relative score. This approach utilises three indexes, namely Morgan Stanley Capital International (MSCI), UBS and Sustainalytics, and further adds additional layers of internal review.

At an intuitional level for example, UBS Asset Management has also shown how in almost every market, its sustainable investments as of March 2019 are returning a slightly higher return than the standard associated benchmarks.

The data suggest one major reason for this is that investing in sustainable products limits the risk of companies suffering from bad publicity, and consequently, from related negative financial performance as reputational setbacks tend to lower stock prices. Based on UBS research, between August 2017 and August 2018, the 20 largest holdings in the MSCI World Index had attracted twice (1,321) as many instances of negative news coverage compared to its sustainable counterpart, the MSCI World ESG Leader with 612.

Furthermore, the UBS MCSI SRI index range outperformed its traditional counterpart in almost all global regions over a five-year period. A key reason identified for the stronger performance of the MSCI SRI index was that certain large corporations who suffered severe sustainability scandals – including BP, Petrobas and even Facebook – were not part of the index because significant ESG risks were already identified beforehand.

Vontobel’s Clean Technology Fund uses an innovative investment methodology to measure potential avoided emissions

Swiss-based Vontobel Asset Management has cooperated with Institutional Services Shareholder Services Inc. (ISS), a provider of corporate governance and responsible investment (RI) which developed the Potential Avoided Emissions (PAE) investment methodology. Avoided emissions are defined as ‘emissions that would have been released if a particular action or intervention had not taken place.’

As of 29 June 2018, the fund’s assets stood at $278.74 million (EUR 247.9 million), with 55 out of its 64 companies qualifying for PAE, or 84% of invested capital. The result totalled to potential avoided emissions of 1,004,745 tons of CO2 equivalent according to the figures of Vontobel.

This pioneering toolkit, which is still a work in progress, goes beyond merely measuring the carbon footprint, often labelled as a static figure primarily useful for backward-looking risk assessments. But attempts to measure the emissions of the entire value chain so is considered useful for solution-oriented capital allocation.

By increasing transparency in view of portfolio companies’ exposure to climate change and carbon emissions, the Vontobel Fund-Clean Technology (VFCT) aims to have a positive impact on the environment in addition to expected financial performance.

“When we started the clean tech fund, we of course didn’t invest in oil, gas, coal and highly polluting companies. And on the other hand, we went one step further to look at where and what is the impact producing of our investments,” said Dr Matthias Fawer Senior ESG analyst at Vontobel Asset Management during a triple bottom line investing (TBLI) panel discussion held in Zurich on 12 June.

“We get the numbers of their products, their machines and we compare it to a baseline. For example, if it’s an LED lightbulb, we can compare the energy savings compared to a conventional lightbulb. And of course the baseline will evolve with time and is a moving target. Companies are already stating their avoided emissions in their sustainability reports,” added Fawer.

ISS-climate has quantified the impact of portfolio companies by estimating the potential avoided emissions. These come from energy-efficient products or services which allow for a reduction in emissions. Each company within the fund has been asked to provide data to calculate avoided emissions relative to a comparable baseline. PAE were calculated on the products sold and services provided during 2017 and possibly impacting the environment throughout their lifetime.

“We have developed metrics for other services and other products which wasn’t easy. It was a process together with the companies we had to engage and ask them, “What is your product really doing?” For example, if someone is providing building services, or heating. Is it energy efficient solutions?” Fawer explained.

“The potential avoided CO2 emissions of this mean that if you invested 10,000 euros, you may reduce the C02 emissions by 41 tons. Just to give you a comparison, the avoided emissions of this fund are 40 times higher than the ordinary conventional carbon footprint of these companies,” elaborated Fawer.

Chart 1: Clean Energy Infrastructure and Building yielded most potentially avoided emissions


There’s an added benefit with the tightening regulatory environment, tax incentives and carbon trading schemes, as companies offering high PAE could enjoy better financial performance in such a transition period.

However, questions remain over how to optimize the relative weighting of ESG rankings versus the rate of return rankings. Clearly, considerations of financial returns have to take priority as it would not be feasible to invest in a company with a glowing ESG ranking that is not making monetary returns.

This problem is solved if the investing universe of companies is large enough to choose the highest levels of ESG compliance. However, if the ESG metrics are not set to a high enough standard then the universe of investible companies will be very large and it would not serve as a driver of corporate change. That is the borderline where sustainable investment shifts to the arena of impact investing, which has the highest level of metrics.

Climate change as a material risk and opportunity

Since 1950, five billion people have been added to the total population of the planet. Whether or not one believes the regulator will come your way, it is more likely that it will. Climate risks need to be actively managed.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) recommends that companies identify climate-related risks and opportunities and related impact as a material transition risk.

“In order to meet the goals, we need $4 trillion every year. At the moment we invest between $1.4 and $5 trillion each year. So there is a $2.5 trillion gap in investment. How can banks help fill this gap in the real economy?” asked Gerhard Wagner, head of sustainable investments at Swisscanto asset management at the TBLI panel discussion held in Zurich on 12 June.

“If the C02 price stays at this level, $100 billion of equity will be gone from the fuel companies. And if it rises further, under a scenario where we have the CO2 price higher than $30 per ton, it’s very clear it will be very tough for some carbon intensive companies to survive,” Wagner further shared.

“However, we have to make it socially acceptable, if CO2 intensive companies suffer and lay off many workers, it cannot be guaranteed that climate policy will be implemented,” Wagner said, adding that, “However, it is riskier to consider that there will not be further regulations”.

The mission of the TBLI Group, a friend of the Wealth and Society Programme, has been a part of the Impact Investing and ESG community for over 20 years, is to create an inclusive values based economy. The aim is to maximize investment flows into sustainability initiatives by showing the opportunities triple bottom line investing offers to investors.



Keywords: Sustainable Investment, Climate Change, Esg, Clean Technology, Corporate Responsibility, Responsible Investmnet


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