2°C scenario aligned investing: the missing link

In a financial sector that is being reshaped by new digital technologies, FinTech is at “the epicenter of disruption”, according to a report by PWC I argue that while technology’s shockwaves may defy the way financial institutions operate, these developments are self-centered and do not fundamentally alter the status quo of the financial sector. A true breach of its status quo should not be based on questioning how the financial sector works but for what purpose. Thus, the essay aims to redefine the latter by reconnecting the financial sector with the environment. The disruptive idea presented below links investment decisions with climate change through a 2°C-benchmark for portfolios. In the long run, this shall enable green investment by default.

While symbiotic linkage between the two systems is not a new endeavor (see the introduction of carbon trading schemes), ecological risks are not yet fully integrated in the core operations of financial institutions. This is both simple negligence with respect to risk management as well as a missed opportunity to recognize that the financial sector has a huge lever when it comes to combating climate change.

Advanced economies have agreed to mobilize $100bn of annual investments for mitigation and adaptation needs of developing countries by 2020 underlining the significance of the financial sector’s role in combating climate change. A large part of these investments is supposed to come from the private sector even though the exact policy instruments to tap these funds have not yet been defined.

This essay makes the case for pulling the lever by positing and answering three questions:

  1. Why does it make business sense to include climate change into investment decisions?
  2. What is missing for a meaningful integration?
  3. How can a 2°C-benchmark for investment portfolios break the status quo?

 

Need for change – Climate change and its consequences for the financial sector

The surprisingly fast ratification of the Paris agreement on climate change is a tremendous step forward towards codifying recognition of the need for an international, multilateral approach to climate change. The regime builds a commitment architecture designed to limit the rise of global temperatures to no more than 2 degrees Celsius (2°C) above pre-industrial levels.

With regards to this goal, carbon dioxide (CO2) has emerged as a key variable – both for tracking human contribution to climate change as well as for linking regulations to it (for the purpose of simplicity, CO2 always includes the main greenhouse gases, i.e. CH4, N2O, HFCs, PFCs, and SF6, as CO2 equivalents). While such regulations impact resource intensive industries in particular, the consequences for financial institutions should not be overlooked. Article 173 of the French Energy Transition Law requires French portfolio managers as of 2016 to report on their carbon footprints. Sweden is considering legislation that goes even further: mandatory stress tests for the pensions and insurance sector that evaluate the performance of their portfolios under a range of climate-change scenarios.

When it comes to investment decisions, there are essentially two incentives for an investor or a financial institution to engage in so-called green finance: ethics and risk management. While ethics often boils down to individual values, risk management is based on rational decision-making heavily influenced by the architecture of the financial system. This essay focuses mostly on the latter of these incentives.

 

Aspire to change – confronting challenges

The large-scale and long-term nature of climate change motivates many financial institutions to ‘kick the can down the road’. However, the risks and opportunities resulting from international developments result in the need for financial institutions to incorporate the potential impacts of climate change into their short- and medium-term business models.

Indeed, green investments grow and tend to be motivated by more than merely ethical concerns. The need to adjust business models accordingly is no longer narrowly represented among a niche of alternative banks but is growing in mainstream financial actors as well. The formation of the Task Force on Climate-related Financial Disclosures (TCFD) in December 2015 under the roof of the Financial Stability Board (FSB) illustrates this fast-paced development. The TCFD’s mission is to “develop voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders”. The question of how to align investments with a 2°C scenario even made it to the FAQ section of the Science Based Targets Initiative. The initiative is a partnership between the Carbon Disclosure Project (CDP), United Nations Global Compact (UNGC), the World Resources Institute (WRI) and the World Wildlife Fund (WWF). It provides guidance for companies to set emission reduction targets that are in line with a 2°C scenario. However, there is no such guidance for financial institutions as of today.

Why is this the case?

An important reason for the lack of such guidance in the financial sector is that quantitative metrics have been created and adjusted with a focus on manufacturing rather than on services. The production of goods emits demonstrably higher levels of direct greenhouse gases into the atmosphere. Associated risks are more tangible and immediate for these companies, thus their reporting on carbon emissions is more evolved than it is for financial institutions.

Consequently, many listed companies report rather extensively on their greenhouse gas emissions generated from up- and down-stream activities of their value chain. Financial institutions, on the other hand, place particular emphasis on emissions that stem either from sources that they control directly or from purchased electricity, heat, and other power sources. However, this focus is misplaced: financed emissions account for more than 95% of a financial institution’s carbon footprint. This is where regulations and risk assessment should be most heavily focused on.

Shortcomings of existing options to assess the climate performance of investments

A comparison of a portfolio's climate performance with that of existing standard indices, such as MSCI World or MSCI Low Carbon, allows only a limited assessment of its climate friendliness with respect to the general world economy. These indices provide little insight on whether one’s investments are in line with the 2°C scenario and thus do not allow for a meaningful risk analysis or effective target setting.

The 2° Investing Initiative has published a benchmarking model which assesses the so-called “energy and technology exposure” of a given portfolio against the desired energy and technology exposure under a 2°C scenario. While this is a promising step towards a forward looking analysis for strategic investment decisions of individual investors, the breadth of comparison between portfolios remains limited. Furthermore, the method is rather inflexible in that it prescribes a certain technological path disregarding alternative routes to similar results.

 

Enabling change – 2°C scenario aligned investing: the missing link

Due to the shortcomings of existing methods, a different approach is needed. According to the TCFD, scenario analysis is key to understanding and analyzing climate-related risks and opportunities. Applying this method comes down to one as-of-yet unanswered fundamental question: How does one meaningfully unpack a global warming mitigation scenario down to the financed emissions of a singular financial institution?

The potentially disruptive solution presented below aims at developing the methodology for calculating a benchmark for stock portfolios based on the Sectoral Decarbonization Approach (SDA) created by the Science Based Targets Initiative. This metric shall enable a financial institution to measure the alignment of the financed emissions of any given stock portfolio with the 2°C scenario as described by the Intergovernmental Panel on Climate Change (IPCC).

Methodological approach

The key to the 2°C-benchmark is data on actual vs. desired carbon emissions categorized by industrial sector.

The starting points for the 2°C-benchmark are the sector weightings of a given portfolio and its financed CO2-emissions. While a financial institution has data on the allocation of its investments readily available, data on financed emissions for public equity – while often not measured or kept track of in-house – can be retrieved without much difficulty from specialized providers.

A significant challenge is extracting meaningful target values from the desired 2°C scenario. To this end, the proposed approach makes use of sectoral carbon budgets as defined by the SDA. The SDA itself uses data available from the International Energy Agency’s (IEA) 2°C scenario as modeled in their 2014 Energy Technology Perspectives report. This scenario is consistent with the representative concentration pathway 2.6 (RCP 2.6) from the IPCC’s Fifth Assessment Report which gives the highest likelihood of limiting global warming to 2°C.

Based on these sectoral carbon budgets and sector weightings of the actual portfolio, a desired 2°C-portfolio is constructed as a benchmark for the actual portfolio. Rather than comparing absolute emissions, respective CO2-intensities need to be calculated since normalizing a portfolio’s financed emissions based on the invested volume provides more insights into its carbon exposure and enhances comparability. The CO2-intensity is calculated by dividing financed emissions by the volume invested, for example x tons CO2 per one million USD invested.

What is the added value of the 2°C-benchmark?

Regulations on carbon emissions are closing in on financial institutions. While thus far most focus lies on the publication of data on emissions, considerations in Sweden point at the next logical step: the integration of target or benchmark values in the context of stress testing for financial institutions. The 2°C-benchmark helps define these values.

The 2°C-benchmark constitutes the connective tissue between two complex regulatory systems: climate change and the financial world. As basis for further climate risk assessments, the reference point can significantly alter international capital flows. A 2°C-benchmark that is fully codified and embedded in both regulatory frameworks and the core business of financial institutions allows the inclusion of externalities from climate change regulations, such as the introduction of carbon prices, into investment decisions.

The incorporation of a 2°C-benchmark has three significant benefactors: governments, financial institutions and their clients.

For governments, the main implication of a 2°C-benchmark, in general, is that it allows for the definition of meaningful target values for climate-related stress testing of financial institutions. A major advantage of the presented approach is that it is flexible and responsive to the evolving environment and needs of financial actors. It can be scaled up or down in response to new climate goals. Furthermore, the benchmark can be expanded to other asset classes such as bonds and funds.

By incorporating a 2°C-benchmark into their reporting and risk-assessment, financial institutions gain valuable insights into their climate risk exposure with respect to regulations. This enables them to anticipate future regulations and pro-actively steer their investments accordingly. The truly disruptive aspect is that by incorporating the 2°C scenario into risk assessments, investors will no longer be forced to make tough decisions between green investment and profit maximization. They will be choosing both by default.

With respect to reporting and other external communication, the 2°C-benchmark has a clear advantage over other options, such as the existing Environmental, Social and Governance (ESG) indicators. It is more straightforward as a proxy for the ecological sustainability of investments: If the intensity of a given portfolio is higher than the intensity of the benchmark, the portfolio is less climate friendly and has a potentially higher climate risk exposure. This creates more transparency for clients who want to include such deliberations into their choice of financial providers.

Current state of development and the way forward

At present, I am developing the methodological framework for the 2°C-benchmark in cooperation with a Swiss bank. A workable prototype of the 2°C-benchmark is expected to be available in May 2017. Further development of the robustness and granularity of the methodology should follow a three-step process.

In the first step, a joint effort with the Portfolio Carbon Initiative and the Science Based Targets Initiative shall strengthen the foundation and tenacity of the model. In the second, a partnership with the IEA shall allow access to the organization’s full database on sectoral carbon budgets instead of only publicly available data. This would enable a more granular representation of sectoral carbon budgets, more precise mapping of carbon budgets to specific subsectors, and a more accurate analysis of actual climate performance than is currently possible. The third step involves outreach to further practitioners and benefactors of the model, such as the TCFD, to determine the best methods to embed the 2°C-benchmark in financial reporting.

The status quo of the financial system can, in fact, not be defined as a state – the system is in flux. It is a time of great challenges but also of great opportunities. We should use this momentum to question and change not only the way we, and financial institutions on our behalf, invest our money but also its purpose. The presented 2°C-benchmark can be the solution – a missing link between the financial sector and climate change. Let’s not break things apart but pick up the pieces and connect the dots.

 

Martin Ott was challenged on his disruptive idea at the 47th St. Gallen Symposium, watch his performance on stage here.
 

We should question and change not only the way we, and financial institutions on our behalf, invest our money but also its purpose.

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