By Todd Bridges, Head of ESG research, State Street Global Advisors

An Increasingly Important Factor for Investors

Climate change is an increasingly important consideration for investors assessing the long-run viability of companies around the world. It’s an area of investor focus, not only for its investment risk implications but also for what it means for company financials, such as earnings and stock price, which represent the value of these future earnings.

In particular, institutional investors are re-evaluating how they value and allocate their assets with climate change in mind.

Building The Right Framework

Leveraging our recent major research we have developed an innovative framework that builds effective and investable climate-aware portfolios.

Our framework differs from earlier approaches in that we target both mitigation and adaptation and employ a variety of metrics across multiple data providers. We purposefully embed climate exposures into the portfolio; we do not seek to hedge climate risk. We also focus on long-only, highly liquid portfolios that can be scaled to sufficient asset size, as opposed to long–short portfolios that are of limited applicability to many investors.

We start with carbon data but move beyond it into other climate metrics that are increasingly available, such as those measuring green or brown revenue and adaptation metrics. In recent years, as the science behind climate change has grown, we’ve witnessed an evolution of the tools institutional investors can employ.

Our framework incorporates both mitigation of climate risk today and adaption to climate change in the future in an investment approach that directly aligns with the 2 Degree scenario, the Paris Agreement and TCFC.

Beyond Carbon Reduction: Mitigation and Adaptation

The mitigation section of our sustainable climate strategy involves an explicit objective to reduce the flow of heat-trapping greenhouse gases into the atmosphere and increase exposure to new energy and green companies. The adaptation section of the strategy involves an explicit objective to increase exposure to companies adjusting to actual or expected future climate impacts (i.e. the physical impacts of climate change).

Mitigation and adaptation are complementary approaches for reducing the risks of climate change impacts over different timescales, ideal given the objective of most institutional investors to balance short-term risk with longer-term opportunities.

Mitigation investment actions refer to all investment activities that are positively related to reducing greenhouse gas emissions and increasing exposure to low carbon economy.

Adaptation investment actions refer to all activities that improve the resilience of an investment portfolio to the physical impact of climate change.

Altogether, investors can achieve significant reduction in exposure to carbon emissions, emissions from fossil fuel reserves, and on revenues dependent on carbon-based sectors. At the same time, they can significantly increase exposure to revenues from low-carbon or green sectors. Our mitigation and adaptation framework has enough flexibility to build portfolios at different levels of concentration, tracking error, and climate risk exposure. For example, we can build a portfolio which aligns with climate model projections. We show how to build a portfolio aligned with the most conservative climate model projections, which seek to limit cumulative CO2 emissions to a threshold below the 2 Degree scenario.

Meeting the Climate Investing Challenge

On the mitigation front, we wanted to integrate aspects related to carbon-related emissions from production, suppliers, and fossil fuel reserves. On the adaptation side, we wanted to address the future opportunities associated with the low-carbon new energy economy and green revenue.

Our strategy allows us to overweight companies that not only are mitigating climate risk today by cutting down on emissions but also those companies that are adapting for future climate risk implications. The strategy is highly flexible, allowing us to calibrate the portfolio to different trajectories for climate projections.

The end result is a strategy that achieves meaningful reduction in targeted climate-related exposures coupled with significantly increased exposure to green sector and low-carbon revenues, helping asset owners prepare their equity portfolio for the transition to a low-carbon economy.