Climate-related Financial Risk: Making a Truly Transformational Change in Investment Strategy

Climate change is an inevitable threat to global and local economies and markets if proper and urgent steps are not taken to mitigate these risks. There is academic evidence that climate change, in the form of transition and physical risks, is adversely affecting financial assets. Since climate change is affecting capital flows and the cost of capital, the corporates are expected to vigorously take both adaption and mitigation measures to control, shift, and manage these risks. On the other hand, the financers, particularly large ones such as banks and institutional investors, are considering these risks in securities selection and portfolio construction.

In the last few years, large financial institutions have invested heavily in capacity building, including skilling manpower, developing new technologies and tools, and creating databases to better understand these risks. The early movers can enjoy the competitive advantage not only in identifying and better managing these risks but also in harnessing the opportunities emanating from climate change. The financial policies of these financial institutions are different from traditional securities selection and portfolio construction. They are redefining their investment strategy – setting new rules and changing procedures – to select securities and design investment portfolios, manage risks, and create a compensation structure. In this article, I have outlined the best practices that will make true transformational changes in investment management concerning climate change.

1. Set a minimum standard

Positive or negative screening is the easiest way of selecting securities. Negative screening involves exclusion of certain industries from her investment universe that are more vulnerable to climate change risks or excluding securities with low ESG or carbon ratings. Positive screening involves selecting industries that will benefit from climate change or include only best-in-class securities based on ESG or carbon rating. These two ways may not be the efficient way of securities selection as they exclude a vast number of industries and securities from the investment universe. Besides, ESG rating is also not fully proven as the best way for securities selection from a climate change perspective since there is a divergence in ESG rating among various rating agencies. This means the investment house can create an inhouse and robust methodology to assess climate change risks and opportunities in the value-creation chain on the corporate’s sustainable profitability and valuation. The methodology can identify securities based on quantitative data (e.g., carbon intensity, energy efficiency, resource efficiency, water management, etc.) and judgment (e.g., the company’s strategy and vision concerning climate change). The quantitative data and judgment can be converted into scores that can decide buy, hold or sell securities from the perspective of climate change.

2. Set a new benchmark

Benchmark is like a gold standard for the fund managers – they always want to beat or at least meet the benchmark without deviating from its risk exposure. However, traditional market indexes are built on historical performance without regard for climate change that will be materialized in the future. This warrants the replacement of traditional benchmarks with a new benchmark that captures climate change risks and opportunities.

3. Invest in climate-risk modeling

The traditional risk management tools such as back-testing are not relevant as climate-related risks are going to be materialized in the future. Hence, fund houses are developing climate-risk modeling in-house or relying on third parties to develop new tools to assess climate risks. However, climate-risk modelling in the financial sector is at a nascent stage and evolving rapidly. So, the available models and databases need to upgrade constantly. The fund house should build in-house capabilities for climate-risk modeling while working with third-party agencies supplying useful data and tools. The fund house should hire climate scientists, catastrophic modelers, and climate finance/policy specialists who can together design inhouse climate-risk modeling.

4. Develop manpower capacity

Fund houses are heavily investing in developing the technical capacity of staff to better assess climate risks and opportunities. These knowledge gaps may lead to an underestimation of climate change risk or overlooking opportunities in lending and investments.  The fund houses can encourage or invest their investment professionals to gain knowledge and expertise in climate change. The fund houses can design specific training for their staff across all levels to better understand the risk. “Certificate in ESG Investing” offered by the CFA Institute and “Sustainability and Climate Risk” certification program by the Global Association of Risk Professionals (GARP) are some good distance learning programs for practitioners.

5. Align compensation structure with climate target

The existing compensation structure of most fund houses is based on the fund manager’s portfolio performance that may not capture climate change risk and opportunities appropriately. The fund house can design the compensation structure based on the combined investment performances and climate resilience of the portfolio. For example, the fund house may set a target for a net-zero portfolio by a specific year with an intermediate target every year.

6. Set new rules

The traditional rules on the market, sector, industry, or target weightings and risk measures need to be revisited. Most of These rules are based on historical performance records that do not capture climate change risk. For example, back-testing, a traditional risk management measure, is not very helpful since most climate-related risks are expected to be materialized in the future and differ. Besides, traditional rules may stifle innovations that are required to address climate change risks and opportunities that have not been realized earlier.

Any transformation changes in investment strategy and portfolio construction need to break existing rules and behavioral barriers and adapt new hypotheses and modify behavior to new dynamics. Climate change is a transformation event in human history and potentially hampers financial asset value significantly and/or suddenly. This new event warrants a radical change in investment practices. Implementing these originative changes in investment practices requires leadership and intensive dialogue with the asset owners to make the portfolio resilient against this eminent risk and harness the opportunities.

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”