As policy makers increasingly seek to act on climate change, investors must look to protect their portfolio from the risks these regulatory changes may have, writes BNP Paribas' Madhu Gayer.
Against the backdrop of 2015 marking the planet’s hottest year since temperatures were first recorded in 1880, the 21st Conference of Parties produced a landmark global climate change treaty under international law, the ‘Paris Agreement’.
The Paris Agreement states that global greenhouse gas emissions should peak ‘as soon as possible’ to keep the global temperature increase to 1.5° – 2°C above pre-industrial levels.
The provisions of the Paris Agreement provide a focal point for institutional investors to assess the potential for regulatory change to pose risks to their investment portfolio strategies. The criticality of the risks inherent is driven by the continuing trend for institutional investors to allocate a significant proportion of their allocation to equity strategies, with the average superannuation fund allocating 49 per cent to equity assets.
As such, the risks to equity strategies from climate change warrant closer attention, given that the drivers of risk and of return to superannuation funds are intrinsically linked to equity portfolios.
Presently, BNP Paribas Securities Services and Avalerion Capital are developing a new climate change stress-testing approach that moves beyond assessing absolute carbon emissions as the principal risk factor. Three fundamental questions lie at the heart of this stress-testing work:
1 - Does climate change policy pose material risks to the expected future performance (defined as impact on profit before tax, PBT) of equity portfolios? If so, which policy factors are most significant?
2 - At what tracking error and performance ‘costs’ can equity portfolios be re-balanced, without any material loss of performance, to mitigate these risks?
3 - How can institutional investors build ‘better’ betas to mitigate losses driven by climate change risks?
We initially focus on carbon pricing as a key policy lever to measure the impact on PBT and are currently assessing energy efficiency and energy subsidies as additional policy measures as well as stranded asset risks.
Carbon pricing is increasingly used to influence emissions behaviours. In the absence of a globally agreed price for carbon emissions and a liquid carbon market, current carbon price regimes exist at various regional, national and city levels.
Price levels in the EU Emissions Trading System (ETS), the world’s largest cap-and trade scheme, have hovered around the US$8-US$12 mark for a long time. France has also recently announced it will set a carbon price floor of around €30 a tonne.
China, for example, is migrating from piloting seven cap-and-trade regional markets to launching the world’s largest national carbon market in 2017. Carbon prices across China’s pilot regions vary, but are typically also in the US$8-US$10 range. Similar price ranges are evident across carbon markets in the US, Korea and India.
These carbon price levels are in stark contrast to the ‘true economic cost’ of carbon, which, depending on the specific study, are estimated to be around US$65 – US$85 per tonne of carbon dioxide equivalent (CO2e). Given these global carbon market and price ‘realities’, our thesis is that carbon is currently an under-priced risk for companies.
It therefore poses a material risk for investors managing equity portfolios, which absolute carbon emissions analysis does not assess.
Taking the MSCI All Country World Index (ACWI) as a benchmark portfolio, we adopted a stress-testing approach that rests on three macroeconomic climate change and associated carbon pricing scenarios until 2025. Our three carbon price scenarios are:
- business as usual baseline
- a moderate price increase; and
- an aggressive carbon price scenario
We estimated the future PBT impairments of a benchmark equity portfolio (MSCI ACWI) under these price scenarios and devised portfolio re-balancing approaches.
Our initial results show that carbon price does pose a material performance risk in four high-emissions sectors:
- basic materials
- energy, and
Impacts range from 2 per cent to 20 per cent of profit before tax in 2025. The three-year ex-post stress-testing of the MSCI ACWI benchmark portfolio with these results shows that the original index would face a carbon price stress risk of 40 per cent to 50 per cent-plus of its aggregate annual PBT for the base case carbon price scenario.
Re-balancing the portfolio using a number of constraints results in a ‘carbon smart’ portfolio that would buffer this PBT-loss stress by over 90 per cent in the carbon price baseline scenario. The ‘costs’ for this rebalancing are a 2.3 per cent per annum tracking error.
The annualised performance of this carbon-smart portfolio is 13.8 per cent a year, in line with the original MSCI ACWI at 13.6 per cent per annum.
In essence, our initial work indicates that creating a smart beta or carbon-smart portfolio can be achieved without sacrificing annualised returns. We believe our approach provides a useful step towards assessing the possible financial impacts of carbon prices on the bottom line of companies.
This has a clear quantitative repercussion for institutional investors given their continued material allocations to equity strategies, and as they assess improvements to their risk management frameworks.
We are continuing to refine and expand our stress-testing results. In our current work we are assessing the energy-efficiency factor, the subsidy policy factor and the impact on fossil fuel reserves, in an attempt to fully stress test the policy impact of climate change on equity portfolios.
Madhu Gayer is Head of Asia Pacific Investment Reporting and Performance at BNP Paribas Securities Services Asia Pacific.
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