During the second phase of our analysis, each provider was asked to evaluate a fixed income, equity and multi-asset portfolio to assess its exposure to climate-change risk and opportunity. Ratings for the four providers were converted to standardized scale for ease of comparison, and each provider supplied ratings for physical risks as well as net transition risks for each company. The data emphasized the challenges presented by this type of modeling.
While the total portfolio assessments were quite similar, the scoring for individual positions and risks varied wildly, highlighting how the models captured different levels of detail. In our review, for example, many companies scored extremely strong in one provider’s assessment but were judged to be exceptionally weak by another.
So why were overall portfolio assessments similar? Dilution. Despite large differences in individual investment scores, when combined based on their position size within the portfolio, outlying scores are muted. Still, the individual investment scores are of utmost importance in the context of portfolio management and construction and can make a significant difference in portfolio returns. We believe that this highlights the advantage of active investment managers who not only know their securities well but also are aware of the quirks and idiosyncrasies of the scenario-analysis model that they use in portfolio and investment decisions.
Case Study: First Quantum
Perhaps the best way to understand differences in climate models is to contrast and compare the scores for one company across providers. First Quantum, a Toronto-based company operating copper and gold mines around the world with significant assets in Zambia, received meaningfully different scenario-analysis results from two providers. These results highlight the differences between providers and their underlying data and assumptions, as well as the necessity to be able to critically analyze scenario-analysis outcomes—something that only active managers with intimate knowledge of their portfolio holdings can provide, in our view.
Provider A considered 12 company sites when evaluating the physical risks of climate change for First Quantum. It determined that the company would benefit by 0.22% in extreme cold but be harmed by 2.21% in extreme heat, for a net physical value at risk of –1.96%. Provider A’s model assigned no effect to the company from extreme precipitation, heavy snowfall, severe wind, coastal flooding or tropical cyclones.
In contrast, Provider C’s model measured physical risks of coastal flooding (–1.13%), river flooding (–0.70%) and chronic impacts (–0.28%). These are slow-onset impacts, such as those observed changes in cost and productivity of labor under increased heat stress, for example. It also included a benefit from adaptation (+0.55%), for a net physical value at risk of –1.56%. Even though each provider approached the problem from a different perspective and scored different factors, the net value at risk was moderately comparable.
However, our portfolio managers, analysts and ESG team noted that both providers failed to include in their analysis the ongoing drought in Zambia. Approximately 90% of Zambia’s power generation is hydroelectric, and there is routine power rationing that will only get worse as drought continues. This is a major, and overlooked, threat to the company’s operations in that country.
Net transition risk calculations exposed significant differences. Both providers included direct greenhouse gas emissions from company-owned power sources (Scope 1 emissions), but only one provider included emissions from purchased power sources (Scope 2 emissions) and downstream emissions in the company’s value chain (partial Scope 3). For most companies, the bulk of greenhouse gas emissions comes from Scope 3.
Provider C, which gave First Quantum a total transition risk score of –62.81%, broke down the score among various elements of its transition risk factors, such as abatement, scope emissions and demand destruction and response. Meanwhile, Provider A assigned a single total transition risk score of –72.35%, which conveyed the underlying elements of operations and business model risk, scope emissions and “one price globally rising over time” for those emissions but did not break out the scores in these areas or how they contributed to the total transition risk score.
The two models are also less aligned when measuring opportunities from climate change. Provider A looks specifically at company patents to measure future opportunities, leaving patent-less First Quantum without potential benefits from climate change. Provider C’s valuation, in contrast, includes an expected +10.7% for increased demand for copper as the transition to electric vehicles continues and assumes +65.6% carbon cost passthrough for a total transition opportunity of +76.3%. When comparing the totals for net transition risk, Provider C assigns a net value at risk of +11.9%, versus –2.0% from Provider A’s more limited opportunity assessment. An active manager with fundamental knowledge of the company is likely able to reconcile these two evaluations to come up with a more appropriate appraisal of transition risk and opportunity.
The Importance of Personal Insight: Woolworths
We also studied the ratings from scenario-analysis providers versus our previously mentioned proprietary scenario analysis for Woolworths, an Australian grocery and supermarket retailer. Our team estimates that the physical risks from supply-chain disruption will be much worse than the estimates from third-party scenario-analysis models. In fact, the AB physical risk rating ranked High as opposed to Low for all four providers. One of our specific concerns is the potential for climate change to affect food supply, leading to high food inflation, which, in turn, could cause the government to limit the return on invested capital for grocers in order to protect consumers.
On the other hand, the scenario-analysis providers all ranked the transition risk for Woolworths as Medium to High, judging that the majority of carbon exposure for most companies comes from Scope 3 fossil fuel emissions (i.e., within a company’s supply chain, customers, etc.). Looking through the Scope 3 lens, a grocery chain’s massive number of suppliers and customers would cause a higher-than-normal value at risk. What those models did not include was the transition opportunity of more environmentally conscious consumers seeking more climate-friendly products, services and places to shop, which caused AB to rate the transition climate change risk for Woolworths as Low.
The Road Forward for Scenario-Analysis Models
These examples show that identifying and quantifying climate risk and opportunity through scenario analysis is difficult work. Trying to do so for an entire portfolio is fraught with even more challenges and opportunities for improvement. But scenario analysis is in its infancy, so substantial change is likely as data and models both become more sophisticated.
The push for better data is real. More countries and institutions have begun to require the inclusion of climate-change data and scenario analysis into public disclosures and reporting. UK regulators, for example, are phasing in this reporting, and it is expected to be required for UK-listed companies, pensions and investment managers by 2025. Australia and New Zealand already require asset owners to provide the information. And the same data are also starting to be required for corporate issuers. While the PRI won’t score signatories on compliance with this recommended practice for the next year or so, we believe that it is coming.
AB is combining the detailed company and sector knowledge of our analysts as well as our extensive issuer engagement on climate issues with the climate risk data available from third-party providers. We believe that this combination should generate better insight than relying solely on external climate-change data and should also provide stronger investment decisions and reporting to clients.
Understanding the discrepancies in this first generation of commercially available scenario analyses is the first step in developing better tools. We expect substantial improvements to models and data as asset owners press their investment managers for reporting that is significant, relevant and incorporated into investment analysis. Firms that actively engage early in this process can influence and shape the development of better models and can better prepare their portfolios and investors for the long-term risks and opportunities that issuers face from climate change in the years to come.