WTW has a long history of helping clients build diversified and robust portfolios for a variety of risks. One of those risks is climate change and we are actively developing products to help our clients manage climate transition risks by using financial metrics in portfolio construction.
WTW’s Climate Quantified Transition analytics are grounded in the way the transition will happen at a global level, helping portfolios align with a pathway to net zero for the world rather than just for the individual portfolio.
About 10 years ago, our team started to look at climate-related financial risk from the perspective of the investor. We looked at several methodologies but decided to go back to one of the fundamentals of finance - that the value of any asset is the net present value of the future cash flows generated from that asset over its lifetime.
We built our models around that fundamental principle, asset by asset, sector by sector while recognising that there is not one single transition but hundreds of them that vary by region and sector.
By looking at each individual business line, we can consider the impact of the transition on a company’s balance sheet not just today, but how it will evolve over the next 20-30 years. That helps us identify companies which might have high transition risk but with growth potential in other lines of business, say a hydrogen company that can switch from grey to green production.
WTW’s Climate Transition Value at Risk (CTVaR) is a new measurement to help investors identify, manage, and mitigate the financial risks of the transition to a low carbon global economy. Our methodology fits with how investors value assets in portfolio construction, so we are not bolting on anything that conflicts with their investment management process.
We are already applying this methodology to advise corporates on strategy, and governments on how to manage the economic transformation required to meet global net zero.
Other metrics are often emissions based, which are reported retrospectively. Although backward-looking, these types of metrics are typically attractive to the regulator in particular because we believe they are relatively simple to understand. Although a tonne of carbon is easy to quantify, the quality of reporting is too inconsistent to be reliable. For investors, carbon-based metrics do not reflect the actual financial risk that a business faces over a transition, nor can they capture potential opportunities. In our analysis, we see extraordinarily little correlation between carbon intensity and financial risk outside of high carbon sectors.
Under a transition, oil or coal demand might be lower. But we will not just see changes in high-carbon sectors where value decline is related to demand reductions and where a price on carbon might indicate risk as a proxy. For example, an equipment manufacturer that supplies the oil and gas industry might be at greater risk in a transition than the carbon intensity of its operations would imply. Also, it may have fewer options to diversify and adjust to a transition without significant capital investment which would require a change in strategy.
Conversely, lithium or copper miners may have high carbon emissions but a more positive cashflow outlook under a climate transition scenario because the transition to net zero will fail without these commodities that are required for renewables or battery technology.
Outside of commodities, we will see the growth of electric vehicles under a transition scenario, alongside different business models, such as car sharing. Other value chains will have to adjust to meet net zero targets such as meat or dairy consumption, that will affect land-use and agriculture. That is why we developed a second part to our modelling, and we now have 500 Climate Transition Controversies (CTCs). These are mini-scenarios that combine fundamental industry research with quantitative analysis to assess products and services other than commodities.
Our methodology combines 500 CTCs and 30 commodity models to consider what that means under the carbon budgets implied by different scenarios. We can look at more stringent goals to get all the way down to 1.5°C or we can look at ones that have delayed transitions either in specific sectors or regions. In reality, the transition is not a straight line to net zero even under relatively benign market conditions. But other factors, such as high interest rates and supply constraints have been intensified by Russia’s war on Ukraine.
CTVaR gives investors more flexibility to accommodate these macro-factors by looking at transition risk as a financial risk. The Climate Transition Index (CTI)1, an easier way for clients to access public equity markets, is just one of these applications. It is a low cost, but comprehensive strategy that enables you to potentially reduce your overall transition risk. It then allows you to allocate your remaining risk budget in the more active part of your strategy.
Many investors are trying to make progress towards net zero goals and meet new reporting requirements. We believe this strategy will work if there are predetermined decarbonisation goals because it is aligned with global net zero targets without being wedded to an annual 7% reduction2.
The CTI helps investors consider the risk in the portfolio, whilst also considering what it will take to generate the economic transformations required to transition.
This can be an ideal solution for clients that are invested in passive equities, but we also recognise that a lot of transition risk is embedded in sovereigns, state-owned enterprises and within fixed income. We have active programmes looking at transition risk in each of these areas.
In fixed income, transition risk can be hard to identify because we feel not much is going to happen in the next couple of years to affect the credit rating. But the longer the tenor, the greater the transition risk. Timing for the issuer and investor is essential.
We still have work to do, as we are constantly updating our models and developing new perspectives on climate transitions, as new technologies evolve, and markets change. Every quarter, we rebalance the weights of the companies in the CTI and incorporate new research or review a company if its strategy has changed dramatically.
CTVaR can also provide more sophisticated and granular insight for investors who want to engage with the companies in their portfolio – but it can also provide investors with a pathway to global decarbonisation rather than just for their individual portfolios. That is good for investors, their clients, and the planet.
1 Towers Watson Investment Services, Inc. (TWIS), may refer you to the STOXX WTW Climate Transition Indices and may receive revenue paid from STOXX. Please see link for additional background.
2 Decarbonisation trajectories for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks include at least 7% reduction of GHG intensity on average per annum.
David Nelson is a Senior Director within the Climate and Resilience Hub (CRH) and developed the methodology behind WTW’s Climate Transition Value at Risk (CTVaR) metric. Prior to joining WTW, David was the Senior Director of CPI’s (Climate Policy Initiative) energy finance program, based in London. CPI’s energy finance program collaborated with national and state governments, public and private firms, investors, and asset managers across the world. Before joining CPI, David worked as an investor and strategic advisor to energy and utilities companies and their regulators in Europe, Asia, North America, South America and Australia for more than 20 years. David has degrees in engineering from the University of California at Berkeley and an MBA from Wharton.
At WTW, we have a team of specialists within the Climate and Resilience Hub dedicated to understanding the impact that the climate transition will have on investors, corporates, and countries. Please get in touch for more information.
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In this special episode of a ESG series looking at the climate risks faced by insurers, we hone in on the transition risks arising from the shift to a low carbon economy.
