Transition risk for resilience, not just Net Zero

Alignment of portfolios with Net Zero targets can lead investors to focus too heavily on carbon-based metrics in the short-term.

Just because a company reports lower carbon emissions, does not mean it is aligned with the necessary transition to keep warming below 1.5^°C, e.g. a service provider whose client base is not aligned with the transition. And many high carbon emitters may actually be part of the solution, helping to significantly reduce their emissions.

Software or equipment companies that supply to the oil and gas industry would be one such example where “carbon risk” might not show up on their balance sheet, but their transition risk via a client base in a declining industry would nevertheless be high. The same could be said of low carbon emitters that will be significantly negatively impacted by required transitions outside of the most obviously impacted industries, such as a change to eating habits. A simple carbon metric might also not capture upsides of the transition, such as a software company that supported the renewables industry.

Craig Baker, Willis Towers Watson’s Global Chief Investment Officer, started the panel discussion by pointing out that this misunderstanding of the real nature of risk was one of the biggest barriers to achieving Net Zero targets. “You miss the true risk you are running if you just focus on carbon intensity. We need more focus on financial risk.”

“Potentially, it can starve the hard-to-abate industries and countries of capital when those are the ones most in need of capital to make the required transition. A focus on carbon also says very little about the financial risk being run in the portfolio.”

Arun Singhal, Qontigo STOXX Global Head of Product Management discussed the market landscape and acceleration of sustainable products being brought to market. Using the ETF market as proxy for index-based sustainable solutions, he noted, “We have studied the global ETF market of over 6,000 ETFs and classified over 500 to be sustainability focused. The majority, if not all climate solutions within the sustainability category, focus on carbon reduction.”

“We strongly believe there is an investor need for solutions alongside carbon reduction to understand the financial exposure to the transition. The STOXX Willis Towers Watson Climate Transition Indices are first to market to provide a systematic, transparent index series which captures financial risk through analysing the bottom-up security level impact of the climate transition.”

A focus on carbon has resulted in some crude decisions, Lord Adair Turner, Chairman of the Energy Transitions Commission, noted. He gave an example of a bus company that was being sold by investors just because it was a high carbon emitter, even though it helped get people out of their cars.

In his view, the biggest challenge to the transition to Net Zero is that there will be diverse winners but concentrated losers. “A lot of people will gain, not just from the avoided climate harm but economically from the transition to a zero-carbon economy,” said Lord Turner.

“Some people will lose – people who sit on fossil fuel assets or people who are in particular forms of employment which are going to change. It is always very difficult politically to engineer change when you have diverse winners – lots of people who are gaining a small amount, and a small number of people who are losing a significant amount. We have to find ways to overcome that -- either by financial engineering or public policy.”

David Nelson, Executive Director of Climate Transition Analytics at Willis Towers Watson’s Climate & Resilience Hub, said that the company was well placed to quantify transition risk given its expertise developed over decades in pricing risk, quantifying losses and natural catastrophe modelling. The detailed work on transition risk “would take years for anyone else to catch up with” because the CTA platform examines the impact of transition risk on more the 30 commodities, with 450 additional factors, called climate transition controversies, that cover everything from the plastics industry to the food we eat. All of this information is applied across more than 7,000 equities.

“In reality, there is not one transition, there are multiple transitions – in different sectors of the economy and regionally,” he said. “Currently, the challenge is that policy is lagging investment and this gives the market and policymakers the false impression that we are in fact already on the path to Net Zero, whereas we are already living through a disorderly transition.”

“Neo classical economists tend to think markets have perfect information – in the real world it requires work and people to find out the information,” said Lord Turner. “The index will be a good thing to buy as long as you believe in this transition. If, however, there is simultaneously political change and we have climate change deniers in power then the index will be a poor investment. The evil person will short this whilst investing big time in fossil fuels – that’s why we need the political will to make it work.”

Bruce Duguid, Head of Stewardship, EOS at Federated Hermes, believes it’s important not just to “steward” the easy assets. He said he’d noticed investors’ “carbon challenge” with mining companies that would have a good transition pathway because of other commodities in copper and nickel that will see increased demand as the world decarbonises. “The biggest opportunity here is stewardship”, he said. “It has to be stewardship not divestment. Divestment will never be a big enough force to drive change.”

Following COP26, investors and product providers continue to assess opaque and fragmented regulation to develop implementable solutions aligned with net-zero targets and accelerate the ambition to meet those targets sooner than 2050.

But one of the strongest emerging narratives is around the need to shift gears from aligning financial flows with Net Zero. Rather, the goal should be to align with the ‘resilient’ transition – that way we can make sure emissions reduce globally, not just at the portfolio level, while including some of the harder political issues such as a ‘just’ transition, where the concentrated losers are not left behind by the diverse winners.