Net-Zero Alignment: Managing Portfolio Risk Along the Net-Zero Journey (MSCI) 12 May 2022
This paper from MSCI examines the challenges presented by both climate change and the net-zero transition to investors looking to measure and manage climate risk in their portfolios. Effective management of climate risk requires a clear understanding of its multifaceted nature.
Broadly speaking, climate risk can be broken down into physical risk and transition risk, and it can impact companies and investors via both microeconomic and macroeconomic transmission channels. The transition to net-zero depends on many factors: policymakers’ decisions, the development and economic feasibility of green technologies, investors’ attitude toward climate risk and net-zero investing and consumers’ sentiment toward low-carbon consumption. This and the long horizon mean that investors face an elevated level of uncertainty when making investment decisions.
One approach is to undertake forward-looking scenario analysis, in which various outcomes for uncertain factors such as policy decisions and the development of green technology can be explored, along with their financial impacts. This is becoming a standard tool for climate risk analysis, supported by major organizations such as TCFD.
In this paper, the MSCI Climate Value-at-Risk (Climate VaR) metric is used to examine climate risk in a set of hypothetical portfolios and explore a few strategies to reduce that climate risk. A second approach could be to incorporate a carbon-emission factor in equity risk models to help quantify the impact of emissions on portfolio returns.
As more investors begin to consider the risk of climate change when making investment decisions, financial markets may see a reallocation of capital from carbon-intensive to carbon-efficient investments — and companies’ emission profiles may emerge as a systematic driver of equity returns. Although climate risk management is not yet widespread among investors or fully standardized by regulation, industry trends are pointing in this direction. Investors may therefore wish to be aware of existing approaches for measuring and managing climate risk.
This report was originally published in https://www.msci.com/www/research-paper/net-zero-alignment-managing/03147524351
