Source: Fitch

Global investors apply increasingly sophisticated portfolio-construction techniques to stress-test the impact of a low-carbon economy on their investments, Fitch Ratings says. Corporate issuers with larger carbon footprints are under increasing pressure to decarbonise in order to maintain access to financing.

Portfolio managers have been moving away from simple screening, exclusion and engagement techniques, which limit their ability to invest in new securities of issuers generating a significant share (more than 10%, for example) of revenues from carbon-intensive operations, such as coal or oil and gas. As investment portfolios may already hold securities that breach these limits, some investors may have flexible policies that allow keeping such investments under certain conditions. Such conditions often require engagement with issuers to develop strategies to reduce exposure to polluting activities, such as credible decarbonisation plans or capital reallocation into low-carbon assets.

More sophisticated techniques include factoring in the impacts of sector and business model disruptions caused by climate-related drivers. Investors also forecast sudden shifts and changes in sector compositions and business models and their timing due to unanticipated climate policies and regulations, higher-than-expected carbon prices, and changes in investor sentiment and consumer preferences. This analysis shows how such changes may affect the profitability, liquidity, solvency and refinancing risks of issuers. These portfolio-level approaches help the investment industry mitigate long-term, transitional, and physical climate risks.

Climate risk is increasingly integrated into credit analysis. Climate risk assessments tend to be more qualitative than quantitative as emissions data is based on previous years and is incomplete. The in-depth understanding of an issuer’s business strategy, its relative positioning amongst its peers and its industry’s current and future regulatory and technology environment shows how climate-related issues might materialise. Investors may assess issuers’ ESG-related governance, strategies, risk management, metrics and targets. Investors will recognise and reward issuers with strong ESG management and reporting, especially those within sectors with high climate-risk exposure.

Pressures on corporates to decarbonise increasingly comes from the banking sector. Stakeholders and regulators force banks’ senior management to look more carefully at bank customers’ carbon footprints and assess how they fit in with their public carbon-reduction targets. Many leading banks have already made public commitments to achieve net-zero targets throughout their entire value chains, including Scope 3 emissions coming from their counterparties, such as borrowers, in line with Paris Agreement timeframes.

Insurers around the world are also implementing decarbonisation plans for their investment and underwriting portfolios. Their carbon phase-out strategy will allow their investment portfolio to hold issuers that adjust their business model and replace their carbon-intensive assets with low-carbon assets over time.

Mounting pressure and closer scrutiny from various finance stakeholders spur implementation of emission-reduction strategies and tightening of decarbonisation targets in the corporate sector. These include the use of more efficient and cleaner technology and equipment, divestments of most polluting activities and investments into low- or zero-carbon operations. European companies have been under most pressure, but other regions are gradually joining in. This includes China, which announced last year its net-zero commitment by 2060, and the US, which re-joined the Paris Agreement in February.