Integrating climate transition risk into investment portfolios

Climate change is a significant risk for investors, from the financial losses incurred from extreme weather events, the asset re-pricing in the transition to a low carbon economy to the use of law courts as a new instrument to enforce and accelerate climate change action.

Introduction

Climate change is a significant risk for investors, from the financial losses incurred from extreme weather events, the asset re-pricing in the transition to a low carbon economy to the use of law courts as a new instrument to enforce and accelerate climate change action. In this article we illustrate how we are integrating climate transition risk into our investment process and the implications from an asset allocation perspective. 

According to MSCI’s own measure, 20% of the MSCI All Country World Index faces asset stranding or significant challenges when it comes to the transition to a low carbon economy¹. At the same time, technologies to address climate change present substantial investment opportunities across all sectors and asset classes.

The traditional approach to assessing climate risk within an investment portfolio has been through carbon foot-printing. This involves identifying the concentrations of carbon across the investment portfolio. However, this approach has suffered from a number of short-comings. For example, it fails to capture information on changes in a company’s carbon exposure or strategy. In addition, the dataset suffers from inconsistent company disclosure and in particular low reporting of Scope 3 emissions, namely the indirect emissions that occur in the value chain of the reporting company.

The past few years has therefore witnessed increasing efforts to improve ESG and specifically climate-related disclosures through, among others, the EU Action Plan and the Task Force for Climate-related Financial Disclosures. As the market awaits a long overdue improvement in ESG and specifically climate-related disclosures, attention has turned to alternative and more sophisticated approaches to measure and manage both physical and transition climate risk within an investment portfolio. Not surprisingly, there is a rapidly developing ecosystem of data providers, asset owner initiatives and online platforms available to financial institutions that provide varying techniques that aim to integrate these risks into the investment process.

In this article, we examine some of the transition risk methodologies available in the marketplace. We provide details as to the approach we are adopting at DWS, namely the DWS climate transition risk rating. This seeks to identify the climate risks and opportunities at a security, sub-sector and sector level basis. This then allows us, among other things, to optimize a portfolio that not only reduces climate transition risk, but, also tilts investments towards entities that promote the low carbon transition.

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