Moving a step beyond grading a company for its carbon footprint, Morningstar announced a new tool on Tuesday to assess the carbon risk of a mutual fund portfolio. Carbon risk, or transition risk, is different than carbon footprinting, which basically is the physical measure of the amount of carbon a company produces. Carbon or transition risk “addresses how vulnerable a company is financially to the transition away from a fossil-fuel-based economy to a lower-carbon economy,” said Jon Hale, Morningstar director of sustainable investing research.
Portfolios that have a low exposure to carbon risk and low levels of fossil-fuel exposure will receive Morningstar’s Low Carbon Designation, a badge so to speak, so investors can quickly identify the funds. The measurement already is live on the Morningstar website.
Morningstar already included carbon footprint designations in its funds, but then Sustainalytics, the company it worked with, suggested an advanced way to measure funds beyond just the carbon footprint. Carbon footprinting “doesn’t tell how much more value is at risk for a company with a high carbon footprint,” and Sustainalytics said it was working on a new level of risk, Hale told ThinkAdvisor. “It’s an advance on carbon footprinting.”
“It’s interesting to contrast [transition risk] with physical risk, which is much more idiosyncratic,” Hale said. “Virtually any public company could have some exposure to climate change through physical risks they might face; it’s almost more about the impact climate change has on specific aspects of their business. Those are things like, where do they do their business, such as in vulnerable areas that are subject to huge weather events, or episodic events, that a catastrophic, or ongoing, like rising sea levels. Or if you’re in the insurance industry, are you insuring areas like that?”
He notes one company that mines salt for de-icing was concerned about the volatility of winter weather. “They can’t predict as well [now] from one season to the next on the demand for their product; those are all physical risks.”
However, says Hale, transition risks take into account the “financial materiality” of a company’s carbon-risk exposure, or its actions and strategy to manage such risk.
“Bottom line: [With] carbon risk, you could have two companies with the same level of emissions,” Hale said. “One company already has been taking action and has a clear-cut strategy in place for how to reduce emissions, and the other doesn’t. So in our new categorization, the one that’s taking action will get a better risk score than one that’s not.”
Hale points out that large-growth funds typically have better carbon-risk scores than value growth funds. In his paper, “New Tools to Assess Carbon Risk in a Portfolio,” he found that U.S. large-value funds devote more than 20% of their assets to the three sectors with the highest levels of carbon risk: energy, utilities and materials. However, large-growth funds have less than 10% invested in those sectors. Further, while large-value funds were only 6.4% weighted in technology, one of the lowest carbon-risk profile industries, large-growth funds had a 17.8% exposure to it.
In addition, diversification was a key ingredient to healthier carbon-risk scores. Developed-market funds focused on Europe ex U.K. had the lowest scores, while Asia ex Japan had the highest, Hale found.
“Part of that comes down to the economic sector and how big all those [factors] play in your economy,” Hale said. “There’s a lot of material manufacturers based in Asia that are higher in carbon risk on the whole. But European companies have started to react to the need to reduce emissions more quickly because regulations are more apparent there.” U.S. funds are on average more diversified and invested in big sectors, like technology, Hale added.
Hale doesn’t see the current U.S. administration’s politics slowing the drive to reduce carbon emissions. “Companies look at the big picture,” he said. “We’re in this transition to a lower carbon world and they want to position themselves as lower carbon companies, no matter what,” he said. “Maybe some carbon regulation will be delayed in some countries, but there’s also a sustainability ethos that seems to be building in a lot of global corporations. They are saying, ‘Yes, we want to contribute to the solution to climate change rather than continue to be part of the problem.’”
— Check out Why Responsible Investing Is Not Limited to ESG on ThinkAdvisor.