Climate Change Is An Existential Threat – Finance Professionals Must Rise To The Challenge
Climate change may be the most impactful event in human history, socially, physically and economically. India is already seeing the impact of climate change first-hand, through extreme weather events such as floods, droughts, and heatwaves. An IMF study in 2019 estimated a 2.6% decline in India’s per capita GDP by 2100 if global warming is limited to 2°C above pre-industrial levels, and as much as 13% in an unmitigated scenario.
Lack of awareness is not an issue at least among affluent Indians; a Yougov international online poll conducted last year showed Indians were most likely among all countries to think human activity is the main reason for climate change, at 71%.
Unfortunately, the finance profession is for the most part behind the curve in analysing its effects, even though climate change is beginning to get priced in by capital markets. A 2019 study by Bolton and Kacperczyk showed the carbon emissions had a statistically significant impact on stock returns of US listed firms. Another study, using data from the Carbon Disclosure Project, showed that the cost of out-of-the-money put options - which reflects the risks of extreme, low probability events materializing - were higher for firms with carbon intensive business models, suggesting that markets factor in carbon risks.
To understand how climate change is included in the investment process, we surveyed our global investment community of CFA charter holders on the topic, including our members in India. When asked whether it is important to have a definitive view on climate change to effectively manage investments today, 75% of senior-level respondents in the C-suite said it is important or very important. However, only 40% of the global respondents and 34% of Indian respondents said their organization incorporates climate risk in the investment analysis. The gap between intent at the top and implementation comes down to the lack of data and measurement tools; more than half our global and Indian respondents cited lack of data and measurement tools as the primary reason their firms are not incorporating climate analysis, ahead of lack of client demand. Interestingly, 26% of our Indian members said their clients want more information and disclosures around climate change, indicating a small but meaningful appreciation of climate risks.
As climate change becomes more prevalent, more pressure will be placed on all stakeholders, including policymakers, companies, regulators, and financial professionals, to take concrete actions that address climate change. CFA Institute believes a price on carbon emissions that considers the negative externality of climate change incentivizes economies to move away from burning fossil fuels. Indian government already imposes significant taxes on petrol and diesel – estimated around $140 and $60 / tonne of CO2 respectively according to the government’s own calculations in 2015 – compared to the recommendations of $40-$80 in 2020, and $50-$100 in 2030 put forth by the Stern-Stiglitz Commission on carbon prices. But removing distortions elsewhere while balancing development objectives would burnish India’s green credentials further.
Climate disclosures by companies have been lacking globally, and India is no exception. However, proposed changes to business responsibility and sustainability reporting (BRSR) would result in a meaningful improvement in disclosures and comparability of Indian companies. Among others, BRSR would require companies to report their total scope 1 and 2 emissions, renewable energy usage, and provide description of initiatives towards a low carbon economy — all of which would be important and decision-useful for investors and financial professionals.
But investors and financial professionals need not wait for perfect information. We recommend analysts to start factoring expected carbon prices into their financial analysis so they can be prepared for a world with more-explicit carbon pricing. Analysts could also run scenario analysis of how companies in a climate sensitive industry might be impacted by expectations under future regulations. They could start taking advantage of climate scenario analysis tools such as Paris Agreement Capital Transition Assessment (PACTA) developed with the backing of UN Principles for Responsible Investment.
As an illustration, we uploaded an equal-weighted portfolio of 3 Indian companies – an oil & gas major, a utility company and an automobile manufacturer – whose businesses will all be affected by transition to a low carbon economy, into the PACTA analytics tool. The tool uses data on companies’ current production and investment plans, and models if the future mix is aligned with 2° goals. As the graphs show, the 2025 production mix for the oil & gas major based on investment plans (first bar) has a negligible share of oil, which is less than the expected fuel mix aligned with the 2° scenario (second bar), let alone the expected fuel mix for the region as a whole. Similarly, the automotive major is projected to have a smaller share of hybrid and electric vehicles in its mix than what is expected under a 2° scenario, and more aggressive investments might be necessary.
Climate change analysis is novel, and not always straightforward. CFA Institute recommends investors and finance professionals familiarize themselves with the TCFD and SASB standards, which are increasingly framing the conversation around climate-related disclosures. Finance professionals must continue to educate themselves in order to provide the climate analysis their clients deserve. They must be prepared to engage with companies and policy makers to ensure investors have the data and tools they need to do the work of finance – i.e. an efficient allocation of capital that helps to tackle the existential threat of climate change.
