Managing Climate Risk in Equity Portfolios: A Case Study

• We considered how climate-related risks affected a “typical” actively managed portfolio, drilling down to different types of risks arising from the transition to a low-carbon economy and physical climate change.
• We selected a sample portfolio, using the Lipper universe of global actively managed developed-market funds. We examined four ways of mitigating climate risk by using simple exclusion strategies.
• Our analysis indicated that our sample portfolio’s exposures to both the transition and physical climate risks could have been meaningfully reduced with little effect on risk/return characteristics.

Institutional investors are increasingly focused on mitigating their climate-related risks.¹ New risk tools can help them better measure those risks. How could such tools be used to help manage climate risk, and what could the impact be on a portfolio’s risk/return profile? We approached this question through a simple case study.

Selecting a Sample Portfolio

We began by selecting a sample portfolio. We wanted this portfolio to reflect that of a “typical” actively managed fund, so we selected a fund that had a five-year return and historical annualized volatility in line with that of the median global developed-market fund in the Lipper database, as of December 2019.²

Measuring Climate Risks

There is no risk management without risk measurement — so the next step was to measure climate risks in this sample portfolio.

To do so, we used MSCI ESG Research’s Climate Value-at-Risk (Climate VaR) scenario-analysis model and calculated the potential impact on portfolio valuation of a scenario consistent with a 2-degree-Celsius (2°C) temperature rise by 2100, coupled with an “aggressive” scenario for physical risk.³ The exhibit below shows an overview of the sample portfolio’s Climate VaR. It assumes the portfolio had USD 100 million in assets.

Transition and Physical Climate Risks’ Potential Impact on the Sample Portfolio 

Assumes a portfolio of USD 100 million. Source: MSCI ESG Research LLC

The aggregated Climate VaR was -7.75%, which means that, under the scenarios considered, climate risks and opportunities could have resulted in a USD 7.75 million decline in the portfolio’s value.⁴

This potential decline can be broken down between transition risks (-0.59%) and physical risks (-7.16%). Further breakdowns are shown in the exhibit above. For example, policy risks contributed substantially to the portfolio’s transition risks (-4.43%), but those risks were in great part offset by transition opportunities (+3.83%). This offset is consistent with the concept of “winners” and “losers” in the transition to a low-carbon economy: The portfolio companies included were engaged in a diverse mix of activities, explaining the downside and upside transition exposures. On the physical-risk side, coastal flooding and extreme heat would have contributed the most downside risk (-6.15% and -1.44%, respectively). Other hazards, such as extreme cold, were in fact associated with a positive impact on the portfolio’s valuation (+0.22%), because the number of days with freezing temperatures were, on the balance, expected to decrease at the locations of portfolio companies.

We also observed that the companies contributing most to climate risks were those active in the materials and real estate Global Industry Classification Standard (GICS^®)⁵ industry groups, as well as those companies with operations in the U.S., China and Canada (see our paper for details).

Managing Climate Risks

After breaking down the sample portfolio’s climate risk, we could then explore ways to potentially manage these risks. To do so, we tested four simple exclusion strategies, each time excluding from the portfolio bottom-decile companies by the following climate-risk measures:⁶

1. Aggregated Climate VaR (combination of transition and physical Climate VaRs)
2. Transition Climate VaR
3. Physical Climate VaR
4. Carbon intensity

We created four new hypothetical portfolios (A through D) that we could compare with the original sample portfolio.

The exhibit below shows the impact of these exclusion strategies on the sample portfolio’s climate risks.

Climate-Risk Impacts of the Different Exclusion Strategies

Source: MSCI ESG Research LLC

It was immediately apparent that the simple exclusion strategies had a very substantial impact on the measures of climate risk. For example, strategy A reduced the aggregated Climate VaR by 74% (from -7.75% to -2.04%), and strategy D reduced the weighted average carbon intensity (WACI) of scopes 1 and 2 by 89% (from 185.87 to 20.67 tons of CO² emissions (tCO²e)/USD million of sales). Such large declines in climate risk indicate that the bulk of the risk was concentrated in a handful of stocks.

We also explored the potential impact each exclusion approach might have on the sample portfolio’s risk/return characteristics, comparing the five-year simulated performance of the strategies, as shown in the exhibit below.⁷

Risk/Return Impacts of the Different Exclusion Strategies

Source: MSCI ESG Research LLC

Interestingly, the traditional risk/return characteristics remained largely unchanged: All strategies had five-year simulated annualized returns in a narrow range, with all but the aggregated approach slightly exceeding the original sample portfolio. Volatilities were slightly below that of the original portfolio, with tracking errors all approximately 1%.

Implications for Portfolio Managers

Can climate risk be mitigated in equity portfolios without disturbing the underlying risk and return characteristics of the portfolio? This case study applied only to a single portfolio and thus cannot be readily generalized, although research by MSCI and others provide other possible risk-mitigation scenarios.⁸ It is still early days in terms of limiting climate risk within equity portfolios, but this type of research offers a promising vein for the future.

¹Krueger, P., Sautner, Z., and Starks, L.T. 2018. “The Importance of Climate Risks for Institutional Investors.” Swiss Finance Institute.

²We started with all global funds available in the Lipper database, selected all the funds that were at least 75% invested in equity and filtered out funds with assets under management below USD 1 million or above USD 500 billion. We also filtered out funds with more than 15% exposure to emerging markets. Finally, we excluded funds with a very large or small tracking error against their benchmark (around 5% of the universe) and funds with “index tracking” in their name.

³MSCI Climate VaR uses a range of different transition scenarios, which are differentiated by (among other factors) temperature targets by 2100 and the “pathways” to achieve such temperature targets. We also use scenarios from different integrated assessment models and other climate models to include a diversity of approaches and assumptions. In this example, we use a 2°C transition scenario produced by the AIM/CGE 2.0 integrated assessment model and an “aggressive” physical-risk scenario based on the 95th percentile of adverse changes in extreme-weather events under the climate-change scenario known as representative concentration pathway 8.5.

⁴The monetary contribution is calculated as the product of the Climate VaR contribution and the portfolio value.

⁵GICS is the global industry classification standard jointly developed by MSCI and Standard & Poor’s.

⁶For Climate VaR, the “worst” performers were those companies with the lowest Climate VaR (which in many cases means the most negative Climate VaR). For carbon intensity, the “worst” performers were those with the highest carbon intensity. Carbon intensity is defined in this analysis as the amount of scope-1 and -2 greenhouse-gas emissions, in tons of CO² equivalent per USD million of sales.

⁷We use a five-year simulation period based on the availability of historical data. This report may contain analysis of historical data, which may include hypothetical, backtested or simulated performance results. There are frequently material differences between backtested or simulated performance results and actual results subsequently achieved by any investment strategy. The analysis and observations in this report are limited solely to the period of the relevant historical data, backtest or simulation. Past performance — whether actual, backtested or simulated — is no indication or guarantee of future performance. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.

⁸See, for example: Badani, J., Doole, S., Kumar, N., and Shakdwipee, M. 2019. “Climate change and climate risk: An index perspective.” MSCI Research Insight; Andersson, M., Bolton, P., and Samama, F. 2016. “Hedging Climate Risk.” Financial Analysts Journal.

Further Reading

Managing Climate Risk in Investment Portfolios

How can active managers put ESG to work?

Foundations of ESG Investing

Deconstructing ESG Ratings Performance

Climate change and climate risk: An index perspective

MSCI ESG Climate Data & Metrics