Accounting for Climate Exposure

I have a confession to make—two years ago, I didn’t care about climate change. As an oil and gas analyst at a mainstream fixed-income investment firm, I was obsessed about short-term oil prices and turmoil in the Middle East. The concepts of stranded assets, divestment, and global warming were long-term issues that I thought were best left to the environmentalists and impact investors. I thought I didn’t need to care unless something might happen in the next six months.

Over the past year, though, my work as a research fellow at Stanford’s Steyer-Taylor Center for Energy Policy and Finance has led to an awakening of sorts. Separated from the constant overhang of short-term performance measurement, I explored the potential impact of climate change on publicly traded investments, only to realize that climate change is having an acute impact now. When investors broaden the definition of climate change impact to include any potential gains or losses to a portfolio related to climate change—called climate exposure—the real-time impact of climate change becomes immediately apparent. An investment’s climate exposure includes elements such as energy efficiency, the increase in frequency and severity of adverse weather, and the costs of adapting to and mitigating those elements. Active asset managers—investment managers who seek to develop portfolios that outperform a benchmark investment index, such as the MSCI World Index—need a competitive edge; integrating this broader consideration of climate into the investment process can provide it, for managers willing to do the work.

Active asset managers often use combined ESG (environmental, social and governance) metrics as a shortcut to incorporate qualitative or long-term issues into investment decisions. But bundling environmental data together with social and governance data misses opportunities afforded by a separate, expansive, and near-term-focused perspective on the climate. For example, Wal-Mart typically scores low on social and governance scales, but its climate exposure profile outshines peers like Costco thanks to its renewable energy program, low carbon emission impact on financials, greater geographic diversity, and a stronger disaster preparedness plan. An active manager who analyzes climate exposure could outperform by buying Wal-Mart if climate legislation changes, energy prices rise, or adverse weather strikes certain regions.

I recently published a paper detailing a new tool that I developed called Relative Climate Value (RCV) that is designed to help investment managers respond effectively to the effects of climate change and shifts in environmental legislation. Essentially, RCV separately analyzes the financial impact of climate exposure elements on different equities so that active managers can react quickly to changes in external drivers. In the paper, I use RCV to examine the impact of climate exposure events such as drought, carbon tax implementation, and severe weather on two representative sectors—auto makers and hypermarkets like Wal-Mart and Costco—and recommend investment decisions for each event. Using this approach, an active manager can react quickly to adverse weather or changes in carbon taxation based on the relative impact the event will have on different sectors.

Of course, a lack of compelling data can make it challenging to incorporate climate exposure into investment models even when the potential impact seems clear and near-term. For example, most equity analysts write off weather as an unpredictable variable. But last winter, I calculated equity valuations for Vail Resorts, Inc. using statistical analysis to predict revenue and expenses for the company under different snowfalls. I also incorporated the impact of climate change mitigation and adaptation activities, such as increasing energy efficiency and snowmaking costs at the company’s resorts. I found that a traditional equity analysis of Vail—the largest publicly traded ski resort in the United States—would overvalue the company by almost 14 percent by not considering climate exposure elements such as a long-term decline in snowfall and increased snowmaking costs.

Mainstream, active investors are not the only beneficiaries of better climate exposure management—corporations, impact investors, and foundations can also benefit from broadening their consideration of climate change within investments. When climate-related adversity occurs, corporations that are more resilient in the face of climate change will outperform less-prepared peers. The RCV model and the Vail case study demonstrate how companies with more effective disaster planning, higher renewable energy usage, lower resource utilization and stronger mitigation and adaptation efforts experience lower relative equity price impact from adverse climate events. By integrating climate exposure into investment decisions, impact investors and foundations can achieve both outperformance and social impact while also rewarding these climate resilient companies with a lower cost of capital.

Recently, I asked a colleague from the mainstream investment management industry about the need to think about climate exposure in investments. Her response was blunt: “I’ll care when somebody makes me care.” Perhaps this study of Vail and the RCV will help convince this skeptic and many others that it’s time for corporations and investors to care.

Read more stories by Donna Bebb.