For investors, transition risk management has notably shifted. It is no longer enough for an investor to know if a company has made a net-zero commitment and whether the target has been approved by the Science Based Targets initiative.
Investors are now applying sophisticated evaluation frameworks to help them better understand the actions companies are taking towards reducing greenhouse gas (GHG) emissions, which is best demonstrated by the broad global adoption of the IIGCC Net Zero Investment Framework.
As investors take a more granular focus, they still face challenges when assessing transition risks in their portfolio due to the very nature of uncertain future outcomes.
There are many views in the market about which climate change scenarios should be leveraged, and no shortage of criticism for the many existing climate models. However, it is critical to remember that climate change pathways are not about precisely predicting the future, but about understanding the range of plausible outcomes to support better-informed decisions.
By assessing company performance against different climate change scenarios, an investor can begin to understand the magnitude of potential risk, identify highest risk holdings and inform engagement strategy.
Three universal steps
While we cannot predict the future with absolute certainty, it is important for investors to gauge companies’ direction of travel. Regardless of what decarbonisation pathway is used to benchmark company performance, there are three universal steps investors could take to orient their transition risk management process towards action.
First, it is imperative to locate transition risk by comprehensively understanding the entire impact of a company’s value chain, considering all Scopes of GHG emissions.
This entails identifying specific points within the value chain where the company is particularly vulnerable to transition risk. On average, Scope 3 emissions account for approximately 60% of a company’s overall GHG emissions footprint. This means that emission reduction strategies for both Scope 3 upstream (supply chain) and downstream (product use and disposal) emissions have the potential to have the highest absolute impact on reducing real world emissions and a company’s transition-related climate risks.
Large institutional investors, such as Norges Bank Investment Management, are asking companies for “science-based short-term, medium-term and 2050 net zero targets and credible transition plans covering Scope 1, Scope 2 and material Scope 3 emissions”. Companies are responding, for example, Telefonica Brasil has identified that the bulk of its emissions come from its supply chain. To address this, it has set clear Scope 3 targets including achieving net-zero emissions by 2040. Its board has endorsed supply chain emissions reductions policies and the company has set clear targets for its suppliers to set emissions reduction targets covering Scope 1, 2 and 3.
Second, investors should size the gap by comparing projected future emissions with decarbonisation pathways. This analysis helps determine the extent to which a company needs to reduce its emissions to align with net-zero commitments.
A company’s net-zero budget will be different depending on the sector and country of operations. For example, Tata Steel is allocated a net-zero budget of 479,143,797 Mt and ArcelorMittal 270,998,284 Mt as part of Morningstar’s Low Carbon Transition Rating.
Last, investors must evaluate the actions taken by the company to address the identified emissions gap. This involves assessing the company’s commitment to emission reduction, such as the use of internal carbon pricing in decision-making, the linkage of CEO remuneration to emissions reduction or broader climate-related targets, and the company’s engagement with tier 1 suppliers, including requirements for their own GHG emissions reduction targets.
Our research has found that telecom services, utilities, household products, automobiles, and construction and engineering are the industries with the highest proportion of companies with strong management scores.
Through these steps, investors can proactively manage transition risk and make informed decisions in support of sustainable and environmentally responsible investments.