Climate and Extra-financial Risk

november 2018

Evaluating the risks of energy transition, climate risks and responsible and sustainable investments is a new issue for financial markets. 

Extra-financial risks have always existed but have never been calculated accurately. They encompass environmental, social and governance risks. For the past ten years, some companies have been integrating them under the name of CSR (Corporate Social Responsibility) which completes the balance sheet publications and other financial statements.
For several years, the international indicator ESG (Environment, Social, Governance) has increased in renown and aims to integrate dozens of qualitative and quantitative criteria respecting many standards and the involvement degree of companies to take into account the energy transition risks, physical / climatic risks, respect for the environment, some social aspects as well as their governance.
The resurgence of climatic problems, the rise of people’s interest to live in a sustainable economy / a fairer society and the multiplication of international summits reflecting the involvement of the world of finance to intervene on this issue.

Graphique indicateur

Following the Paris Agreement on Climate Change (COP21), France has become a pioneer in the development of greener growth through the law n°2015-992 of August 17th, 2015 relative to energy transition. This law sets the objectives of a new French energy model and supports green growth by reducing France’s energy bill through the development of carbon-free energies.
In particular, Article 173 sets out the obligation for institutional investors to publish transparently their integration of ESG criteria, their participation in the energy transition and the mitigation of climate change for their investment operations in their annual report.

The extra-financial risk indicators of a portfolio

Many international organizations have presented relevant indicators to measure all climate risks or E, S and G criteria. Among them, the TCFD Task Force on Climate-related Financial Disclosure* regularly publishes recommendations to that effect. They are followed by various extra-financial data providers who provide investors with numerous indicators (between 100 and 400 per company).

Whether for the ESG** indicator, the carbon footprint, the brown activity rate, the level of involvement in strong controversies** or ethically controversial activities**, calculations are made on the basis of information provided in company annual reports, various publications from companies, authorities, media, judiciary, through direct calculations, estimations by statistical models or extrapolations by activity sector.

As a result, these indicators reflect the corporate transparency level and their willingness to disclose the information needed to calculate these indicators. However, there are some constraints in using this raw data. Wrongly / poorly / not transmitted information generates indicators with a biased score.
Investors also need the universe covered by data providers to be maximized and they take into account tens of thousands of listed companies to obtain an interpretable and reliable result.
The funds structures in which these indicators are calculated are sometimes complex or multi-level, that requires extensive research and development work.

Today, the climate risk calculation and the alignment of investment with green and sustainable objectives is supported by increasing regulation. Some asset managers and some countries just begin to use these criteria respectively in their investment and regulatory choices, believing that the extra-financial risk will be far more important in long term than the stock market fluctuations and economic cycles.

Ultimately, the idea is to be able to anticipate risks through Value At Risk and Climate Stress Test (for example, stress testing the impact of a carbon tax on a portfolio of assets). The underlying idea is also to disinvest risky assets or to cover these risks in one way or another (derivatives…).

Funds or asset managers have now the obligation to report on these indicators and the actions they intend to put in place to improve them, as for a credit rating. This need therefore requires some investment for asset managers (data providers, reporting management).

At the same time, continuing to invest in companies that stand out by non-compliance with certain criteria can scare away investors and endanger these funds.

By avoiding the risk of investing in risky businesses (nuclear, coal, fur), with social aspects too low (employees suicide rates, male-female parity), weak governance (establishment of management, lack of committee of audit), which does not take into account the energy transition risk (energy mix diversification, coal shutdown) and continues to operate in hazardous areas (flood zones, cyclone zones), profitability should be more stable over the long term (lower volatility and more robust performance).

The extra-financial risk will ultimately become a major financial risk and will have to be taken into account by portfolio managers. Within a few years, the correlation between extra-financial and financial will be better measured, understood and considered.

The advent of Responsible Finance

New generations care about the state of the planet. This subject has become major even if it only represents the beginnings of a change that is intended to be much more important.
If investors and asset managers want to limit the impact of climate effects that are increasingly felt and if standards in this area are increasing, then yes, we are slowly entering the era of responsible finance. This finance will profoundly change the economy as we know it in the medium term since the divestment of companies that do not make efforts will force them to revise their economic model. But for that, standards must be better defined, imposed and be the same for everyone.

Today, there are several certifications and labels to identify responsible and sustainable funds. We can, for example, quote the SRI (Socially Responsible Investment) label and the TEEC label for “green” funds (Energy and Ecological Transition for Climate). Nevertheless, it will obviously be necessary to pay attention to the effective investments of the funds certified by these labels and to remain attentive to the “green washing”.

Les risques climatiques et extra financier

Finally, the current change in our way of consumption and our economic system must necessarily be undertaken by political actors (for its structuring) and economic actors (for its application). Studies estimate that 70% of today’s students will have a job that does not exist yet. Many opportunities will be created in the area of climate risk and extra-financial performance measurement, especially in market finance. Moreover, new positions combining knowledge of financial products (analyst, quant), statistical calculation and measurement of environmental, social and governance indicators are already emerging. Making the link between the highly technical professions of finance and more human aspects (social, governance) can only bring more sense to financial professions that can sometimes be sorely missed.

Next steps in extra-financial reporting

Today, the non-financial reporting market is not mature and little standardized. There are many company data providers that apply different algorithms. The diversity of financial products makes it difficult to calculate a single indicator that can be used to understand the direction / risk of a portfolio or investment strategy. How to differentiate / assimilate the risk of a bond, a stock, a sovereign debt, a convertible bond or a derivative?

Europe must standardize the future of extra-financial reporting in the coming months and the Basel Committee should meet on this subject for the next directive to be issued in the coming years; all financial actors will have to follow their recommendations.
The United Nations has issued its own SDG recommendations (Sustainable Development Goals) that should apply to countries with clear targets set for 2030. These goals are being adapted for companies that are starting to report on these 17 defined sustainable development goals.

In conclusion, climate change is not a fashion trend but an international willingness to repair the planet we are progressively destroying. This historic effort must involve all economic actors and finance will be a driver to act quickly and respect the time constraints set at international summits. Many new jobs should emerge in this field in the short term as that of R&D Analyst.

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