Morningstar Magazine - June/July 2018 - 80

Strategies

New Tools Assess Carbon Risks
in Portfolios
The transition to a low-carbon economy
poses risks investors should understand.

exposed to carbon risk. While a portfolio's
exposure to fossil fuel is a major component
of its carbon risk, a much wider range of industries,
approaching half the overall market cap by
some estimates, have exposure to carbon risk
through trends such as the shift to renewables or
electric vehicles. A carbon-risk assessment
can provide information on overall risk exposure
and where in the portfolio the risk is located.
Measuring Carbon Risk

INVESTMENT RESEARCH: CARBON

Jon Hale

The new Morningstar Portfolio Carbon Risk Score
gives investors the means to evaluate
the carbon risk embedded in a fund's portfolio.
Sometimes referred to as transition risk, carbon risk
addresses how vulnerable a company is
financially to the transition away from a fossilfuel-based economy to a lower-carbon economy.
It's a transition that is already under way,
as companies respond to pressure to lower their
carbon emissions from regulators, customers,
other stakeholders, and investors.
For investors, there is an increasing desire to
understand carbon risk and its implications for the
risk and return of their portfolios. The Financial
Stability Board's Task Force on Climate-Related
Financial Disclosures issued guidance in 2017
for companies to report to investors on climaterelated risks. The task force recommends
that companies disclose to investors how their
corporate strategy is affected by climate risk;
how they identify, assess, and manage climate
risk; the metrics and targets they use to manage
climate risk; and their governance oversight
of climate-related risks and opportunities. In late
2017, a group of investors launched the Climate
Action 100+ initiative, pledging to engage with the
100 global companies that have the highest
levels of carbon emissions about taking action in
line with the task force's recommendations.
To date, investors with $28 trillion in assets under
management have signed on to the initiative.
Although understanding both physical risk and
transition risk is important, more investors
are attempting to measure carbon risk in their

Morningstar June/July 2018

portfolios. The Financial Stability Board's climate
task force recommends that asset managers
and asset owners report on the carbon emissions
associated with their portfolios. Signatories to the
2014 Montreal Carbon Pledge, sponsored by the
Principles for Responsible Investment and signed
by more than 120 asset managers and owners with
more than $10 trillion in assets, have committed
to measuring and disclosing the carbon footprint
of their equity portfolios on an annual basis.
The Portfolio Decarbonization Coalition has 28
asset managers and owners with $3 trillion in
assets committing to reducing the carbon exposure
in their portfolios. Article 173 of France's Law
on Energy Transition for Green Growth requires
asset managers and owners of portfolios
with more than EUR 500 million in assets to report
on their exposure to transition risk or explain
why they do not think doing so is necessary.
Understanding carbon risk in a portfolio can help
investors make better decisions. Investors typically
do not know the extent to which a portfolio is

Most efforts to measure carbon risk in portfolios
rely on a technique called "carbon footprinting."
A portfolio's carbon footprint is calculated
by estimating the greenhouse gas emissions that
are attributable to each underlying holding.
So-called Scope 1 (direct) and Scope 2 (indirect)
greenhouse gas emissions are typically
included. Scope 1 emissions emanate from a
company's internal operations, including onsite
energy production, vehicle fleets, manufacturing
operations and waste. Scope 2 emissions are
indirect emissions generated by the production
of energy used by the company.
Carbon footprinting has limitations. These include
emissions data provided by companies that can
be incomplete or inaccurate, or not independently
verified. Footprinting does not account for Scope
3 emissions, which are indirect emissions
that occur in the upstream and downstream value
chain of a company. Furthermore, a carbon
footprint is not a direct measure of risk, but more
of a starting point for considering the magnitude
of carbon risk faced by a company. A carbon

EXHIBIT 1

Sustainalytics' Company Carbon Risk Rating Most firms have a medium carbon
risk score, meaning that they have a fair amount of unmanaged carbon risk.
Risk Score

Rating

50+

Severe

30-49.9

High

246

10-29.9

Medium

0.1-9.99

Low

Negligible

Source: Sustainalytics. Data as of 04/30/2018.

Number of Companies

2,090
744
696
0

600

1,200

1,800

2,400

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018