Would you buy a house for yourself to live in without considering the future implications of acquiring that specific piece of real estate?
Most likely not.
What you would probably do is compare different real estate options for their location, pricing, quality and size. And perhaps you would even have a list of non-negotiables you are not willing to give up.
Just as you wouldn’t buy a house without some proper analysis of whether it brings your money’s worth, try considering a similar thought process for impact investing.
When you have a list of potential companies to invest in, in order to choose the best one, you may want to think about similar characteristics as when buying real estate. Think of it this way:
- Location: You probably want to know the geographical location of the company, understand what the sector’s outlook is and how the company compares to peers.
- Pricing: You will want to analyse if the company’s future potential has been (in your view) fully integrated in current pricing.
- Quality: Then, obviously, the company has to show good fundamentals and, ideally, potential for value increase in future.
- Size: And last but not least, how much of a stake and a say you will have in the company by buying its shares is also something you would likely want to know.
You notice that it's valuable to consider how the market, sector (or neighborhood 😉) and the company itself will develop in the future. Also, emerging regulation could affect the company’s business environment imposing more stringent financial or environmental requirements the company needs to comply with. So you need to be aware of the policy and regulatory setting as well. If not, you may be buying something with a lot less value in a couple of years. The same goes for investing where assets can devalue over time due to climate change, for example so-called “stranded assets”.
Any major purchase or investment has the potential to go wrong if not analysed through a proper forward-looking lens. If you are considering investing and looking to benefit from the future upside related to positive outlooks and increase in value, you cannot rely purely on historical data. You know how the story goes: historic performance is no guarantee of future performance.
Then what to do?
At a minimum, it’s a good idea to integrate climate and carbon metrics in analysing a company's current performance.
Historic carbon footprint data tells about a company’s past performance. Such metrics can help in understanding how a company has developed and what actions it has taken over time. For example, has it been consistently decreasing its emissions in the past? Or has the company been able to reach its targets in terms of emission reductions?
This is valuable information for tracking climate-related performance of a company you have invested in, but does not work too well in company comparisons. (In fact, carbon footprints are not very useful when comparing companies in general, as reporting practices and scopes vary so much between industries, it’s like comparing oranges to apples. But that’s a different story.)
Additionally, is it possible to calculate and set boundaries for return on carbon (similar to the good old return on equity, ROE) to complement the analysis? In this case, a company operating in a certain sector would need to show strong financial performance to justify high carbon intensity of its assets. Otherwise a company with low carbon intensity would be considered as more carbon efficient in generating returns.
But, as mentioned above, historical data and metrics don’t always tell the full story.
Forward-looking metrics are needed to capture the fact that investment decisions are also based on companies’ outlooks, future plans and projections.
These new metrics, however, need a high level of transparency, in order to be able to truly inform the investment decision-making process -- and to allow more allocation of capital towards climate-resilient companies.
To be able to allocate capital towards climate-resilient companies, we need transparent, forward-looking climate metrics in the investment world.
There have been several attempts at creating such transparent metrics in the past. Yet the challenge has boiled down to these metrics being based on proprietary methodologies and requiring additional data collection.
For example, data and service providers specializing in climate-related risks and opportunities do offer their clients climate data and analysis on metrics like carbon value at risk, or carbon risk weighted assets. Yet, there is no general best practice on how to calculate such metrics, and different data providers use their own methodologies which in turn provide differing results. The remaining challenge is to make forward-looking climate metrics calculable for any company with a balance sheet and profit and loss account. As a minimum, achieving this requires companies across industries to disclose their Scope 1, 2, and 3 emissions.
Publicly listed companies disclose detailed figures on their financial performance. For example, price to earnings ratio (P/E) is used to give an idea of whether a company is over- or undervalued by the market. So why not use a corresponding climate-adjusted ratio to evaluate whether a company’s climate action is on the right track or just full of hot air promises waiting to get blown up and exposed to greenwashing? Could a company’s P/E ratio provide a more climate-adjusted picture if company’s earnings were adjusted for negative financial impacts of climate risks? Or how about simply calculating a carbon adjusted earnings per share, where estimated financial cost of carbon would be deducted from the earnings per share?
Price of carbon offsets is currently around €50 per tonne -- something that is expected to increase in the future. According to the Carbon Pricing Leadership Coalition, a carbon price of US$100/tCO2 could be needed by 2030 to support reducing carbon emissions in line with Paris Agreement’s temperature goals.
So let’s say we take a company’s current Scope 1, 2, and 3 emissions and multiply these by the cost of carbon. How much would it cost today and in 10 years for a company to emit X amount of CO2e? Seeing the negative monetary impact on a company's earnings should definitely affect investment decision-making. Then the companies either need to act to get rid of high carbon emissions or be prepared to take the hit. A decision not to act will not only lead to carrying the rising cost of carbon -- but also dealing with other issues that could affect the business such as increasing customer concerns and public opinion for companies to shift to renewables.
Food for thought
Just as emissions’ accounting standards have come a long way and the financial industry has gained some common understanding on how to measure financed emissions, could establishing common forward-looking climate metrics become the next priority on the impact investment to-do-list?
After all, you want to invest in assets that will still be there after a decade or two (or even longer). Just as anyone wouldn’t want their property investments to be swept away by a hurricane, wildfire or flooding, shielding investments against climate change risks is, equally, as important.