We tried to make the case in a previous article that detailed disclosure of corporate emissions in the “scope 1-2-3” format has not moved the needle on emission reductions. Not even a tiny bit.
We then suggested that a smarter decarbonization strategy would simply bypass the time and resource-intensive emissions reporting – especially scope 3 emissions which happen entirely outside of a company’s boundaries and control – and go directly to decarbonization driven by government incentives and, yes, standards for direct emissions from critical sectors like transport, power generation and agriculture that have deep connections to many parts of the economy.
But, you might ask, if we let companies off the hook on emission disclosures, how will investors assess their climate risk? The point we’ll make here is hopefully an obvious one. In most cases, a company’s emission numbers bear no relation to the climate risk that the company might have to deal with: investors don’t need more emissions numbers to assess climate investment risk.
From an investor’s perspective, there are two parts to the risk posed by climate change when it comes to investing in a specific company: physical risk and transition risk. We’ll discuss them one by one.
Physical risk has nothing to do with a company’s direct or indirect emissions
Physical risk is largely collective. In other words, potential economic impacts resulting from climate-related events – extreme weather, rising sea levels, floods, forest fires – will impact society as a whole. While we cannot predict these impacts with any certainty, we can assess the climate trajectory we are on and with it the likelihood of these events and, for this, emissions data is useful. However, that emissions data is already available – we know the total global emissions with a high degree of precision. Attributing those emissions to specific companies adds no value in this context.
Of course, we should try to understand how specific sectors or companies might be impacted by climate-related events, depending on their products, supply chains or geographies, and so their adaptation plans would be of interest to investors and worth disclosing. But, again, this has nothing whatsoever to do with the companies’ direct or indirect emissions.
Transition risk manifests at the sector level and applies to entire cohorts of companies
Transition risk has more direct links to sector-level emissions. However, to understand why we do not need additional emissions information from companies to assess transition risk, it is useful to understand the “risk materialization” story.
Investors talk about company risk when there is uncertainty about a future event that could have an impact on that company’s financials. In the case of a transition driven by climate policy, what we are trying to understand is how a specific company is going to be impacted by the transition.
So, an investor might describe transition risk for a company as follows: “I invest in the Big Energy Company (BEC) and if there is a transition I suspect it will be impacted somehow – I don’t want to lose my money so I want to better understand this risk to determine if I should do something about it.”
So, to get a better handle on the risk, this investor will probably want to determine the following things:
- What triggers could induce the transition, or what triggers might accelerate it? How likely is it that we will see these triggers?
- What will the transition look like and how will the characteristics of the transition relate to this company’s business?
- How long will the transition take, and how much of an opportunity will the company have to adapt and perhaps change its business model?
- What is the likely end-state of the economy after the transition and will BEC be well-positioned to remain competitive based on its current activities or, potentially, a new business model it can transition to?
To get a steer on the potential answers to these questions, the investor will likely take as a starting point the questions of whether or not we have a transition, and whether it is an accelerated transition. This, of course, depends largely on whether governments are likely to act, and how they will act. Will they introduce carbon taxes? Will they subsidize nuclear energy or hydrogen on a massive scale? Will they ban the burning of coal?
So, to determine how likely the transition is and what it will look like, the BEC investor will follow elections, knowing that progressive parties are more likely to act on climate change than conservative parties; will follow political debates around public policy interventions, and will assess what types of interventions governments are prioritizing and the likelihood of those policies getting implemented. The investor will not only assess the likely impacts of effective climate policy such as the IRA in the US but will also follow discussions around carbon taxes and cap-and-trade programs, and will probably conclude that a carbon price high enough to induce rapid change is far in the future.
In addition, the investor will understand that much climate policy will be directed at the most polluting kinds of energy, but also that some sectors and technologies such as global shipping and steelmaking are hard to decarbonize. So, the investor will study the types of energy sources BEC uses or produces, and will assess how climate policy might change the supply and pricing of these energy sources, and what potential substitutes are. The investor will also think about the core competencies of BEC and whether it will be able to comply with upcoming climate regulations or shift its focus towards other activities that allow it to remain profitable.
Finally, the investor will understand that the transition risks for BEC will be determined to a large extent by whatever transition risks the cohort of companies similar to BEC faces. If BEC is an oil producer, it will largely face the same risks as other oil producers in the industry. If BEC is a utility producing coal-fired power, it will largely face the same risks as other coal-fired power producers. While policy action will be driven in part by the collective emissions that are produced by certain sectors or cohorts, policy action will not be more impactful to companies that are responsible for higher emissions in that cohort compared to those that are responsible for lower ones.
Climate investment risk can be evaluated without company-level emission disclosures
You may have noticed that not once in this description have we referred to BEC’s scope 1, 2 or 3 emissions as required inputs into the investor’s thought process. This is simply because a company’s annual emissions are not material to assessing that company’s investment risk in the real world, double materiality proposals notwithstanding. Physical and transition risks are an integral part of the investment risk equation and can be evaluated without any dependence on company-level emission disclosures.
So, if you see investors evaluating companies without looking at emissions, what they are really doing is cutting out the unnecessary inputs and focusing on what really contributes to climate investment risk.
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.