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Sustainability Matters

How Investors Can Mitigate Climate Risks in the Stock Market

Risks associated with climate change include drought, loss of agricultural crops, and floods.

Scientists have long been sounding the alarm on the urgent need for climate action—and that urgency is particularly clear this year, as the effects of global warming were visible around the world.

Investors in European companies will be particularly impacted by the climate risks in the Southern Europe region. After a summer with record heat and drought in Italy and other parts of Europe, the continent has transitioned into an autumn with equally alarming weather patterns: unusually high temperatures and, in some places, devastating rains.

According to the Sixth Assessment Report of the IPCC, or Intergovernmental Panel on Climate Change, rising temperatures, which are already higher than 1.1 °C, are projected to devastate the Southern regions.

We take a closer look at the risks impacting this region.

Climate Risks in Europe

IPCC identified four key climate risks for Europe:

  1. Increased human mortality and morbidity and unprecedented changes in ecosystems.
  2. Substantive agricultural production losses for most European areas over the course of the 21st century, which will not be offset by gains in Northern Europe.
  3. Water scarcity: In Southern Europe, more than a third of the population will be exposed to water scarcity at 2 degrees C global warming level, or GWL; under 3 degrees C GWL, this risk will double.
  4. Flooding and sea-level rise: Above 3 degrees C GWL, damage costs and people affected by precipitation and river flooding may double.

According to the IPCC, there are several measures Europe can take to address these risks. They include behavioral changes as well as building interventions, changes in farm practices, greater efficiency in the use of water, implementation of systems to manage floods, and changes in the way land is used.

Scientists warn that existing plans to tackle climate risks are insufficient in many parts of Europe, and there are numerous barriers to increasing mitigation measures, such as limited resources, lack of private sector and citizen engagement, insufficient mobilization of finance, lack of political leadership, and low sense of urgency.

Measure Carbon Risk

With this mind, there are a few tools that investors in the European equity market can use to assess climate risks in their investments.

One is the Carbon Risk Rating, developed by Morningstar Sustainalytics, a division that provides sustainability research. Morningstar Sustainalytics defines the Carbon Risk Rating as the degree to which a company’s economic value is at risk in the transition to a low-carbon economy.

Scores range from 0 to 100, where lower scores are better, indicating lower carbon risk. If the score is zero, it means that the company has little to no material risk in a low-carbon economy. If it is more than 50, it means that the company is unlikely to survive in a low-carbon economy.

The Morningstar Portfolio Carbon Risk Score is the asset-weighted carbon risk score of the equity or corporate-bond holdings in an index or portfolio (long positions only), averaged over the trailing 12 months.

The analysis of the Morningstar Developed Markets Europe Index shows that the 12-month average Portfolio Carbon Risk Score was equal to 7.96 points. Essentially, the average climate risk of the companies in this index can be considered low (as of June 30, 2022).

The historical series of the Portfolio Carbon Risk Score Morningstar DM Europe Index shows that since 2017, when the data became available, the carbon risk has decreased, especially because of to the increase of the firm’s management actions to mitigate it.

One component of the Portfolio Carbon Risk Score is the carbon-management score, which evaluates a company’s preparedness and track record in managing carbon operations and manageable products and services risks. According to Morningstar data, the carbon-management score for the index increased from 44.71 to 65.41 points over the same period.

Measure Fossil Fuel Involvement

Another way to understand climate risks in the Morningstar DM Europe Index is by measuring the fossil fuel involvement (that is, the percentage of the fund’s assets that are involved in fossil fuels), with Morningstar’s Portfolio Fossil Fuel Involvement metric.

Companies are considered “involved” in fossil fuels if they derive at least an aggregate 5% share of total revenue from some combination of the following activities: thermal coal extraction, thermal coal power generation, oil and gas production, and oil and gas power generation.

Companies deriving at least 50% of their revenue from oil and gas products and services are also included.

Fossil fuel involvement in the index decreased sharply during the coronavirus pandemic, when energy stocks were penalized and, consequently, their weight in the index fell. The most recent data, however, shows an increase after the Russian invasion of Ukraine.

How You Can Reduce the Climate Risks in Your Portfolio

Investors who want to reduce the climate risks in their portfolio can choose climate-aware funds and ETFs that have a climate benchmark.

European Union Benchmark Regulation stipulates that indexes used in the EU must follow specific requirements in order to be badged as one of two types of climate benchmarks:

  • EU Climate Transition Benchmarks, or CTB: The underlying assets are selected, weighted, or excluded to create a portfolio on a decarbonization trajectory in accordance with the minimum standards laid down by the European regulator.
  • EU Paris-Aligned Benchmarks, or PAB: Underlying assets are selected in such a manner that the resulting benchmark portfolio’s greenhouse gas emissions are aligned with the long-term global warming target of the Paris Agreement.

Morningstar Indexes, which are compliant with EU Benchmark Regulation, show lower climate risk. In particular, the Morningstar Developed Europe PAB has a 12-month average Portfolio Carbon Risk Score of 5.86, and a 12-month average Portfolio Fossil Fuel Involvement of 3.99% (as of June 30, 2022). The Morningstar Developed Europe EU CTB has a Portfolio Carbon Risk Score of 6.84 points and a Fossil Fuel Involvement of 8.15%.

Looking at performance, the Morningstar DM Europe CTB Index has done slightly better since Morningstar has been performing data (Dec. 20, 2014), but the differences are minimal compared with the other two indexes. On the other hand, the volatility of the Europe climate benchmark (measured by standard deviation) has been slightly lower over the last five years.