As the effects of climate change continue to accelerate, the importance of integrating climate risk into investment processes has gained pace.
Physical risks are the visible impacts of climate change - sudden events like storms that cause local damage, or gradual changes like rising seas that reshape coastlines over time.
However, for investors, transition risk often presents a more immediate concern. While physical climate risks and transition opportunities are important considerations, transition risks typically have a more significant portfolio-wide financial impact since they affect a broader range of economic sectors. Physical risks in comparison tend to be more geographically dispersed across large portfolios.
As we move towards a low-carbon economy, transition risks are the financial effects caused by policy changes, new technologies, and shifts in market attitudes. As it stands, carbon prices have already been legislated in more than 40 countries, and is likely to accelerate following the progress of Article 6 from COP29. If carbon pricing continues to increase and emissions limits tighten, this could significantly impact companies portfolio-wide.
At Emmi, we focus on transition risk. Why? Because while environmental changes happen slowly, human actions can be swift. Markets can change rapidly, potentially catching unprepared investors off guard.
Our analysis at Emmi demonstrates that transition risk follows the 80/20 rule (Pareto Principle) in most portfolios - about 80% of climate transition risk is generally concentrated in just 20% of holdings. To illustrate this, we reconstructed the S&P500 using a climate resilience framework that measures transition risk, creating a climate-optimised portfolio that closely tracks the index.
While there are a range of quantitative metrics you can use to construct a climate resilient portfolio, we’ve focused on the following:
Carbon Intensity
Reduction Requirements
Potential Carbon Liability (Climate VaR)
Company Targets and Emissions Forecasts
Our reconstructed Climate Resilient Index preserves over 80% of the original S&P500 structure while minimising transition risk exposure.
Carbon Intensity
A portfolio's carbon intensity measures how much carbon is associated with each dollar invested across its holdings. Portfolios with higher carbon intensity typically indicate greater exposure to companies with carbon-intensive operations, potentially leading to increased risks as carbon constraints tighten. We use carbon intensity as a ‘normalised’ value to compare portfolios with different AUMs.
| Scope 1+2 Carbon Intensity | Scope 1+2+3 Carbon Intensity |
S&P500 | 25 | 238 |
Climate Resilient Index | 8 | 42 |
The Climate Resilient Index is 82% less carbon intensive than the original S&P500 index. The difference between Scope 1+2 versus Scope 1,2+3 carbon intensities demonstrates the quantum of carbon risk held in upstream and downstream supply chains (i.e. Scope 3 emissions) when compared with operational emissions only - particularly in mining, resources, and industrials companies.
Emissions Reduction Requirements
This metric indicates how much a company will need to reduce emissions by to be unaffected by transition risk for a particular scenario. For example, under the IPCC 4 degree scenario, eBay has an emissions reduction requirement of 0%, so carries no transition risk. However, under the NGFS Below Two Degrees scenario, it has an emissions reduction requirement of 25% by 2030 based on current emissions.
Portfolio managers seeking to build climate-resilient portfolios must focus on reducing their emissions exposure. Limiting transition risk across holdings helps protect portfolios against potential policy shocks driven by climate change responses.
| 2030 Reduction Requirement (IPCC Net Zero) | 2030 Reduction Requirement (NGFS Two Degrees) | 2030 Reduction Requirement (NGFS Current Policies) |
S&P500 | -19% | -13% | -9% |
Climate Resilient Index | -11% | -8% | -6% |
While the emissions reduction requirement is lower under the Climate Resilient Index, the portfolio still carries some level of transition risk across the three scenarios.
Transition Risk Exposure - Potential Carbon Liability (or Climate VaR)
Reduction requirements inform a portfolio manager how much each company will need to reduce their emissions by to have no transition risk exposure in a carbon constrained world. Emmi’s PCL translates this reduction requirement into a value at risk metric by overlaying each scenario’s carbon price trajectory. As a portfolio manager, this is an essential cog in quantifying climate transition risk in terms of returns erosion. Climate risk is often viewed as an abstract, distant risk - but using the PCL, we can model the direct effects on your portfolio and its return profile all the way down to the holdings level.
| 2030 PCL (IPCC Net Zero) | 2030 PCL (NGFS Two Degrees) | 2030 PCL (NGFS Current Policies) |
S&P500 | -15% | -5% | -1% |
Climate Resilient Index | -6% | -1% | -0% |
While this visualisation looks similar to the emissions reduction requirement, it represents how much value the portfolio would lose if these carbon constraints were implemented in 2030. For a $100m portfolio under the IPCC Net Zero scenario, this represents a financial erosion of $15m for the S&P500, and a $6m erosion for the Climate Resilient Index.
Company Targets and Likelihood Analysis
While our baseline analysis assumes flat projected emissions beyond the current year, we also assess these metrics assuming company reductions targets and their 'likely' emissions reduction based on real reductions they have made across their supply chain. This allows us to evaluate both the best case (companies meeting their stated targets) and worst case (business as usual) scenarios, while establishing likely reduction pathways based on past performance.
For a risk as monumental as climate, this kind of scenario analysis is essential in understanding portfolio risk.
Limitations
One thing to consider when constructing a climate resilient portfolio is the sectoral changes that occur. Portfolio managers should be cognisant that a low transition risk portfolio will have lower sector allocation to energy, industrials, and utilities companies given that most transition risk is held in these industries.
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