Companies contribute to, and are affected by, climate change. Portfolio managers are under increasing pressure to demonstrate how they factor this into stock selection. We suggest a solution.
Climate-adjusted cash flow: The goals of the Paris Agreement, financial regulation and asset owner demand are pushing for more transparency on capital allocation. This means that shareholders have to be ready to defend high carbon holdings. We take existing discounted cash flow valuation methodology and apply a climate lens to revenues, costs and investment in order for portfolio managers to be able to capture climate factors. This analysis builds on our previous report ‘Keeping it Cool - Assessing Climate Risk’, 12 September 2016.
Tactical inertia: Ultimately, the end goal is to design a way to capture the value of future income generation potential, profitability and real assets of companies in the face of uncertain responses to climate change. Identifying the types of climate risks, opportunities, and disruptive factors is not difficult, but quantification of them is. Uncertainty over the scale and timing of these factors, and expectations that climate change plays out over a long time in the future, have led to inertia on valuation in our view.
Data dilemma: Well prepared companies know and disclose how much CO2 they emit, so they know how much they contribute to warming. The trouble is only half of the MSCI ACWI index constituents disclose CO2 data. Disclosure is the first step to a robust corporate strategy.
Risky business: Revenues, costs and investment are the key drivers here. We think that climate factors must be taken into account more thoughtfully when deriving future cash flows. This necessarily involves adjusting future revenues (up or down in light of climate factors), future costs (with potential disruption and technology), and investment (according to long-term business strategy or regulations). Each of these will be affected by the climate in the future, and this has a knock-on effect on the cash flows which form the basis of company valuation.
Corporate engagement: An iterative process of engagement is the only way of getting it right. We consider it important for investors to seek information on climate data and climate strategy. For corporates, when they are in dialogue with investors they can refine climate data to make it more useful and comparable. We believe this two-way flow of information will help both investors and corporates be better prepared for the lower-carbon economy of the future.
Bringing the future into the present: We argue that future climate consequences are not adequately captured in current equity market valuations, mainly because of uncertainty on the scale, magnitude, and timing of climate change as a disruptive factor (for the value and income generating potential of assets). The report aims to provide more clarity for climate relevance in valuation, and to identify future growth potential.