Earnings at risk:
What climate change means for equity returns

Some investors are taking on more risk than they realise by assuming it’s ‘business as usual’ for high-impact carbon emitters. In a new normal where emitting carbon incurs higher financial penalties, investors need to consider carbon pricing risk – the gap between the current carbon price and the future price they might have to pay in a 1.5-2°C world.

More than ever, investors believe in the importance of responsible investing. In the climate arena, there’s a growing agreement that humanity must change its course to protect the environment.

And yet, when we discuss this topic with investors, we find there are often some misgivings.

Yes, we’re told, ESG and climate are important – but it’s hard to understand exactly how important, and harder still, it is to integrate these concerns into a portfolio.

These misgivings often reveal a sense of dichotomy. On one hand, mounting evidence compels us all to make a climate impact with our portfolios. On the other, our fiduciary duty instructs us to act in the best financial interests of the principal. For many investors, those objectives remain hard to reconcile.

Recently, we have been looking for a way to bridge the gap between financial risk and climate risk, and to help investors connect the dots between the climate imperative and the pursuit of the optimal risk-adjusted return.

Carbon pricing risk is a very interesting way of doing just that. In our view, integrating carbon pricing risk analysis will give investors a bigger picture view of financial risk and how to optimise a particular portfolio in relation to it.

Carbon pricing risk: an increasingly necessary metric

Let’s examine what we have just called ‘carbon pricing risk’. To be more specific, we’re referring to what might happen to a portfolio when we account for the carbon price in our risk analysis. 

Carbon pricing is a network of global initiatives designed to curb carbon emissions. In the chart below, you can see (left hand side) that 23% of carbon global emissions are now ‘covered’ by carbon pricing initiatives such as carbon taxes and emissions trading systems. The red bar shows EU allowances, and the big blue bar on the rightmost column is China.

This chart shows carbon pricing schemes are growing globally. The right hand chart shows how these schemes are spread around the world.

Source: S&P Global, Carbon Price Dashboard by WorldBank, IBRD and IDA. Past performance is not a reliable indicator of future performance.

Carbon pricing is proliferating, and even though it is still a nascent initiative and remains complex and fragmented, it will improve over time. What we want to highlight now is the important link between the carbon price and unpriced risks which might be embedded in a portfolio.

Unpriced carbon cost

When viewing the issue through a data scientist’s lens, a key metric to look at is unpriced carbon cost. This is the difference between what a company pays now in terms of carbon price and what it will pay in future. For this we use data from Trucost, part of S&P Global.

Source: S&P Global

Trucost defines three carbon price scenarios in its methodology. In each of these forecasts, carbon prices rise dramatically over the coming years – meaning a growing gap between current and future price, and thus a greater unpriced carbon cost. Given carbon pricing schemes are one of the main tools in the policymaker’s kit, we are confident in saying the carbon price will only continue to increase over time.

Projecting carbon price impact on earnings

We selected Trucost’s medium (“delayed action”) carbon price scenario for our analysis. Despite it being the middle path, we feel this could actually be a conservative assumption of where the carbon price could go.

To look at how unpriced carbon price risk could affect companies’ profitability, we started with the MSCI World index. Using earnings statements, we tried to represent the carbon price risk – again, that’s the difference between what the company pays today and what it might pay tomorrow – and what that would represent as a share of their EBITDA. This gave us a measure of “earnings at risk”, or more accurately, EBITDA at risk. (EBITDA refers to earnings before interest, taxes, depreciation and amortisation and is a common metric for evaluating a company’s operating performance.)

Our analysis highlights a significant risk to future earnings from the unpriced expected future carbon price, especially in sectors such as energy, materials and utilities. In the utilities sector for example, the projected carbon price increases might wipe out 50% of the sector’s average EBITDA by 2040.

It’s important to note that 2040 is far in the future, and that these results depend heavily on modelling and on what changes are made to companies’ emissions and business models by then. So, we can’t safely say that this will happen. However, based on all the data we have access to, we can start to see carbon prices might pose a significant risk for these companies’ earnings, on the basis of their current emissions and financial health.

Climate Transition & Paris-Aligned solutions

In this article, we are ultimately performing a simple stress-test. How would a sector, or a portfolio, react to carbon price changes and how would this feed through to earnings and market value? 

To continue the investigation, we looked at the alternative exposures to certain mainstream indices, using Paris-Aligned and Climate Transition benchmarks, or ‘PAB’ and ‘CTB’ respectively. These benchmarks, and the ETFs tracking them, aim to reduce the carbon emissions of a given exposure immediately – by 50% for PAB and 30% for CTB – and put a portfolio on a trajectory of reducing carbon emissions over time, typically by 7% per year.

So, we conducted the same exercises as before – same benchmark, same universe, same portfolio. As the carbon emissions are cut by 50%, we can very simply divide the earnings at risk by a factor of two (see Earnings at Risk chart below).

Scope 1, Scope 2 and Scope 3 upstream (supply chain effect) emissions are included, while Scope 3 downstream & upstream (change in demand due to rising costs) emissions are excluded in this analysis.
Source: S&P Global, Amundi, Data as at 11/10/2021. Past performance and/or forecasts are not a reliable indicator of future performance.

We conducted the same exercise for enterprise value at risk, meaning the projected reduction in enterprise value in a portfolio (see Enterprise Value at Risk chart below). This starts from Europe in light blue, to Climate Transition in turquoise blue, to Paris-Aligned in green. We can see here a quite mechanical reduction in risk when investing in CTB or PAB benchmarks. It’s also interesting to note that this reduction is quite consistent across regions.

Scope 1, Scope 2 and Scope 3 upstream (supply chain effect) emissions are included, while Scope 3 downstream & upstream (change in demand due to rising costs) emissions are excluded in this analysis.
Source: S&P Global, Amundi. Relevant Benchmark is the relevant MSCI standard index of the region, Climate Change / CTB index is the available Climate Transition Benchmark by MSCI and PAB Index is the corresponding Paris Aligned Benchmark published by S&P on the relevant region. Data as at 11/10/2021. Past performance and/or forecasts are not a reliable indicator of future performance.

So, if you’re looking at a Europe, US or World portfolio, and want to reduce carbon emissions, that reduction comes with a commensurate reduction in financial risk. From an investment perspective, therefore, this might actually make your choice more fiduciary.

Our conclusion is the following: since carbon pricing is here to stay, and the price is very likely to increase in future, it poses a huge and underappreciated risk for companies, especially in the energy, materials, and utilities sectors. Climate indices such as the Paris-Aligned Benchmark (PAB) significantly reduce carbon emissions, and in doing so, could significantly reduce the carbon pricing risk embedded in holdings like this in your portfolios today.

Through our analysis, we can make a solid link between carbon emissions to the financial performance of a portfolio.

To learn more about our climate ETFs, including detailed performance and risk breakdowns, please get in touch with your usual Amundi contact or explore our Climate hub.

CAPITAL AT RISK - ETFs are tracking instruments. Their risk profile is similar to a direct investment in the underlying index. Investors’ capital is fully at risk and investors may not get back the amount originally invested.
UNDERLYING RISK - The underlying index of an ETF may be complex and volatile. For example, ETFs exposed to Emerging Markets carry a greater risk of potential loss than investment in Developed Markets as they are exposed to a wide range of unpredictable Emerging Market risks.
REPLICATION RISK - The fund’s objectives might not be reached due to unexpected events on the underlying markets which will impact the index calculation and the efficient fund replication.
COUNTERPARTY RISK - Investors are exposed to risks resulting from the use of an OTC swap (over-the-counter) or securities lending with the respective counterparty(-ies). Counterparty(-ies) are credit institution(s) whose name(s) can be found on the fund’s website amundietf.com. In line with the UCITS guidelines, the exposure to the counterparty cannot exceed 10% of the total assets of the fund.
CURRENCY RISK – An ETF may be exposed to currency risk if the ETF is denominated in a currency different to that of the underlying index securities it is tracking. This means that exchange rate fluctuations could have a negative or positive effect on returns.
LIQUIDITY RISK – There is a risk associated with the markets to which the ETF is exposed. The price and the value of investments are linked to the liquidity risk of the underlying index components. Investments can go up or down. In addition, on the secondary market liquidity is provided by registered market makers on the respective stock exchange where the ETF is listed. On exchange, liquidity may be limited as a result of a suspension in the underlying market represented by the underlying index tracked by the ETF; a failure in the systems of one of the relevant stock exchanges, or other market-maker systems; or an abnormal trading situation or event.
VOLATILITY RISK – The ETF is exposed to changes in the volatility patterns of the underlying index relevant markets. The ETF value can change rapidly and unpredictably, and potentially move in a large magnitude, up or down.
CONCENTRATION RISK – Thematic ETFs select stocks or bonds for their portfolio from the original benchmark index. Where selection rules are extensive, it can lead to a more concentrated portfolio where risk is spread over fewer stocks than the original benchmark.
Limits of the methodology of the Benchmark Index are described in the prospectus of the ETF through risk factors, such as the market risk linked to controversies and the risks linked to ESG methodologies. The decision of the investor to invest in the promoted fund should take into account all the characteristics or objectives of the fund. 

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