October 30, 2007
Connecting the Dots Between Climate Change, Companies, and Financial Performance
by Anne Moore Odell
Laying the groundwork for new investment products, Innovest releases the first study relating how
companies manage climate change risk to their financial performance.
Investors can't rely on companies' disclosures on climate change issues alone to make informed
decisions, a new study from Innovest suggests. The complexity of the issues around climate change
requires investors to examine investment opportunities company by company, searching out unbiased
research tools. With wild variations in risk management strategies relating to climate change
issues between companies in the same sector, due diligence is especially important.
"Carbon Beta and Equity Performance", An Empirical Analysis: Moving from Disclosure to
Performance," Innovest Strategic Value
Advisors calls on its experience with climate change gained, in part, from five years of
writing the Carbon Disclosure
Project's global reports. This study is the first step in rectifying a dearth of evidence and
tools that help investors link climate change and financial performance.
The study found
that over the past three years companies with climate change risk management already in place, for
the most part, out-performed companies within the same sector that didn't have policies in place.
The Carbon Beta Study is the result of a research project by Innovest to test its premise
that Carbon Beta ratings are positively correlated to financial performance. The study was
constructed to demonstrate what the effect of Innovest's Carbon Beta ratings are at the scale of an
investment portfolio. The Carbon Beta Rating Platform is a proprietary risk analysis model designed
The starting point for the platform is Innovest's database of over 1,500
Carbon Beta ratings that represent a global universe of large cap companies. Out of these, around
850 companies operating in industries of significant carbon intensity were analyzed in greater
The next step in developing the model was to construct a thorough financial
performance study to test empirically the proposition that companies with superior carbon
management practices and strategies financially out-perform their peers.
Managing Director, Head of Carbon Finance at Innovest, explained, "We used share price performance
with dividends reinvested, i.e., total return, as a proxy for financial performance."
of this total global universe of the world's largest companies, Innovest constructed two investment
portfolios. One portfolio was comprised of the companies rated above average, the carbon leaders,
while the other portfolio was comprised of the companies rated below average, the carbon laggards.
Through quantitative techniques, sector biases and regional biases were eliminated from the two
Innovest then back-tested the relative performance of the two portfolios
over a three-year period using Innovest's time series of company ratings for each month. The same
methodology was used to construct sub-sets of the study for different parts of the globe.
Trevet told SocialFunds.com where he envisions other studies could continue: "Further studies
would require a deepening of the performance attribution by sector, a further neutralizing of other
financial factors, and perhaps a study of a cap-weighted carbon enhanced strategy to refine the
performance measurements. Also, a live simulation would allow for tracking the out performance over
longer period of time."
The Carbon Beta ratings capture three dimensions of carbon
performance, each being relevant to shareholder value, Trevet explained.
dimension is a company's carbon strategy and governance. This relates to the strategic decisions of
aligning corporate strategy to the realities of an increasingly carbon constrained environment. The
model puts forth that a superior carbon strategy indicates a governance with vision, foresight, and
agility, three mainstream factors that drive share price performance, Trevet proposed.
The second dimension of the Carbon Beta ratings is carbon risk assessments along the entire
value chain, with a focus on what impacts shareholder value.
"The most current and
pressing risk is regulatory, translating directly into increasing operating costs and therefore
eroding profit margins. Indirect risks translate into increased electricity, transport, and
supplies costs," according to Trevet. "And finally, market related risks arise from changing market
demand for more carbon efficient products."
The third and last dimension explored is
strategic profit opportunities. Climate change and the imperative necessities of curtailing
greenhouse gas emissions is a strong motivation for innovation, the study reports. Companies who
are taking the lead in R&D and introducing climate-friendly products and services are likely to
increase their competitive edge, market share, and fuel their growth. One example Trevet offered of
the increase in opportunities is the 25% or more annual growth of the clean-energy market.
"Investors have first to realize that carbon risk is not mono-dimensional - not simply measured
by the carbon footprint, real or estimated - but is also driven by corporate strategies and
innovation," Trevet concluded. "As Innovest has consistently demonstrated over the years, share
price performance is driven by risks, strategy and management, and innovation. Our latest study on
Carbon Beta demonstrates this thesis for climate change."
The study is only the first step
in examining a complex field and the study's authors seem well aware it is the springboard to
future projects. Acknowledging the sometimes-daunting speed that new information about climate
change is being released, the study ends, "Given the velocity of change in both the public policy
environment and companies' responses to it, the premium attached to up-to-date research and
analysis is both considerable and growing over time."
Innovest, with offices in New York,
Toronto, London, Paris, San Francisco, Sydney, and Tokyo, is a global investment research company
that specializes in what Innovest describes as "non-traditional" shareholder research.