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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.

In "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 by Innovest.

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 depth.

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.

Pierre Trevet, 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."

Out 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 portfolios.

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.

The first 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.

 

 
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