Climate Transition Risk, Part Three: Are Private Asset Managers Ready for Stricter Climate Regulations?
Abdulla Zaid, Burgiss
Key Takeaways:
Climate transition risk estimates allow investors to put a climate price tag on private assets and compare exposure across regions and asset classes.
Climate transition risks in Latin America and Africa are exceptionally high, as both regions host some of the most carbon-intensive private assets in terms of direct emissions.
Distressed Debt and Real Asset funds appear to be facing the highest levels of climate transition risk, while Venture Capital funds are on the opposite end of the scale.
This is the third blog in the “Climate Transition Risk” sequence, which explores how increasingly stricter climate regulations may impact private companies’ costs and profitability. The previous blogs—Part One: An Introduction and Part Two: An Upstream Approach—discussed the financial materiality of greenhouse gas (GHG) emissions in private portfolio companies and estimated profitability losses if private companies had to pay a carbon price on their energy bills (an emission tax imposed at the energy supplier level, i.e., upstream).
In this blog, we utilize Scope 1[1] carbon intensity estimates[2] from Burgiss and MSCI to explore how a global carbon price floor can impact costs and EBITDA margins for over 54,000 private portfolio companies within Burgiss’ data.
Carbon Pricing Regulations: A Brief Introduction
Carbon pricing is an increasingly common climate policy tool used to meet regional, national, and subnational emission reduction targets, either through a carbon tax or an emission trading system (ETS). A carbon tax defines a price per tonne of carbon dioxide equivalent (tCO2e), while an ETS sets an emission reduction target and allows market forces to set the carbon price. According to the World Bank, an estimated 23% of global GHG emissions are subject to a carbon price under 47 national and 36 subnational jurisdictions.[3] Examples of carbon pricing regulations include the EU ETS, the China National ETS, and the Sweden carbon tax. Globally, carbon prices can range from less than USD 1/tCO2e to over USD 100/tCO2e.[4]
For the purposes of the climate transition risk analysis, let us assume that all private companies are subject to the current carbon pricing regulations that exist in their respective geographical locations and sectors. For example, all private power companies in the EU are assumed to be subject to a carbon price of EUR 86.53/tCO2e under the EU ETS,[5] although it is possible that a number of these companies may presently be exempt from the carbon pricing regulation.
The analysis uses carbon price data from the World Bank’s Carbon Pricing Dashboard,[6] which outlines the existing regulations and associated carbon prices at the regional, national, and subnational levels. Based on the geographical locations and sectors of these regulations, an estimated 9% of the global private company count within the Burgiss Manager Universe (BMU) may currently be subject to a carbon price.
Carbon Quest: Where to Look?
Understanding the financial materiality of private companies’ GHG emissions is central to our climate risk analysis. Financial materiality is the relevance of a specific environmental, social, and governance (ESG) factor to a company’s financial performance, business model, and enterprise value, which can affect investors’ returns. For example, GHG emissions can be relevant and financially material to carbon-intensive companies due to growing regulatory restrictions and associated compliance costs.
Using the Sustainability Accounting Standards Board (SASB) Standards, the private companies within the BMU are divided into two segments—one with financially material exposure to climate policy and risk and another one with non-material exposure (“material” and “non-material”).[7] Similar to what was demonstrated in the introductory blog, in valuation terms, only 8% of the BMU has material exposure to climate risk as well as—unsurprisingly—a Scope 1 carbon intensity that is 20 times higher than that of the non-material segment.[8]
While climate transition risks can be estimated for all private companies, we only focus on the subset of companies whose emissions are financially material to investors.
Estimating Climate Transition Risks by Asset Class and Region
The downstream approach uses Scope 1 carbon intensity estimates (in tCO2e/USD million revenue) from private companies to examine how an increase in a carbon price (in USD/tCO2e) could impact their profitability, measured by changes in EBITDA margins (EBITDA Margin = EBITDA/Revenue). Essentially, this approach estimates the carbon emission cost per one million US dollars of revenue. See the Appendix for more details on the methodology.
The climate-scenario analysis in this blog uses a global carbon price floor of USD 75/tCO2e. The International Monetary Fund (IMF) recommends that this price level be achieved by 2030 to limit global warming to 1.5°C–2°C or 2.7°F–3.6°F.[9] Figures 1 and 2 illustrate the changes in EBITDA margins resulting from a USD 75/tCO2e carbon price floor, in terms of both the fund’s asset class and the portfolio company’s location.
At a USD 75/tCO2e price floor, and after accounting for any existing carbon prices, Distressed Debt and Real Asset funds appear to be facing the highest levels of climate transition risks, while Venture Capital funds are on the opposite end of the scale.
Results suggest that private companies in Distressed Debt and Real Asset funds’ portfolios may see average declines in their EBITDA margins of 5.6 and 3.7 percentage points in a USD 75/tCO2e carbon price floor scenario.
The elevated climate transition risks in these two asset classes may be fueled by the high carbon intensities of the underlying portfolio companies, which also may currently be subject to low carbon prices.
Figure 1: Estimating Climate Transition Shocks by Asset Class at a USD 75/tCO2e Carbon Price Floor
Data as of Q3 2022. The figure outlines the change in EBITDA margins in a USD 75/tCO2e carbon price floor scenario versus no change in carbon prices. Each private company has an EBITDA margin shock from the change in carbon price and the carbon intensity estimate. These shocks are then averaged at each fund’s asset class level, weighted by the holding’s net asset value (NAV).
Carbon intensity estimates are only calculated for companies within Burgiss’ data. Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet.
Source: Burgiss, MSCI ESG Research LLC
At the regional level, Latin America and Africa host some of the most carbon-intensive private assets in terms of direct emissions (Scope 1 carbon intensity). In Africa, carbon price coverage is among the lowest globally, while carbon prices in Latin America are relatively low compared to the region’s elevated carbon intensity averages. These factors have led both regions to be on the “High-Risk” side of the climate transition risk scale.
Across private companies with emissions that are financially material to investors, Europe’s Scope 1 carbon intensity is comparable to that of North America, the Middle East, and the global average. However, because of Europe’s relatively elevated carbon prices and carbon price coverage, the adverse impacts of climate transition risks and EBITDA margin losses may be limited to only 0.3 percentage points in the case of a USD 75/tCO2e global carbon price floor.
Figure 2: Estimating Climate Transition Shocks by Region at a USD 75/tCO2e Carbon Price Floor
Data as of Q3 2022. The figure outlines the change in EBITDA margins in a USD 75/tCO2e carbon price floor scenario versus no change in carbon prices. Each private company has an EBITDA margin shock from the change in carbon price and the carbon intensity estimate. These shocks are then averaged at the geographical locations of the portfolio companies, weighted by the holding’s NAV.
Carbon intensity estimates are only calculated for companies within Burgiss’ data . Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet.
Source: Burgiss, MSCI ESG Research LLC
Pricing the Carbon Behind the Curtain
Globally, carbon pricing is on the rise and may result in a noticeably higher cost for carbon-intensive companies. The introduction of (or increase in) a carbon price means that companies may face eroding earnings and squeezed margins, resulting in financial pains that can eventually lead to valuation write-downs and lower returns for investors. Using climate transition risk models—both upstream and downstream—will allow investors to put a climate price tag on private assets and compare exposures across regions and asset classes.
[1] Scope 1 emissions are direct GHG emissions from sources controlled or owned by an entity. GHG Protocol.
[2] Measured in tCO2e per USD 1 million of sales. Carbon intensity estimates are only calculated for companies within Burgiss’ data. Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet. Therefore, only companies will have climate transition risk estimates. Source: Burgiss, MSCI ESG Research LLC.
[3] Carbon Pricing Dashboard. World Bank. Data as of April 1, 2022. https://carbonpricingdashboard.worldbank.org/
[4] Carbon Pricing Dashboard. World Bank. Data as of April 1, 2022. https://carbonpricingdashboard.worldbank.org/
[5] Carbon Pricing Dashboard. World Bank. Data as of April 1, 2022. https://carbonpricingdashboard.worldbank.org/
[6] Carbon Pricing Dashboard. World Bank. Data as of April 1, 2022. https://carbonpricingdashboard.worldbank.org/
[7] Burgiss has mapped over 120,000 private portfolio companies and properties from the BMU to the SASB Standards.
[8] Data as of Q3 2022. BMU.
[9] Launch of IMF Staff Climate Note: A Proposal for an International Carbon Price Floor Among Large Emitters. IMF. June 18, 2021. https://www.imf.org/en/News/Articles/2021/06/18/sp061821-launch-of-imf-staff-climate-note