Climate Transition Risk, Part One: An Introduction
Abdulla Zaid, Burgiss
This research brief is Part One of the Climate Transition Risk blog series.
Key Takeaways:
Greenhouse gas (GHG) direct emission (Scope 1) is estimated to be financially material to a relatively small fraction of Buyout funds’ U.S. holdings: 7% by valuation and 10% by company count.
Private companies with financially material GHG emissions have a carbon intensity estimate of ~256 metric tons CO2/USD million sales, or about 20 times the level exhibited by the non-material segment.
Private capital investors are currently facing two types of climate risks: physical and transition. Physical risks result from extreme climate events, such as floods, wildfires, heatwaves, and hurricanes, that cause financial losses. Transition risks arise from moving toward a carbon-constrained economy, driven by changes in climate policies, cheaper low-carbon technologies, and a shift in consumer and investor sentiments toward green solutions.[1]
Measuring climate-transition risks as well as conducting climate stress tests are increasingly gaining momentum, as worries mount over the risk of stranded assets[2] and the uncertainty around their long-term valuations. For instance, the Bank of England has indicated that if government policies were to change globally in accord with the Paris Agreement, two-thirds of the known global fossil fuel reserves would not be burned, which would lead to changes in the value of fossil fuel investments.[3]
This article is intended to serve as an introductory piece to a sequence of articles that will estimate climate transition risks of private companies and examine how their profitability could be impacted by various carbon pricing schemes. The first step, in this article, is to map the financial materiality of GHG emissions to private companies in order to estimate their carbon exposures. The scope of the article covers US portfolio companies, held by Buyout funds.
Emissions Are Not Created Equal: Identifying Materiality within Buyout Funds
Calculating climate transition risks requires an understanding of the financial materiality of GHG emissions in private companies and the consequent exposures to climate regulatory risks. Financial materiality can be understood as the relevance of a specific ESG factor to a company’s financial performance, business model, and enterprise value. For example, GHG emissions can be relevant and financially material to carbon-intensive companies due to the growing regulatory restrictions and the associated compliance costs.
Using the Sustainability Accounting Standards Board (SASB) Standards, Burgiss’ universe of private companies is divided into “material” and “non-material” segments based on the financial materiality of their direct GHG emissions (scope 1).[4] These two samples are expected to be fundamentally different in terms of their carbon footprints, climate regulatory exposures, and climate transition risks. Burgiss has mapped over 120,000 private portfolio companies and properties from the Burgiss Manager Universe (BMU) to the SASB Standards, allowing Limited Partners (LPs) to detect opportunities and risks in their portfolios.
Figure 1 shows that GHG emissions are estimated to be financially material to only 7% of the Buyout funds’ aggregate U.S. holdings valuation, or to 10% of the underlying U.S. private portfolio companies, by count. The “material” subset is relatively small but has a scope 1 carbon-intensity estimate of about 256 metric tons CO2/USD sales, or over 20 times the non-material subset’s average,[5] demonstrating a significant exposure to climate policy. Identifying the material subset (10% of company count) will allow LPs to effectively monitor and engage with General Partners (GPs) on this concentrated part of their portfolios and the associated carbon footprint and climate regulatory risks.
Figure 1: SASB GHG Emission Materiality: Climate Vulnerabilities Within Buyout Funds
Data as of Q2 2022. This analysis is based on an aggregated underlying holdings valuation of ~USD 1.2 trillion in U.S. portfolio companies that are held by Buyout funds. Carbon footprint analysis is based on ~98.6% of the net asset value (NAV). Carbon intensity estimates were calculated only for companies within the private capital universe. Therefore, properties, natural resource investments, and infrastructure assets generally do not have available estimates yet. The sectoral percentages are based on holdings valuation shares. The sector classification is based on SASB’s Sustainable Industry Classification System (SICS).
Source: Burgiss, MSCI ESG Research LLC
Looking Ahead
While private markets are inherently opaque with minimal climate disclosure, LPs’ growing engagements with GPs and portfolio companies could prove valuable in expanding climate transparency. Prioritizing climate disclosure engagements with companies that face financially material climate transition and regulatory risks may be valuable in risk management and mitigation.
The next articles will examine climate transition risks across private companies and estimate the impact of various carbon-price scenarios on profitability, using upstream and downstream approaches.
[1] Climate-related risk drivers and their transmission channels. April 2021. Bank for International Settlements. https://www.bis.org/bcbs/publ/d517.pdf
[2] Assets that could suffer from an unanticipated premature devaluation due to changes associated with the transition to a low-carbon economy, such as regulatory changes. Carbon Tracker. https://carbontracker.org/terms/stranded-assets
[3] Climate change: what are the risks to financial stability? January 2019. Bank of England. https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability
[4] Scope 1 emissions are direct greenhouse emissions from sources controlled or owned by an entity. GHG Protocol.
[5] Burgiss, MSCI ESG Research LLC