The Climate Intelligence Landscape: Current Limitations and the Road to Improved Financial Signals

Many investors consider it their fiduciary duty to assess the financial consequences associated with climate change. This requires combining the fields of climate economics and investing, something we explored in a previous post, noting the difficulties in bringing these fields together due to different institutional histories, separate scales of considerations, distinct tooling, and more.¹

Despite the differences, these fields are merging. At their intersection, investors are starting to use a variety of signals to forecast financial risks and opportunities, shaping both how they invest and how they engage with companies in their portfolio. In this post, we explore what type of signals investors seek, and the status and limitations of the current data landscape.

Signals That Work for Investment Decisions

Investors who are considering how the climate transition will impact their portfolio companies’ bottom line require a measurement model that provides a coherent view of multiple phenomena. In research circles, establishing such a model is complicated, and in this case requires unpacking several questions such as: what are the dynamics in an economy that values the reduction of GHGs? How is climate economics relevant to any one company? What will the financial outcomes be?

Each of these questions opens up yet more questions, and in turn may be measured in multiple ways. Translating research ideas into formal assessments therefore requires determining what good measurement proxies look like. Identifying these proxies is key: they will help to predict a financial outcome, such as how cheap electricity will impact the bottom line, while misusing a proxy may obscure a financial possibility, or even lead you to make the wrong bet.

While the appropriate metrics will vary depending on the specific use case, in this instance, information signals should be financially material, forward-looking, about both risks and opportunities, and cover many companies, which we elaborate on below.

Signals Should Be Financially Material

This refers to information signals that help investors assess which (and to what degree) risks and opportunities might affect a company’s financial performance and, ultimately, its enterprise value and returns to investors. A company’s climate strategy can be financially prudent in many ways: from reducing the volatility of its operating costs, to increasing its long-term revenue potential. In all cases, management should be explicit about how a strategic pillar eventually can translate to bottom-line impact.

Signals Should Be Forward-Looking

Information should help investors navigate potential future outcomes. The past is only relevant insofar as it helps investors understand the future. Say a company has failed to meet greenhouse gas (GHG) reduction targets several years in a row. Does this mean the company is at risk in the transition to a lower carbon economy? Not necessarily. There can be valid reasons that have little to do with the company’s own operations and more to do with a transient business environment.

Signals Should Be About Both Risks and Opportunities

Investors want both upside exposure and downside protection. Some investment theses, such as the stranded assets theory, target long-term risk reduction, while others seek to expose investors to potential upside, for example via reducing costs by targeting energy efficiency.²

Signals Should Cover Many Companies

Most larger institutional investors are broadly diversified, with stakes in hundreds or even thousands of companies across industries, indices and markets. As climate mitigation impacts essentially all companies, it’s important that portfolio managers and analysts can evaluate comparable data across their holdings base.

Why the Current State of Data Falls Short of Investors’ Needs

Two of the most common proxies³ in the area of climate intelligence rely on carbon footprints and climate strategy disclosures.

A carbon footprint assessment evaluates the impact of sourcing, production, and usage of a company’s products. It is also an input to related assessments such as carbon intensity and carbon burden. Carbon footprints are not financial evaluations. They are simply operational accounting facts. To understand the financial implications of a company’s position vis a vis climate change, investors turn to management themselves.

Climate strategy disclosures represent management’s view of climate-related risks and opportunities. These are published in many forms and through many channels, from sustainability reports to custom third-party frameworks. Importantly, not all sustainability disclosures are financially material, so from an investor perspective, it is important that companies ground their climate reporting in disclosures that can affect financial performance and influence investor decision-making. For this, annual reports often provide more trustworthy signals.

Limitations to Existing Signals

While information sources such as carbon footprints and company disclosures provide a solid start, it is important to work with a clear-eyed understanding of the current data landscape and its limitations.

Financial Metrics Need to Differentiate Between Risk Mechanisms

The carbon footprint was not designed to measure financial risk. However, it is still being used as such. One problem is that not all carbon sources of a given scope/category indicate the same level of risk. A more mechanistic framework that traces carbon to specific line items on financial statements would help investors reason through potential scenarios. For example, consider a semiconductor company that uses copper and cobalt – both with similar GHG footprints. Economic dynamics that raise the price of one would not necessarily raise the price on the other.

Forward-Looking Metrics Must Acknowledge That the Future May Be Structurally Different From the Present

Carbon intensity metrics are based on a company’s current GHG emissions – not its potential future exposure. A copper mining company’s decision to contract with a solar panel manufacturer indirectly helps all those who decide to use solar electricity to reduce their emissions.⁴ The copper company’s current emissions intensity, however, doesn’t foreshadow either the potential impact on emissions or the new revenue opportunity. There are many other examples, from precision agriculture⁵ to the lightweighting of vehicles.⁶

Measures Based on Climate Disclosures Lack Coverage

The most widely available reporting measures, such as carbon footprint signals, are more sensitive to risks than to opportunities.⁷ For certain investors, that will be enough, but for others, there is also the upside potential. For example, an investor may want to make a bet on increases in copper prices. Such upside bets rely on signals based partially on disclosures, for which there is no universal reporting framework. This may leave broadly diversified investors in the dark, lacking data to track, reference, and connect the dots between historical performance and forward-looking financial materiality across their portfolios.⁸

How Combining Insights Across Multiple Channels Makes Climate Data More Intelligent

Investors seeking to identify the companies positioned to do well in a lower carbon economy need tools that combine information from across channels to provide standard points of comparison, and actionable insights into expected effects on future financial performance. While more robust, consistent corporate reporting would be welcome, equally important in today’s information landscape is what we do with existing data. Different initiatives and research providers try to fill the coverage gap, but investors still lack suitable tools to bridge broad, systemic climate forces with the specific circumstances of their individual investments.