In this study, we tested how climate value at risk (CVaR) performs as a tool to call attention to stocks with elevated physical risk exposure. We aimed to de-risk portfolios by excluding names with elevated climate VaR. While data on CVaR is limited, we found that the so-created “CVaR portfolio” outperformed the benchmark in our sample period1 because the excluded stocks exhibited much lower returns over the period.
CVaR portfolios have historically outperformed their benchmarks, and the majority of their excess returns can be explained by security selection rather than climate-related sector biases. Importantly, during climate disasters, the excluded securities significantly underperformed the benchmark and the CVaR Aware portfolio.
CVaR is a relatively new concept that measures the “size of loss attributable to climate-related financial risks, by comparing the value of assets in a world with climate change, relative to the same world without climate change.”2 One of the earliest uses of CVaR calculated the value at risk of global financial assets based on two scenarios: (1) a business-as-usual (BAU) scenario (based on a 2.5oC carbon emission mitigation pathway), and (2) an improved scenario based on a 2oC pathway.3 It observed that 16.86% (roughly USD $24.2 trillion) of financial assets were at risk based on a BAU scenario, and this fell to about 1.77% of financial assets (roughly USD $2.5 trillion) under a 2oC pathway.
The significant increase in CVaR exemplifies the need for detailed value-at-risk scenarios that can inform clients about the historical price volatility related to climate risks and help them monitor tail risks. Notably, these numbers may be conservative given that the latest evidence implies a temperature rise closer to 3–4o C under current policies, based on the Intergovernmental Panel on Climate Change (IPCC) Working Group III reference pathways.4
Climate VaR is estimated by several financial and environmental, social, and governance (ESG) data vendors, including MSCI and Institutional Shareholder Services (ISS). Most of these vendors align with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations for conducting scenario analysis. For this exercise, we used the value-at-risk metrics provided by MSCI ESG Research, a vendor that used 15 years of securities data to form a calculation of climate VaR. MSCI calculates CVaR for each individual issuer, under various scenarios.
1 June 2018 to March 2022.
2 The Economist Intelligence Unit, “The Cost of Inaction: Recognising the Value at Risk from Climate Change,” Economist Impact (2015). Appendix written by Vivid Economics.
3 Simon Dietz, Alex Bowen, Charlie Dixon, and Philip Gradwell, “‘Climate value at risk’ of global financial assets,” Nature Climate Change, 6(7), (2016): 676–679. https://doi.org/10.1038/nclimate2972.
4 Intergovernmental Panel on Climate Change, “IPCC Sixth Assessment Report: Climate Change 2022: Mitigation of Climate Change,” USA: Cambridge University Press (2022).
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The views expressed are the views of Mohit Rakyan and Mohamed Rehan through March 5, 2023, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected.
Sample portfolio returns shown above are hypothetical and are based on the returns of the underlying market indices in the proportions shown above. For Figures 3 and 4, the hypothetical CVaR Aware, and CVaR Exclusions portfolios were built using the the value-at-risk metrics provided by MSCI ESG Research, a vendor that used 15 years of securities data to form a calculation of climate VaR. The methodology used was to take the security-level MSCI CVaR as of May 31, 2022, and backfill the data for the testing period defined in the Figures. The CVaR Aware portfolio excludes the names deemed most susceptible to climate risk, per MSCI ESG Research, while the CVaR Exclusions portfolio includes only those names.
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