To evaluate the viability of a company’s efforts to reduce carbon emissions and the implications for investors, Aberdeen Standard Investments uses a three-step process for screening, assessing carbon risk, and evaluating company strategy.
This case study from Aberdeen Standard Investments originally appeared in the CFA Institute report "Climate Change Analysis in the Investment Process."
At Aberdeen Standard Investments, we are particularly interested in transition stories from companies that can demonstrate that they have embarked on a journey to decarbonise their operations. Our assessment follows a three-step process: screening, carbon risk assessment, and evaluation of strategy. This framework enables us to objectively measure the viability of decarbonisation and its implications for the company as well as investors.
As an example to illustrate our framework, we will look at Company A, an integrated utility company based in Asia. It generates, transmits, and distributes electricity to residential, commercial, and industrial customers. At the moment, 100% of its power generation comes from fossil fuels, but the company has stated its ambition to move away from heavy-polluting coal and increase the share of natural gas and renewables used to generate power.
Step One: Screening
The first step is looking at absolute, relative, and expansion thresholds to understand whether the company is in alignment with the Paris Agreement’s 2°C warming limit. For example, absolute triggers, such as the overall CO2 the company emits, are useful for identifying which companies will be among the largest emitters. On a relative basis, we can identify if a material portion of a company’s operations are in coal-fired power generation. The expansion threshold aids in understanding whether a company has committed to further investing in coal-fired assets. In our framework, we flagged Company A for breaching the “relative basis” threshold because it was generating more than 20% of its power from coal.
Step Two: Carbon Risk Exposure
The second step is carbon risk assessment, which helps us to understand a company’s exposure at the asset/operator level. Here we take a deep dive into the characteristics of the operator’s physical assets, such as location, operational lifetime, and fuel mix profile. These elements provide us with important information on several levels. The location tells us whether the company operates in a jurisdiction that has existing or proposed plans for carbon taxation, for example. Asset lifespan tells us about stranded asset risk—the longer a plant’s operational lifetime, the higher the risk that it will not be economically viable to exploit it in the future. We also consider the plant’s emission profile, including absolute emissions and emission intensity, because the more CO2 a company emits, the higher the potential for future carbon tax costs. Finally, financial metrics also play a key role in our carbon risk assessment because ultimately, we want to understand whether the company has the ability to limit the effects of increased costs (carbon tax, costs of complying with stricter environmental regulations) on profit. Capital expenditure plans of the company for maintaining coal assets and/or expansion of the coal fleet are also strong indicators of how coal exposure affects its bottom line.
In our example, Company A has a single coal plant that represents approximately 60% of its power generation capacity and is estimated to be operational well into the 2040s. Although its emission track record has not been published, Company A disclosed that it spent more than US$1 billion a few years ago on a major emission control project. It also disclosed that it has no capital expenditure plans for investing in further coal-fired assets.
Step Three: Carbon Strategy
The third and final step in our analysis is to look for evidence on the viability of the company’s decarbonisation plan. What is Company A’s strategy in transitioning away from coal? We look for objective, factual disclosures on the overall vision.
Starting at the top, the C-level oversight tells us whether a company has a board-level committee in charge of sustainability and whether key performance indicators for the energy transition are tied to executive remuneration. We also assess the company’s level of effort to communicate with investors, such as through sustainability reports and/or by joining such global disclosure initiatives as the CDP or TCFD. For Company A, we were satisfied to see both that its Sustainability Committee has a primary role in overseeing the management of the group’s sustainability issues and that its Audit & Risk Committee is responsible for the assurance of sustainability data.
We assess whether the company has committed to decarbonisation targets and timelines, as well as whether it discloses the types of projects that will bring the company closer to achieving those targets. Company A committed to an early retirement of 50% of its coal units by 2025. It also embarked on a radical fuel mix change from coal to gas through the construction of two new gas-fired power plants by 2020 and 2023. It disclosed the amount of emission reduction that it would achieve from the change from coal to gas-fired power generation. Finally, it set a target to increase the share of renewable energy in its generation mix to 30% by 2030.
Based on these plans, we noted that Company A’s risk of coal lock-in is minimal. In other words, the company’s current plans suggest that its coal-based share of power generation will dramatically diminish and fall below our initial 20% threshold during the next decade.
Based on our holistic assessment of current carbon exposure and strategy for future decarbonisation, we are supportive of Company A’s efforts and believe that the company can play a positive role in climate change transition.
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