Faculté des HEC

Université de Lausanne

Master of Science in Finance

SUSTAINABILITY AWARE
ASSET MANAGEMENT

Eric Jondeau
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 SAAM
Lecture 6: Climate Change and Climate Risks

Eric Jondeau

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 Objectives of the Lecture
In sustainable asset management, there are two main topics:

- how to build a portfolio that satisfies some criteria related to climate change
(decarbonization)?

- how to build a portfolio that satisfies some Environmental, Social, or Governance

criteria (ESG investing)?

- We start with the presentation of Climate risks (Lecture 6)

- Then, we present the Portfolio construction under climate risks (Lectures 7 – 9)

- Then, we will learn about ESG investing (Lectures 10 – 12)

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 Concepts

This lecture is related to climate change:

- It summarizes some results related to the “Science of climate change” (IPCC,

Intergovernmental Panel on Climate Change)

- It describes these implications of climate change from a finance perspective

o What is climate risk?

o How do we measure climate risk in finance?

o What is the regulation of climate risk?

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 Objectives of the Lecture
Readings
IPCC 6th Assessment Report: “Climate change 2021 – The Physical Science Basis –
Summary for Policymakers”

Bolton, P., Despres, M., Pereira Da Silva, L.A., Samama, F., and Svartzman, R.
(2020), “The Green Swan | Central Banking and Financial Stability in the Age of
Climate Change”, BIS Publication, https://www.bis.org/publ/othp31.htm

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 Objectives of the Lecture

è Climate Change

- Climate Risk Measurement

- Carbon Data

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 Global Warming (or Climate Change)
Global warming is the long-term heating of Earth's climate system observed since the
pre-industrial period (between 1850 and 1900) due to human activities, primarily fossil
fuel burning
Change in global surface temperature (annual average) as observed and simulated

Source: IPCC, 6th assessment report, summary for policymakers (2021), page 7.
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 Some Definitions
Greenhouse gases (GHG) absorb and emit radiation energy, causing the greenhouse
effect:
• Water vapor (H2O)
• Carbon dioxide (CO2) 74%
• Methane (CH4) 17%
• Nitrous oxide (N2O) 6%
• Tropospheric Ozone (O3)

Carbon dioxide equivalent (or CO2e) is a term for describing different GHG in a
common unit
• A quantity of GHG can be expressed as CO2e by multiplying the amount of the
GHG by its global warming potential over a period of 100 years
• 1 kg of methane corresponds to 23 kg of CO2 (lifetime: 12 years)
• 1 kg of nitrous oxide corresponds to 296 kg of CO2 (lifetime: 121 years)

Source: IPCC.

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 Annual CO2 Emissions by Region
Carbon dioxide (CO₂) emissions from the burning of fossil fuels for energy and cement
production

Source: Global Carbon Project (https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions)

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 CO2 Emissions in 2017 (36.2 billion tonnes in total)

Source: Global Carbon Project (https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions)

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 Cumulative CO2 Emissions (1.5 trillion tonnes since 1751)

Source: Global Carbon Project (https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions)

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 Source of CO2 Emissions by Fuel Type (World)

Source: Global Carbon Project (2022) (https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions)

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 GHG Emissions by Sector (World, 2016) (49.4 billion tonnes CO2e)

Source: Climate Watch, the World Resources Institute (2020) (https://ourworldindata.org/emissions-by-sector)

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 Modeling the Interaction between Climate and Economy
Integrated Assessment Models (IAM) have 3 components

- Economic growth
- Climate dynamics
- An objective function

Mechanics of economic models of climate risk

Production Climate Impact and Objective

change damages
Industry and Measures
business Change in Losses on and tax
generate CO2 radiative the entire policies to
emissions warming; economy control CO2
ocean current; emissions
sea level rise

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 Modeling the Interaction between Climate and Economy
The most famous IAM is the Dynamic Integrated model of Climate and the Economy
(or DICE) developed by Nordhaus (1993, 2018). Sketch of the model:

Step 1: Production results in CO2 emissions (𝐸! = 𝑓(𝑌! ) with 𝑌! : gross output)
CO2 accumulation results in CO2 concentration (𝐶! = 𝜙" 𝐶!#$ + 𝛽" 𝐸! )

Step 2: CO2 concentration results in increase in radiative forcing (𝐹! = 𝑔(𝐶! ) + 𝐹%&',! )
Radiative forcing affects temperature (𝑇! = 𝜙 ) 𝑇!#$ + 𝛽) 𝐹! )

Step 3: Increase in temperature generates climate damages (𝐷! = 𝑎$ 𝑇! + 𝑎* 𝑇!* )

Impact of damages can be attenuated by an abatement technology at a cost
+
Λ ! = 𝑏$ 𝜇! ! with 𝜇! percent reduction in CO2 emissions: 𝐸! = 𝜎! (1 − 𝜇! )𝑌!
(𝜎! is the exogenous reduction in CO2 intensity of production)

Step 4: Damage and abatement cost results in a loss of production so that net output is
𝑄! = (1 − 𝐷! )(1 − Λ ! )𝑌!
Production is reduced because of the damages and because a fraction of the
production is devoted to reducing CO2 emissions

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 Modeling the Interaction between Climate and Economy
Difficulty: Calibration of the model parameters because the model is highly nonlinear
and non-stationary

In fact, the climate block is more complicated (temperature for atmosphere, upper ocean,
and lower ocean). Emissions flow into the atmosphere but ocean can capture part of the
emissions.

Applications:
- Compare baseline scenario of the different models
- Compute the 2°C scenario, the optimal welfare scenario, etc.
- Compute the social cost of carbon (SCC): optimal tax rate for carbon emissions.
SCC: Economic cost caused by an additional tonne of carbon dioxide emissions (no
consensus)
• $266/tCO2 for Stern (2007)
• $57/tCO2 for Golosov et al. (2014)
• $31.2/tCO2 for Nordhaus (2018) in optimal welfare
• $229/tCO2 for Nordhaus (2018) in 2.5°C scenario
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 IPCC Projections
The Intergovernmental Panel on Climate Change (IPCC) is the United Nations body
for assessing the science related to climate change (GIEC in French)

The IPCC was created to provide policymakers with regular scientific assessments on
climate change, its implications and potential future risks, as well as to put forward
adaptation and mitigation options

Working Groups:

• Working Group I (WGI): physical science underpinning past, present, and future
climate change
• Working Group II (WGII): impacts, adaptation and vulnerabilities related to climate
change
• Working Group III (WGIII): climate change mitigation, assessing methods for
reducing greenhouse gas emissions, and removing greenhouse gases from the
atmosphere

2021-2022: 6th Assessment Report (https://www.ipcc.ch/assessment-report/ar6/)

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 IPCC Assessment Report 6 (2021)

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 IPCC AR6: Possible Climate Futures
Scenarios are called Shared socioeconomic pathways (SSP)
• SSP1 Sustainability – Taking the Green Road (Low challenges to mitigation and adaptation) The
world shifts toward a more sustainable path.

• SSP2 Middle of the Road (Medium challenges to mitigation and adaptation) The world follows
a path in which social, economic, and technological trends do not shift markedly from historical
patterns.

• SSP3 Regional Rivalry – A Rocky Road (High challenges to mitigation and adaptation) A
resurgent nationalism, concerns about competitiveness and security, and regional conflicts push
countries to increasingly focus on domestic and regional issues.
• SSP4 Inequality – A Road Divided (Low challenges to mitigation, high challenges to adaptation)
Highly unequal investments in human capital and increasing disparities in economic opportunity
and political power, lead to increasing inequalities both across and within countries.

• SSP5 Fossil-fueled Development – Taking the Highway (High challenges to mitigation, low
challenges to adaptation) This world places increasing faith in competitive markets, innovation
and participatory societies to produce rapid technological progress and development of human
capital as the path to sustainable development.
Source: IPCC (2017), The Shared Socioeconomic Pathways and their energy, land use, and greenhouse gas emissions implications: An overview.

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 IPCC AR6: Projections of population and economic growth
Population GDP

Source: https://www.carbonbrief.org/explainer-how-shared-socioeconomic-pathways-explore-future-climate-change

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 IPCC AR6: Projections of Carbon Emissions
Future annual emissions of CO₂ (GtCO2/year) Temperature
rise in 2100 SSPx-y:
- x: number of the
+4.4°C
scenario
- y: total radiative
forcing (in W/m2)
+3.6°C by 2100

Radiative forcing
measures the
change in the
energy balance of
+2.7°C the Earth's climate
system caused by
+1.8°C certain factors,
+1.4°C
primarily
greenhouse gases
and aerosols.

Source: IPCC, 6th assessment report, summary for policymakers (2021), page 16.
See also: https://ourworldindata.org/co2-and-other-greenhouse-gas-emissions.
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 IPCC AR6: Projections of Temperature
Changes in global surface temperature. Temperature differences relative to the average
global surface temperature of the period 1850–1900 are reported in °C.

Source: IPCC, 6th assessment report, summary for policymakers (2021), page 18.

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 IPCC AR6: Remaining Carbon Budget
Estimates of historical CO2 emissions and remaining carbon budgets. Estimated
remaining carbon budgets are calculated from the beginning of 2020 and extend until
global net zero CO2 emissions are reached.

Source: IPCC, 6th assessment report, summary for policymakers (2021), page 38.
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 IPCC AR6: Carbon Dioxide Removal (CDR)
Anthropogenic CO2 removal (CDR) has the potential to remove CO2 from the
atmosphere and durably store it in reservoirs. CDR aims to compensate for residual
emissions to reach net zero CO2 (or GHG) emissions or, if implemented at a scale where
anthropogenic removals exceed anthropogenic emissions, to lower surface temperature.

• Nature-based solutions
o Afforestation
o Reforestation
o Restoration of peat bogs
o Restoration of coastal and marine habitats
• Enhanced natural processes
o Land management and no-till agriculture, which avoids carbon release through soil
disturbance
o Better wildfire management
o Ocean fertilization to increase its capacity to absorb CO2
• Technology solutions
o Bioenergy with carbon capture and storage (BECCS)
o Direct air capture (DAC)

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 Objectives of the Lecture

- Climate Change

è Climate Risk Measurement

- Carbon Data

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 Climate risks and financial losses
Climate Risks include physical risks and transition risks:

• Physical risks represent the economic costs and financial losses due to increasing
frequency and severity of climate-related weather events (e.g., storms, floods or heat
waves) and the effects of long-term changes in climate patterns (e.g., ocean
acidification, rising sea levels or changes in precipitation).

• Transition risks are associated with the uncertain financial impacts that could
result from a rapid low-carbon transition, including policy changes, reputational
impacts, technological breakthroughs, or limitations, and shifts in market
preferences and social norms.
A rapid and ambitious transition to lower emissions pathways means that a large
fraction of proven reserves of fossil fuel cannot be extracted, becoming “stranded
assets”, with potentially systemic consequences for the financial system.

Remark: A third type of risk, liability risk, is sometimes mentioned. This refers to the impacts
that could arise tomorrow if parties who have suffered loss or damage from the effects of climate
change seek compensation from those they hold responsible. However, such costs and losses are
often considered to be part of either physical or transition risk.
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 Climate risks and financial losses
Physical Risk Transition Risk
• More an operational risk than a • A business risk
business risk
• Measuring transition risk is a
• Measuring physical risk is a difficult difficult task
task
• Impact on many sectors (energy,
• Strong impact on real estate and utilities, materials)
insurance sectors
• Probably high impact on stock prices
• Probably low impact on stock prices

Source: BIS (2021), page 19.

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 Physical Risks: Number of Reported Natural Disasters

Source: EMDAT (2022). https://ourworldindata.org/grapher/natural-disasters-by-type

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 Annual Deaths from Natural Disasters (per 100,000 people)

Source: EMDAT (2022). https://ourworldindata.org/grapher/decadal-average-death-rates-from-natural-disasters?country=~OWID_WRL

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 Physical Risks: Climate Disasters
1960-2019 1960-1979 1980-1999 2000-2019
Average number of climate-related disasters per year
Floods 84.0 20.9 69.5 161.5
Storms 66.6 25.2 72.9 101.8
Landslides 11.8 4.0 12.7 18.7
Wildfires 7.3 1.8 8.2 11.9
Heat waves 3.4 0.8 2.4 7.0
Cold waves 6.3 0.5 4.2 14.4
Droughts 11.9 5.6 13.2 16.8
Average number of deaths per disaster
Floods 107 493 155 37
Storms 481 2585 274 108
Landslides 102 367 89 55
Wildfires 8 6 10 7
Heat waves 858 197 277 1124
Cold waves 72 306 97 58
Droughts 8509 40088 5828 82
Source: EMDAT (2020)

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 Physical Risks: Financial Losses from Climate Disasters

Source: Statista (2022). https://www.statista.com/statistics/612561/natural-disaster-losses-cost-worldwide-by-type-of-loss/

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 Transition Risks
Transition risks are relevant to financial institutions holding at least two types of
financial sets (representing about 30% of global equity and fixed-income investments):

Tier 1 – Securities of firms that may be impacted directly by regulatory limits in terms
of their ability to produce or use fossil fuels (e.g., coal, oil and gas, and extraction
companies) (Stranded Assets)

Tier 2 – Securities of firms that are energy-intensive (e.g., forestry, paper, metals, and
mining, etc.).

A good measure of transition risk is carbon risk.

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 Transition Risks: Stranded Assets
Limiting global warming to less than 1.5°C or 2°C requires keeping a large proportion
of existing fossil fuel reserves in the ground. They are called Stranded Assets.

• These assets have suffered or may suffer from unanticipated or premature write-
downs, devaluations or conversion to liabilities

• For example, a 2°C alignment implies to keep a large proportion of existing

fossil fuel reserves in the ground (around 30% of oil reserves, 50% of gas
reserves and 80% of coal)

• Risk factors: Regulations, carbon prices, change in demand, social pressure, etc.

• The discounted loss in global wealth resulting from stranded fossil fuel assets may
range from $1 trillion to $4 trillion (Mercure et al., 2018), far below the International
Renewable Energy Agency’s (IRENA) (2017) estimate of $18 trillion.

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 Objectives of the Lecture

- Climate Change

- Climate Risk Measurement

è Carbon Data

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 Carbon Data
The GHG Protocol corporate standard classifies a company’s GHG emissions in
three scopes:

• Scope 1: GHG emissions generated from burning fossil fuels and production
processes which are owned or controlled by the company (direct emissions).

• Scope 2: GHG emissions from consumption of purchased electricity, heat, or steam

by the company (first-tier indirect emissions).

• Scope 3: Other indirect GHG emissions that occur in the value chain of the
reporting company, including both upstream and downstream emissions, such
as from the extraction and production of purchased materials and fuels, transport-
related activities in vehicles not owned or controlled by the reporting entity,
electricity-related activities not covered in Scope 2, outsourced activities, waste
disposal, etc.

Remark: Scopes 1 and 2 are mandatory to report, whereas scope 3 is voluntary (and
harder to measure and monitor).

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 Carbon Indicators

Source: https://www.myclimate.org

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 Carbon Indicators
Carbon emissions: measured in tonnes of CO2 equivalent (tCO2e)

Carbon intensity: amount of GHG emissions per unit of revenues. It is measured in

tonnes of CO2 equivalent per dollar of revenue (tCO2e/$ million).

How to find data of carbon emission and intensity?

• Carbon Disclosure Project (CDP) is a not-for-profit charity that runs the global
disclosure system for investors, companies, cities, states, and regions to manage
their environmental impacts
(https://www.cdp.net)

• Trucost was established to provide the data, tools and insights needed by
companies, investors and policy makers to deliver the transition to a low carbon,
resource efficient economy
(https://www.trucost.com)

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 Carbon Data
Examples of Scope 1–3 Carbon Emissions and Intensity (2019)

Walmart Southern Exxon

Company Mobil
(Retail) (Elec. prod.) (Oil&gas prod.)
Scope 1 emissions (mln tonnes) 6.1 88.2 111.0
Scope 2 emissions (mln tonnes) 13.1 3.4 9.0
Scope 3 emissions (mln tonnes) 40.7 5.0 107.3
Revenue (bln $) 514.4 20.7 255.6
Scope 1 intensity (tonnes/$ mln rev.) 11.9 4269.3 434.3
Scope 2 intensity (tonnes/$ mln rev.) 25.4 165.7 35.2
Scope 3 intensity (tonnes/$ mln rev.) 79.0 240.0 419.8
Scope 1-3 emissions (mln tonnes) 59.8 96.6 227.3
Scope 1-3 intensity (tonnes/$ mln rev.) 116.3 4673.8 889.3

Source: Trucost (2021).

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 Distribution of Carbon Emissions and Intensity (2019)
Scope 1 Carbon Emissions (tCO2e) Scope 1 Carbon Intensity (tCO2e/$ mln)

Source: Trucost (2021).

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 Distribution of Carbon Emissions and Intensity (2019)
Scope 1-2 Carbon Emissions (tCO2e) Scope 1-2 Carbon Intensity (tCO2e/$ mln)

Source: Trucost (2021).

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 Distribution of Carbon Emissions and Intensity (2019)
Scope 1-3 Carbon Emissions (tCO2e) Scope 1-3 Carbon Intensity (tCO2e/$ mln)

Source: Trucost (2021).

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 Distribution of Carbon Intensity by Sector (2019, World)
Carbon intensity Scope 1-3 (tCO2e/$ mln revenue)

Remark: Box represents the IQR range. Max and min represent Q3 + 1.5 IQR and Q1 - 1.5 IQR, respectively.
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 Distribution of Carbon Intensity by Region (2019)
Carbon intensity Scope 1-3 (tCO2e/$ mln revenue)

Remark: Box represents the IQR range. Max and min represent Q3 + 1.5 IQR and Q1 - 1.5 IQR, respectively.
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 Which Scope to Use?
Scopes 1 and 2 are mandatory to report and should be included in any portfolio
construction

Scope 3: It matters for some industries

- Banks emit little carbon directly, but they finance polluting firms (Scope 3)
- Car producers have a large influence on the emissions of their cars (Tesla vs. Ford)

Problem: most companies do not disclose Scope 3 emissions. They are estimated by data
providers (CDP, Trucost) but estimates include some uncertainty.

Sectors for which Scope 3 is likely to be material

- Upstream Scope 3:
o Energy, utilities, materials, chemicals, industrials, consumer goods

- Downstream Scope 3:
o Sold products: oil and gas, automobiles, technology, apparel, chemicals
o Financed emissions: financials
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 Which Scope to Use?

Source: Trucost (2019)

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 Which Scope to Use?

Source: Based on Inrate data

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 Double Counting
Double counting: case where the same tonne of carbon is counted multiple times within
a portfolio.
Examples:
Category Scope Example
Electricity Scope 2 Company A produces the electricity (Scope 1) purchased by
producer/user company B (Scope 2)
Supplier/user Scope 3 Company A uses the energy-consuming goods (Scope 1)
produced by company B (Scope 3)
Product/energy Scope 3 The petrol produced by company A (Scope 3) is burnt by the
vehicles operated by (Scope 1) or produced by (Scope 3)
company B
Producer/retailer Scope 3 Company A is a retailer (product in use Scope 3) of goods
purchased by company B (Scope 3)
Large and diversified portfolios are more prone to double counting.
In principle, the same emissions could be counted 3 times
Eliminating all double counting is virtually impossible (requires input-output models)
It may reach up to 30-40% of total emissions.
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