Zacharias Sautner, Laurence van Lent, Grigory Vilkov and Ruishen Zhang contribute to the sustainable investing literature with their June 2021 study, “Firm-level Climate Change Exposure.” They began by noting: “Climate change has started to significantly affect a large number of firms. While some firms face direct costs from change in the physical climate, others are adversely affected by policies and regulations that are implemented to combat global warming. At the same time, climate change does provide opportunities for some firms, those, for example, operating in renewable energy, electric cars, or energy storage. With the consequences of climate change becoming more observable, the debate has intensified over whether capital markets are paying enough attention to the financial impacts of climate change.”
They then noted the challenge that investors face in determining firm-specific exposures to climate change: It remains unclear how the climate will change and whether, how and when policymakers will tighten regulation; the effects of climate change are uneven across firms, even within the same industry (many factors that affect a firm’s ability to adapt to a greener economy exhibit large firm-level components such as managerial skill, innovation or financial constraints); and there is no common practice among academics or practitioners for how to reliably quantify firm-level climate change exposure.
To try to address the problem, the authors used transcripts of 10,158 quarterly earnings conference calls of publicly listed firms from 34 countries to construct time-varying measures of how market participants perceive these firms’ exposures to climate change. Their data sample spanned the period 2002-2019. They used a machine-learning keyword-discovery algorithm to capture exposures related to opportunity, physical and regulatory shocks associated with climate change. They noted that a benefit of using earnings calls is that they are less susceptible to “greenwashing” by management: “Indeed, even if management tries to evade the topic of climate change or to window dress their achievements, analysts could act as a counterpoint by asking probing questions. This is different from other documents such as annual reports or press releases, which exclusively reflect the views of management.” This hypothesis is supported by the evidence from the 2021 study “Cheap Talk and Cherry-Picking: What ClimateBert has to say on Corporate Climate Risk Disclosures,” which found that climate risk disclosure in annual reports is mostly cheap talk, with firms cherry-picking the information they provide.
To benchmark and compare their measures, Sautner, van Lent, Vilkov and Zhang used data (available 2009-2017) on firms’ Scope 1 carbon emissions from CDP. Scope 1 emissions are direct emissions, which come from the combustion of fossil fuels or from releases during manufacturing. They focused on Scope 1 rather than Scope 2 or Scope 3 emissions, as they are directly owned and controlled by firms. They then scaled these emissions by total assets in order to obtain a measure of carbon intensity.
As a second benchmark, they used data on firms’ ISS Carbon Risk Rating from ISS ESG, which constructs data to assess firms’ carbon-related performance. ISS Carbon Risk Rating is available annually and is based on several factors, including the carbon impact of a firm’s products (e.g., the revenue shares of products associated with a positive or negative climate impact) and carbon emission reduction targets and action plans. The ISS sample contained 9,995 firm-year observations from 3,306 firms in all 34 countries covering the period 2015-2019.
They also evaluated data on other metrics, including climate policy regulation, extreme temperatures, public attention to climate change, institutional ownership, country mandatory ESG disclosure and financial statement data. Following is a summary of their findings:
- Earnings calls started to address climate issues in the mid-2000s. There was a small decline in the period leading up to the 2012 Doha Climate Summit, which was widely perceived as unsuccessful in addressing climate change, and a leveling off in subsequent years (though this level remained high compared to the pre-2011 period). There was a renewed increase in climate change exposure following the 2015 Paris Agreement.
- The sectors with the highest overall perceived exposure to climate change were utilities, construction and coal mining.
- Utilities topped the exposure ranking for both opportunity and regulatory shocks, which signifies that utilities faced opportunities (e.g., renewable energy) and regulatory risks (e.g., carbon taxes) related to climate change.
- Physical climate change exposure was highest for paper and allied products, heavy construction, coal mining and insurance.
- Industries that appear not to have material exposure to climate change included educational services, hotels and communications.
- There was a strong positive association between both carbon intensity and ISS ratings and their aggregate exposure measure. However, their climate change exposure measures captured more firm-level heterogeneity, with the disagreement being particularly high among firms with high risk (low ratings), not among firms with high opportunities (high ratings).
Investor takeaways
Sautner, van Lent, Vilkov and Zhang’s measure of how market participants perceive a company’s exposures to climate change, based on earnings calls (which reduce the risk of greenwashing found in annual reports and news releases), summarizes the perceived exposure to upside and downside shocks, helping investors with their capital allocation decisions.
Another takeaway is that academic researchers are increasingly finding ways to utilize artificial intelligence tools, such as natural language processing, to help understand how markets price risk and expected returns. For those interesting in how these tools are being used, I recommend a visit to Sparkline Capital’s website to read the work being done by Kai Wu.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Zacharias Sautner, Laurence van Lent, Grigory Vilkov and Ruishen Zhang contribute to the sustainable investing literature with their June 2021 study, “Firm-level Climate Change Exposure.” They began by noting: “Climate change has started to significantly affect a large number of firms. While some firms face direct costs from change in the physical climate, others are adversely affected by policies and regulations that are implemented to combat global warming. At the same time, climate change does provide opportunities for some firms, those, for example, operating in renewable energy, electric cars, or energy storage. With the consequences of climate change becoming more observable, the debate has intensified over whether capital markets are paying enough attention to the financial impacts of climate change.”
