Managing Risks for

a Changing Climate
A Guide for
Institutional Investors
 2

Acknowledgements
Morningstar Sustainalytics would like to thank the following
members of our Climate Solutions team for their input and feedback
on this ebook:

Clark Barr Michael Hayne

Director of Methodology and Product Architecture Director, Product Strategy
Sarah Cohn Anya Solovieva
Senior Vice President, ESG Marketing Global Commercial Lead
Jonathan Feldman Alicia White
Product Manager Senior Product Manager
Fredrik Fogde
ESG Research Associate Director

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Contents
Introduction: The Financial and Market Burdens of Climate Change 04

Today’s Major Investment Risks Due to Climate Change 05

Risk One: Physical Climate Risk 06
Risk Two: Transition Climate Risk 07
The Undervaluation of Climate Risk in the Market 08

Essential Actions for Responding to Portfolio Climate Risks 10

Action One: Communicate Organizational Commitments 11
Action Two: Source The Most Accurate Data Available 12
Action Three: Conduct Scenario Analysis 12
Action Four: Report on Climate Risk Via Established Frameworks 13

Addressing Challenges in Assessing and Reporting on Climate Risks 16

Challenge One: Assessing the Validity of Portfolio Companies’ Net-Zero Commitments 17
Challenge Two: Collecting Data Across Company Reports and Documents 18
Challenge Three: Estimating Issuers’ GHG Emissions 18

The Urgent Task at Hand: Measuring to Manage Climate-Related Risk 19

Managing Risks for a Changing Climate: A Guide for Institutional Investors 4

Introduction: The Financial and Market Burdens of Climate Change

Triggered by the climate crisis and calls for transparency from investors, The growing materiality of climate-related financial burdens has prompted
governments are enacting a wave of new climate regulations. For financial institutions governments and regulatory bodies to enact legislation that mandates businesses
and asset managers this means obligatory reporting on climate-related risks, to employ tracking, measuring, and disclosure mechanisms that account for
greenhouse gas (GHG) emissions, and detailed plans to reach net-zero emissions different environmental metrics, strategies, and risks.
by 2050 in lending and investment portfolios. The year 2050 might seem a
In the European Union, the Corporate Sustainability Reporting Directive (CSRD)
lifetime away, but the financial impacts of the climate crisis are already being felt,
came into law in 2023 as a more comprehensive replacement of the Non-Financial
prompting changes to the global financial system.
Reporting Directive (NFRD), requiring roughly 50,000 companies to report on
The previous eight years from 2014 to 2022 have been the warmest on record a broad range of sustainability issues. In the U.S., the Securities and Exchange
globally and this rise in temperatures has resulted in an increase in the frequency Commission’s (SEC) proposed climate disclosure rules would also compel
and severity of extreme weather events.1 In 2022, 18 climate-related disasters large companies to report climate data and strategies beginning in 2024.6
struck the United States, each causing damages exceeding US$1 billion. In total,
With additional climate-focused legislation on the way in jurisdictions
extreme weather events caused US$165 billion in damages in the U.S. that
around the world, the evolving regulatory landscape exposes businesses to added
year. The number of billion-dollar disasters in 2022 was the third highest total of all
risks. On top of the physical risks of climate change that can damage company
time, only behind 2020 (22 disasters), and 2021 (20 disasters).2
infrastructure, the transition risks posed by these changing regulations present
Climate-related insured losses are also on the rise. A report from Munich Re another hurdle.
puts the 2022 global insured losses at US$120 billion, on par with figures from
To reach net-zero emissions in financial institutions’ lending and investment
2021 and higher than the previous five-year average of US$97 billion.3
portfolios by 2050 requires a massive restructuring of their capital allocation.
Hurricane Ian, which made landfall in September 2022 on the west coast of Florida,
Vetting portfolio companies for their climate risk management, carbon
was responsible for about half of the total insured losses worldwide, making it
emissions, and net-zero strategies is critical for banks and asset managers in the
the second-costliest tropical storm after Hurricane Katrina in 2005. Extensive floods
pursuit of their climate goals. Many financial institutions are now making
in Pakistan and Australia, which resulted in damages totaling US$15 billion and
net-zero pledges yet remain uncertain about how to get there. The following sections
US$4 billion respectively, were other key contributors to 2022’s high tally of insured
of this book will help to answer the question, “We’ve committed to net-zero by
losses. The rising insurance costs due to climate change are even rendering
2050, now what?”
some assets uninsurable.4, 5

“We’ve committed to net-zero by 2050,

now what?”
Today’s Major
Investment Risks Due
to Climate Change
Evaluating portfolio climate risk begins with an understanding of what climate
risks actually are.* We know that hurricanes, fires, and floods pose a risk to
physical assets, but how do you valuate that risk? Transition risks, such as carbon
taxes or net-zero mandates, can pose obstacles for businesses to overcome.
But which investments are vulnerable to climate-related penalties or having their
assets left stranded?
There is no simple formula for evaluating climate risk because of the uncertainties
and complexities involved in forecasting and assessing. The speed and
stringency with which government regulations are enacted are subject to political
interests. The timing and severity of physical hazard events can never be
predicted with absolute certainty.
However, using forward-looking models and scenario analysis can help paint a
detailed picture of what a portfolio’s climate risk may look like, providing
investors with the outlook and data they need to make informed decisions and
manage their climate risks.

*Unless otherwise stated, we use the term climate risk(s) in a broad sense throughout, as the risks (i.e., environmental, business,
societal, existential, etc.) presented by global climate change. Physical climate risk and transition climate risk are later presented with
their own distinct meanings.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Today’s Major Investment Risks Due to Climate Change 6

Risk One: Physical Climate Risk

Physical climate risks include the hazards related to the increasing severity and Figure 1. Acute Versus Chronic Physical Climate Hazards
frequency of extreme weather events, as well as the long-term gradual
changes in climate. Physical climate risks pose material risks to companies,
Acute Chronic
as they have the potential to damage assets, increase repair costs, and
hinder productivity.
Physical climate risk can be separated into two categories: acute and chronic
Cyclone Wind
(Figure 1). Acute hazards are high impact, short-term threats posed by
extreme weather events like floods, hurricanes and wildfires. Chronic hazards are
the threats created by gradual long-term changes in climate. Damage to
Flooding
assets due to freeze-thaw cycles, soil subsidence, or coastal inundation are all Freeze-Thaw
Coastal
Forest Fire
examples of chronic hazards.7 Inundation
Soil Subsidence
Extreme Heat

Extreme Wind

Source: Morningstar Sustainalytics. For informational purposes only.

For more details see Morningstar Sustainalytics guide
Physical Climate Risks: Preparing Your Portfolio for a Changing Climate
Managing Risks for a Changing Climate: A Guide for Institutional Investors Today’s Major Investment Risks Due to Climate Change 7

The Potential Impacts of Physical Climate Risks to Companies

Risk Two: Transition Climate Risk
One obvious impact of physical climate risks is damage to company property. Transition risks include the potential financial, reputational, and litigation impacts
A company’s vulnerability and exposure to these risks are determined by caused by the dynamic landscape of government regulations, emerging
factors including geo-location, construction quality, frequency and severity of technology, and consumer preferences. Changing regulations include reporting
physical hazards, and relative importance of impacted assets. requirements, carbon taxes, emissions caps, and financial penalties for
non-compliance. This is an extra layer of risk that investors, asset managers and
The amount of physical climate risk that an asset carries has a direct impact on
financial institutions need to consider.
the price of its insurance premiums. The global insurance landscape is
seeing more climate-related claims year over year.8 The more vulnerable a company As the world transitions to a low-carbon economy to mitigate additional physical
is to climate risks, the more it can expect to pay in insurance premiums. climate risks and losses, companies face the possibility of stranded assets
Research from the Swiss Re Institute expects global property catastrophe premiums and higher operating costs as they are required to shift to greener technologies.
to increase by up to 41% (US$183 billion) by 2040 due to climate risk.9 And as changes in climate policies that either hinder or promote certain
technologies are enacted, operational changes in global production will soon
Consequently, assets with high risk and high insurance rates can experience a
follow. This will impact the demand and cost of existing processes and the
related loss in value. Even as insurance premiums increase, some insurers
value of the infrastructure supporting them.
may refuse to cover certain assets. The California wildfires of 2017-2018 resulted
in 235,250 non-renewals of policies, an increase of 31%. And one in ten These costs can be offset by realizing higher growth, saving on inefficiencies and
homes in Canada are now effectively uninsurable due to flooding risk.10, 11 expenses, avoiding regulatory risks, accessing cheaper capital, and
creating new sources of value for customers. The longer a company delays its
Physical climate hazards also have an impact on productivity. Hazards like heat
transition, however, the greater the costs will become — and fewer
and flooding can result in equipment failures and personnel shortages that
opportunities will be available to offset those costs.14
cause operational outages, lowering productivity. During a record heatwave in the
U.K. in 2022, a data center’s inability to maintain a safe operating temperature
due to a failed cooling system and extremely high outside temperatures resulted in
a service outage for some Google Cloud services.12 Conservative estimates
from the International Labour Organization (ILO), based on a global temperature
Research from the Swiss Re Institute expects global
rise of 1.5°C by the year 2100, suggest that, “in 2030, 2.2 percent of total
working hours worldwide will be lost to high temperatures,” resulting in economic property catastrophe premiums to increase by up
losses of US$2.4 trillion.13 to 41% (US$183 billion) by 2040 due to climate risk.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Today’s Major Investment Risks Due to Climate Change 8

The Undervaluation of Climate Risk in the Market

According to a study by the International Monetary Fund (IMF), climate risk is not Figure 2. The Scopes of Carbon Emissions
accurately reflected in global equity valuations. Past high-impact disasters
have not had a large influence on market valuations, and future climate risk is not
CO2 N2O CH4
yet fully appreciated by investors. The study’s analysis found that, “Climate
change physical risk is not being factored into equity valuations.”15 There are two
SF6 Carbon Dioxide PFCs Nitrous Oxide HFCs Methane NF3
Sulfur Hexaflouride Perfluorocarbons Hydrofluorocarbons Nitrogen Triflouride
principal reasons that climate risks are undervalued in capital markets:
incomplete data and the short-term nature of markets.
Scope 2 Scope 3 Scope 1 Scope 3
Incomplete Data Indirect Indirect Direct Indirect

With only partial policy actions by governments and regulators, investors’ evaluations
of issuers’ exposure to climate risks are based, for the most part, on
Purchased Leased Assets Company Use of Sold Products
voluntarily reported information. Without a mandatory and standardized reporting Electricity, Vehicles
Steam, Heating
framework, it’s difficult to gather the necessary data, and harder still to and Cooling
Employee Commute Leased Assets
compare that information between companies and across industries.
Company
Facilities
When conducting climate risk assessments, crucial data is often unavailable and
Fuel and Energy End-of-Life Treatment
the lack of uniformity in reported data makes it difficult to evenly assess a of Sold Sroducts
portfolio of companies. An analysis of companies’ emissions data reporting found
Transportation
that in fiscal year 2021 close to 60% of scope 1 and 2 emissions data and over and Distribution Processing of
75% of scope 3 emissions data were unreported.16 Mandatory climate risk disclosures, Sold Products
which are likely coming to the U.S. and are mandated in the EU Action Plan
Business Transportation
for Financing Sustainable Growth’s CSRD, will not only provide investors with reliable Travel and Distribution
data, but will make it much easier to analyze those disclosures using the
same formats, definitions, and calculations.17
Purchased Goods Waste Capital Investments
and Services Goods

Franchises

“Climate change physical risk is not being Upstream Reporting Downstream

factored into equity valuations.” ­- International Monetary Fund Activities Company Activities
Source: Technical Guidance for Calculating Scope 3 Emissions, GHG Protocol. For informational purposes only.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Today’s Major Investment Risks Due to Climate Change 9

The Short-Term Nature of Capital Markets

Another reason for the mispricing of climate risks is the short-term nature of
capital markets. Business leaders, driven by shareholder demand, want to
maximize company performance year on year and quarter on quarter. Term limits
for board members can influence them to operate in a manner that is best
suited for the duration of their contract, but not necessarily in the best interest of
the company’s long-term stability.
However, research from McKinsey Global Institute concludes that despite the
pressures on corporate executives to inflate short-term performance,
“companies deliver superior results when executives manage to create long-term
value and resist pressure from short-term investors.”18
An investigation of New York Stock Exchange data by Reuters found that an investor’s
average holding period for a stock is five and a half months.19 As a result,
investors may overlook chronic physical climate risks and transition risks because
they are unlikely to materialize during the traditional investment time horizon.
However, these shorter holding periods tend to undervalue the physical climate and
transition risks that a company is exposed to.
As those long-term risks begin to emerge, investor confidence in an issuer can
crumble, creating a drop in asset values and a ripple effect through investor
portfolios.20 Understanding issuers’ physical and transition climate risks allows
investment managers to amend their portfolios well in advance of the
materialization of hazards, potentially limiting market panic.
Essential Actions for
Responding to Portfolio
Climate Risks
The climate crisis and regulatory developments are pressing organizations to
make climate commitments, analyze their exposure to climate risk, and
disclose physical climate and transition risks. Most organizations are committing
to reach net-zero emissions by 2050, in line with the obligations of the Paris
Agreement.21 A commitment, however, does not equal a guarantee. Commitments
that don’t have intermediate science-based targets nor disclosed strategies
to reach those targets are quickly being labelled as greenwashing and rejected by
regulatory bodies.22
Companies, investors and financial institutions can enhance the validity of their
climate commitments by: establishing programs focused on managing
climate risks and opportunities, in alignment with the Taskforce on Climate-related
Financial Disclosures (TCFD) framework; tying executive compensation to
GHG emissions reductions or wider climate-related targets; establishing and holding
regular meetings with an internal climate committee; and measuring, tracking,
and reporting on key climate metrics.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Essential Actions for Responding to Portfolio Climate Risks 11

Action One: Communicate Organizational Commitments Action Two: Source The Most Accurate Data Available
To effectively manage climate risk, commitment needs to come from an Access to the right data can support making good decisions and complying with
organization’s leadership. The board of directors is responsible for implementing regulatory bodies. Institutional investors and financial institutions that are
climate risk management into the fabric of the organization. As such, climate signatories to the TCFD are required to disclose their climate-related risks in
risk assessments must be integrated into all financial risk considerations like credit alignment with the framework, so it’s important that they have access to
risk, liquidity risk and operational risk. Accountability mechanisms, such as the right information. This means retrieving accurate data from portfolio companies.
linking executive pay to climate performance or regular climate committee meetings,
While the pace of implementation of climate disclosure frameworks differs around
are good governance practices that will keep businesses alert to evolving
the world, companies may already be disclosing their climate-related data
climate risks.
to a recognized global framework. In these scenarios, investors and financial
Part of a robust climate risk strategy includes the commitment to reach net-zero institutions can be relatively confident in the data they are receiving.
emissions in lending and investment portfolios by 2050, complete with Companies that are not reporting to such a framework may be providing less
intermediate targets and strategies to hit those targets. Net-zero resources, reliable or incomplete data. Investors and financial institutions should be
implementation guidance, improved target setting, regulatory updates, and pushing their portfolio companies to disclose their data to a globally recognized
peer accountability are all available to banks who join the Net-Zero Banking Alliance, climate framework like the TCFD, or the International Sustainability
a coalition of over 100 banks in more than 40 countries that represent 41% Standards Board’s (ISSB) Climate-related Disclosures Standard.23 Doing so will
(US$73 trillion) of global banking assets. Similar guidance can be found for asset provide investors and financial institutions with access to more reliable data
owners at the Net Zero Asset Owner Alliance, and for companies at the and enable their compliance with policy regulations.
Greenhouse Gas Protocol and the Science-Based Targets initiative (SBTi).
Managing Risks for a Changing Climate: A Guide for Institutional Investors Essential Actions for Responding to Portfolio Climate Risks 12

Action Three: Conduct Scenario Analysis

Another vital tool for investors in evaluating portfolio climate risk is scenario
analysis. Climate change scenario analysis allows investors to include
climate change risks in their asset allocation strategy. General circulation models
(GCMs) are used to model the historical and future climate of the world
under different GHG concentration scenarios. By applying the climate predictions
from these models with additional models on physical hazard formation and
modeling the consequences for global economics and energy systems, investors
can use a variety of scenarios to assess the potential impacts on their
investments from future physical and/or transition risks. With scenario analysis,
investors can understand how their baseline risk in a better-case climate
outcome compares to a worse-case climate outcome scenario.
The UN Principles for Responsible Investment (PRI) have commissioned a team of
experts to develop such scenarios for the better-case climate outcome, referred
to as the Inevitable Policy Response (IPR). These scenarios are specifically for use
by investors to assess transition risks.
The IPR, like the name suggests, refers to assessing the government policies that
would inevitably be required to facilitate an economic transition to minimize
global warming and their impact on the global energy system and land use.
The IPR produces two such climate scenarios: the Forecasted Policy Scenario
(FPS) and the Required Policy Scenario (RPS). The FPS provides a forecast
of the likely policy developments. The RPS acknowledges that the FPS scenario
will not reduce emissions sufficiently to minimize global warming to 1.5°C
and goes beyond likely policy implications to illustrate the measures required to
stay below a 1.5°C temperature rise. Investors can use these scenarios to
understand the transition climate risks in their portfolios, a process that is becoming
mandatory in some jurisdictions, as well as being a key part of TCFD and ISSB
disclosure recommendations.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Essential Actions for Responding to Portfolio Climate Risks 13

Action Four: Report on Climate Risk Via

Established Frameworks
There are many different climate disclosure frameworks available to investors and Figure 3. Select List of Jurisdictions with TCFD-Aligned Reporting
financial institutions to develop and validate their net-zero strategies, monitor
and track their progression, and evaluate the climate-related risk of the companies
in their portfolios. Institutions that are not already reporting should familiarize
themselves with the frameworks relevant to their region in order to prepare for
mandatory reporting, and to help mitigate climate risks in their portfolios.

Taskforce on Climate-related Financial Disclosures (TCFD)

The TCFD is the leading framework for financial institutions’ climate-related risk
disclosures. The TCFD framework covers four core thematic areas:
governance, strategy, risk management, and metrics and targets.24 Good examples
of what reporting on each thematic area looks like can be found in the
Climate Disclosure Standards Board’s Good Practice Handbook.
Corporate reporting in line with TCFD criteria is being mandated across a growing
number of jurisdictions. A TCFD-aligned disclosure is already mandatory
in the U.K.,25 and similar requirements are coming to the EU,26 Switzerland,27 and
Canada28 in 2024. Each jurisdiction may have minor tweaks to the framework, TCFD Country Alignment
but the core pillars will remain the same.
Australia Japan
Brazil New Zealand
Canada Singapore
European Union United Kingdom
Hong Kong United States

Source: Morningstar Sustainalytics. For informational purposes only.

Managing Risks for a Changing Climate: A Guide for Institutional Investors Essential Actions for Responding to Portfolio Climate Risks 14

International Sustainability Standards Board (ISSB) Sustainability Sustainable Finance Disclosure Regulation (SFDR)
Disclosure Standards As a regulation included in the European Commission’s Action Plan for Financing
The ISSB standards are set to be released in 2023.29 They will include guidance on Sustainable Growth, the EU’s strategy for sustainable finance, the SFDR aims
broader environmental, social and governance (ESG) reporting along with to improve transparency in the market for sustainable investment products. Under
climate-related risk reporting. It’s expected that 40 or more countries could adopt the SFDR, certain financial market participants are required to disclose how
an ISSB-aligned reporting mandate after its release.30 In the U.K., it’s they consider sustainability risks in their investment process, what metrics they
anticipated that the ISSB will replace the TCFD-aligned requirements.31 However, the use to assess ESG factors, and how they assess investment decisions that
frameworks are expected to remain aligned with each other, ensuring might result in negative effects on sustainability factors, called principal adverse
interoperability for companies and stakeholders using both frameworks. impacts (PAIs). SFDR requirements may apply to both EU firms and non-EU
firms operating within the region. Firms may also be required to make disclosures
One key difference between the TCFD framework and ISSB standards is that the
at both the entity/company level and at the product/fund level.
ISSB standards will introduce industry-specific approaches. Additionally,
reporting on scope 3 GHG emissions will be mandatory in ISSB disclosures, Financial market participants are required to publish on their websites information
whereas they are currently optional under the TCFD.32 about their policies to integrate sustainability risks in their investment decision-
making process. Firms must also report on how they have integrated sustainability
Securities and Exchange Commission (SEC) Climate Disclosure Rules risk in their remuneration policies. Additionally, firms are expected to report on
Also being released in 2023 are the SEC climate disclosure rules. This set of rules how they consider and act to alleviate the adverse sustainability impacts of their
will likely require mandatory climate-related disclosures from all publicly investments or provide an explanation of why they do not.35
listed companies in the United States. The disclosure rules are expected to include
carbon emissions, climate risks, and climate-related goals or targets.33 Corporate Sustainability Reporting Directive (CSRD)
The CSRD is the EU’s version of climate disclosure rules, although it includes
The disclosure rules were designed in close accordance with the TCFD but will see
sustainability factors more broadly. The CSRD came into law in January 2023
a degree of variation. Scenario analysis is not required under the SEC proposal,
and is an update to the Non-Financial Reporting Directive (NFRD), bringing a more
whereas it is required with TCFD; the conditions to demonstrate materiality are
thorough reporting system that requires roughly 50,000 companies to report
lower in the SEC rules; and scope 3 emissions are expected to be required
as compared to the 12,000 companies under the NFDR.36 The more detailed
where they are material to a business.34
information companies are required to provide under CSRD will support
investors’ compliance with the SFDR.
The CSRD’s climate disclosure section will include scope 3 emissions and
scenario analysis.37
Managing Risks for a Changing Climate: A Guide for Institutional Investors Essential Actions for Responding to Portfolio Climate Risks 15

Net Zero Investment Framework (NZIF)

Developed by the Institutional Investors Group on Climate Change (IIGCC), this Table 1. Climate Reporting Requirements by Country
framework is not a reporting requirement, but rather guidance on how
investors can reach net-zero in their investment portfolios. “The framework puts Stage of
For Reporting For Financial Reporting
Regulatory
forward metrics to assess investments and measure alignment, and Corporates Year Institutions Year
Maturity
requires investors to set clear, science-based targets at the portfolio and the asset
class level.”38 Proposed
Australia 2023 Australia 2023
Requirements
Recommended metrics for investors to track include the percentage of their
portfolio with net-zero targets, their level of capital expenditure relating to Malaysia 2023 Thailand 2024

EU Taxonomy activities, and their exposure to fossil fuel reserves.39 United

2023
States
Net Zero Alliances
The Net Zero Banking Alliance (NZBA) and Net Zero Asset Owner Alliance (NZAOA) Voluntary
Russia 2023 Japan 2022
Reporting
are UN-backed coalitions of banks and asset owners, respectively. Pledging a
commitment to reach net-zero by 2050 gains members access to net-zero transition Malaysia* 2022
resources and guidance, target setting advice, regulatory updates,
and peer accountability. Mandatory United Eurpean
2022 2021
Reporting Kingdom Union
The Net Zero Asset Managers initiative (NZAM) is a commitment from 301
signatories with US$59 trillion in assets under management.40 Signatories Singapore 2022 Brazil 2022

of the NZAM commit to reach net-zero emissions by 2050 across all assets
Hong Kong 2022 Singapore 2022
under management, setting interim targets that include a 50% reduction in
carbon emissions by 2030. Egypt 2022
New
2022
Zealand
United
Switzerland 2022 2022
Kingdom

Canada 2024

*Reporting for Malaysian financial institutions will become required for reporting periods starting in 2024.
Mexico, India, South Africa, and South Korea have also recommended their respective governments codify
reporting for companies or financial institutions into official regulations.
Source: Morningstar Sustainalytics. For informational purposes only.
Addressing Challenges in
Assessing and Reporting
on Climate Risks
Regulations vary depending on jurisdiction, but in general, climate risk reporting looks
similar worldwide thanks to widespread adoption of the TCFD framework
and the incoming ISSB framework. That said, it doesn’t mean that climate risk
reporting is straightforward and easy. There are many challenges that
institutional investors and financial institutions face when assessing and reporting
on their climate risks.
Managing Risks for a Changing Climate: A Guide for Institutional Investors Addressing Challenges in Assessing and Reporting on Climate Risks 17

Challenge One: Assessing the Validity of Portfolio Challenge Two: Collecting Data Across Company
Companies’ Net-Zero Commitments Reports and Documents
While strategies to achieve net-zero may differ by company and by industry, there Despite the regulations that mandate climate disclosures, there are still many
are universal components of a net-zero commitment that should be accounted challenges in collecting and analyzing company data. The scale at which
for. First, the pledge to reach net-zero by 2050 or sooner must be made by the head financial institutions need to collect and compile data can be enormous depending
of the organization.41 Following that, there must be science-based targets to on the size of their lending and investment portfolios. Further complicating
reduce GHG in the short, medium, and long term, signaling an achievable path to matters, not all companies report their data to the same degree or use the same
net-zero. Other things to look for are a detailed decarbonization strategy, format and terminologies in doing so. Data gaps can aggravate reporting
capital allocation alignment disclosure, climate risk and opportunities disclosure, challenges for financial institutions.
and a TCFD-aligned disclosure.42
Investors and financial institutions need to dig deep to analyze the validity of
companies’ commitments and run forward-looking scenario projections to gauge
the effectiveness of those commitments in the short, medium, and long term.

“In the transition to a low-carbon economy, success

will require not only a commitment to align to net-
zero emissions, but also leadership buy-in, a sound
strategy, and access to metrics based on science.”
-­ Fredrik Fogde
ESG Research Associate Director, Climate Solutions
Morningstar Sustainalytics
Managing Risks for a Changing Climate: A Guide for Institutional Investors Addressing Challenges in Assessing and Reporting on Climate Risks 18

Challenge Three: Estimating Issuers’ GHG Emissions

Although more companies are reporting emissions data, the reality is that 60% of
scope 1 and 2 emissions data and over 75% of scope 3 emissions data are
left unreported.43 For most companies, that data will have to be estimated.
Scope 3 GHG emissions are the most complex component of emissions reporting.
Without access to detailed company data regarding its supply chain, scope 3
emissions are nearly impossible to evaluate. Averages based on industry-level data
can be used to get a rough estimate of a company’s scope 3 emissions
but are hard to rely on by themselves. So, how can investors get a more accurate
estimation of an issuer’s GHG emissions?
A bottom-up approach to estimating GHG emissions uses companies’ reported
scope 1, 2, and 3 emissions as the baseline average at a subindustry level.
Taking this baseline average and then applying a multi-metric, multi-factor model
will provide a more accurate number that accounts for geographic location,
company size and scale, and business models. This number is a much more reliable
estimation and will also help investors fulfill reporting requirements like those
of the TCFD.

“60% of scope 1 and 2 emissions data and over 75%

of scope 3 emissions data are left unreported.”
-­ Nick Burniston
Associate Director, Senior Product Manager, Climate Solutions
Morningstar Sustainalytics
Managing Risks for a Changing Climate: A Guide for Institutional Investors

The Urgent Task at Hand: Measuring

to Manage Climate-Related Risk
“We’ve committed to net zero by 2050, now what?” Now the real challenge begins.
Between conducting climate and policy scenario analyses, coming to grips
with the global reporting frameworks, assessing the validity of company net-zero
commitments, and many more climate risk management responsibilities,
financial institutions will have their hands full preparing for the low-carbon transition.
Climate-related risk will need to be integrated into the overall enterprise risk
management process of institutional investors and financial institutions,
with board members and executives developing committees to manage climate
risk.44 Understanding the extent of the exposure to physical and transition
climate risks in a portfolio will mean assessing company actions, evaluating the
impact of their commitments, analyzing their management preparedness,
and developing strategies to mitigate these risks.
Variations in companies’ net-zero commitments and pathways due to their
industry and subindustry exposure to climate-related risks can lead to
large inaccuracies between climate-risk estimations and real-world data. Engaging
the support of climate-risk professionals that understand the differences
between the net-zero approaches of various industries and subindustries will
provide financial institutions with the actionable data that they need to
capitalize on the low-carbon transition and achieve net-zero by 2050.
Managing Risks for a Changing Climate: A Guide for Institutional Investors 20

Learn How Morningstar Sustainalytics Can Help

Investors on Their Journey to Net-Zero
Regulatory developments and market guidance such as the TCFD and EU Action Low Carbon Transition Rating
Plan have placed urgency on the investment community to take a more active The Low Carbon Transition Ratings provide investors with a science-based
role to address global climate change. Morningstar Sustainalytics’ suite of climate forward-looking assessment of public issuers’ alignment to a net-zero pathway
solutions can help you ensure your portfolios are aligned to net-zero. by 2050. Investors can respond to regulatory initiatives, implement net-zero
strategies, fulfill client net-zero mandates, and obtain transparency into company
actions by integrating climate research into their investment
decision-making processes.
Physical Climate Risk Metrics
Physical Climate Risk Metrics are designed to help investors understand their
direct and indirect exposure to physical climate risks and the potential financial
impacts to their portfolio companies.
Carbon Emissions Data
Carbon Emissions Data are designed to provide investors with powerful insights to
assess and analyze companies’ carbon emissions. Backed by best-in-class
multi-factor regression models to predict carbon emissions, our Carbon Emissions
Data can help investors respond to regulatory requirements and initiatives such
as the EU Action Plan, TCFD, and PRI.
Engagement Services – Net-Zero Transition Engagement
Sustainalytics’ Engagement Services helps the world’s leading asset owners and
asset managers to foster constructive dialogues with target companies.
Informed by our company research, our program helps clients achieve consistent
ESG engagement outcomes and promote and protect long-term shareholder
value. The Net Zero Transition Engagement Program will support institutional
investors to advance their net-zero stewardship ambitions by establishing an
effective climate-focused dialogue with high-emitting companies on their journey
to net-zero carbon emissions.
 21

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 22
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About Morningstar Sustainalytics
Morningstar Sustainalytics is a leading ESG research, ratings and data firm
that supports investors around the world with the development and
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solutions to meet the evolving needs of global investors. Today, Morningstar
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