Methodology for the assessment of Climate Risk in Private Equity Investment Portfolios

The Thesis is focused on describing the methodology adopted by the consulting company "Environmental Resources Management" (ERM) to assess climate risks and opportunities linked to Private Equity investments portfolios. This is an emerging field of application, as the literature reviewed did not highlight any study describing a comprehensive methodology adopted to assess the climate risk according to the Task Force on Climate-Related Disclosure (TCFD) guidelines for a Private Equity investment portfolio. The TCFD subdivides the climate risk into physical and transition risks. The first is related to the augmented occurrence of extreme events due to climate change, both acute (i.e., river flooding, coastal flooding, extreme winds and storms, landslides, wildfires) and chronic (i.e., extreme heat and water stress), while the second is related to the risks and opportunities that potentially can arise during the transition towards a lower carbon economy, which can be grouped under three main aspects: Policy & Legal, Market & Technology, Reputation & Brand. The potential financial implication of climate risk for a private equity investment portfolio is assessed by ERM starting with a high level screening of the invested companies. At this stage, for transition risks, based on the economic sector in which the company operates and the potential eligibility under upcoming regulations (e.g. EU taxonomy, Carbon Border Adjustment Mechanism, EU Emission Trading System scheme) a score representing the severity of the risk is given. Regarding physical risks, the analysis is conducted at the operational site level, and based on their position open sources database are consulted for each type of risk to assign a risk score. The companies most exposed to climate risk are selected to proceed with further assessment of the materiality of the detected potential risks. This is done starting a discussion with those portfolio companies, in order to gather additional data regarding their exposure to the risks. Regarding physical risks, information on the supply chain and on the operations carried out by the business are collected, regarding transition risks information on the company size, on the key clients and on the supply chain are requested. If the potential materiality is confirmed, a scenario analysis is performed to understand potential future impacts. Concerning physical risk it is done according to two scenarios published by the Intergovernmental Panel on Climate Change (IPCC), which are the sustainable one, the SSP1-2.6, and the business as usual one, the SSP5-8.5 for two time horizons: 2030 and 2050. Concerning transition risks IEA scenarios are taken as reference, in particular the NZE (sustainable) and STEP (business as usual). If the materiality is confirmed by the scenario analysis, a quantification of the potential financial impact is carried out, based on the availability of the company's data and scenario projections data. A critical review of the methodology based on the application to case studies and scientific studies' review underscore the robustness of the methodology, even though some technical limitations related to the inherent uncertainty of the field of study are detected. In conclusion, the methodology has been applied to a limited amount of case studies until the scenario analysis, while the quantification of the financial impact has still not be requested by the market, further applications will allow an improvement on its weaknesses.