Glossary

Active ownership refers to the proactive role that institutional investors play in influencing the behaviour of the companies in which they hold investments. This involvement may take various forms, including direct engagement with company management (including via participation in collaborative initiatives), utilisation of ownership rights, and potentially resorting to public campaigns or litigation. The overarching goal is to impact policies, strategies, practices, or specific decisions of the invested companies. Active ownership may encompass considerations related to both financial and impact objectives. In the realm of climate change, it can target various aspects such as advocating for enhanced disclosure of climate impact, risks, and opportunities. This may extend to influencing the integration of climate considerations into decision-making processes, as well as advocating for measures that contribute to the reduction of adverse climate impacts.

Agency problems at firms arise when the managers (agents) do not act in the interest of the shareholders (principal).

For example, the CEO may decide to use corporate cash to purchase a private jet instead of distributing an extra-dividend to shareholders. Shareholders do not have full information about what is happening at the company. At the same time, managers can make decisions that benefit themselves instead of the stakeholders (including the shareholders). The corporate inefficiencies that are associated with the conflict of interests between management and shareholders are called agency costs.

An insurance contract by which the insured person pays a premium today in exchange for receiving lifetime income.

Asset-liability management (ALM) refers to the adaptation of the portfolio management process to the presence of constraints relating to the commitments represented by the investor's liabilities. 

Best-in-class or positive screening involves selecting, for each investment sector, the assets with the most positive scores on relevant environmental, social, and governance ESG criteria. An aggregate ESG score may be determined based on combinations of single factors by a third party. External ESG scores can be used to obtain a proxy for a company’s ESG performance through a standardized system and, as such, can prove useful for asset managers or asset owners with a limited understanding of how to design their own selection criteria based on various sustainability factors. Positive screening is based on more objective criteria than negative screening, since there are now rating agencies producing ESG scores based on an aggregation of factors. However, there is still a great lack of convergence between the ratings of the various rating agencies. 

The Carbon Disclosure Project (CDP) is a global not-for-profit organisation that collects and analyzes data on climate change and carbon emissions, such as greenhouse gas emissions and internal carbon price (ICP),  from thousands of organisations worldwide. The CDP is reported to be the largest effort to assemble standardised data on carbon emissions as well as information on companies’ risks, opportunities, and strategies to manage the effects of climate change. The CDP started in 2002 at the request of 35 institutional investors managing more than $4.5 trillion of assets. By 2023, CDP endorsement has grown to 740 investors with more than $136 trillion of assets under management, collecting information from more than 23,000 companies, representing two thirds of global market capitalisation.

A measure of the total greenhouse gas (GHG) emissions caused by a corporation, categorized into 3 groups. Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased energy sources. Scope 3 includes emissions outside the boundaries of operational control of a firm, either downstream, generated by product use by the customer, or upstream, generated by a firm’s supply chain.

In the context of the fight against climate change, it has become increasingly important for a large number of organisations to report the so-called carbon footprint. Simply put, the carbon footprint is a quantitative measure of carbon emission or CO2 emissions by a given institution/corporation as a function of the activities.

An approach that consists in internalizing the social costs of carbon emission in economic transactions. Carbon pricing can be implemented via the introduction of carbon taxes, and/or via the introduction of carbon markets, involving emissions trading systems (ETS) where emitters can trade emission units to meet their emission targets.

Refers to the negative impact of unexpected changes in carbon prices on corporations and equity portfolios. 

A carbon tax is a fee imposed on the carbon content of fossil fuels, which is intended to encourage companies and individuals to reduce their carbon emissions by making it more expensive to use fossil fuels. The revenue generated from a carbon tax can be used to fund climate change mitigation and adaptation measures, or to reduce other taxes. Carbon taxes are one of the policy instruments that can be used to achieve the goals of the Paris Agreement and limit the rise of temperatures below 2°C.

The changes in global temperature, ice melting, precipitation, wind patterns and other climate occurrences that are particularly apparent from the mid of last century onwards. Such changes are attributed largely to the increased levels of greenhouse gas (GHG) produced by human activities.

Climate emulators are simple reduced-form models often used to explain the output of more complex climate change models. The latter model the complex interactions between various components of the climate, such as the atmosphere, oceans, land surface, and ice. Their high computational costs, however, render these models unsuitable for studying the feedback between the planetary system and human behaviour. Hence the academic community often resorts to simpler, appropriately calibrated, reduced form models.

The climate emulators found in Integrated assessment models (IAMs) such as DICE typically consist of two submodels: a temperature model, which determines how the CO2 concentration in the atmosphere translates into an increasing average temperature, and a carbon cycle model, which predicts how atmospheric CO2 concentrations evolve as a result of biogeochemical processes.

Refers to the array of financial markets, institutions, instruments, and investment practices aiming at reducing global greenhouse gases (mitigation) and at enhancing the resilience of human and ecological systems to negative climate change impacts (adaptation).

Climate risk refers to the potential negative impacts of climate change on economic, social, and environmental systems. It encompasses both physical risks, such as the impact of extreme weather events, sea-level rise, and changes in temperature and precipitation patterns, as well as transition risks, such as policy, legal, technological, and market changes needed to address mitigation and adaptation requirements related to climate change.

Climate transition risk is expected to emerge from a disorderly transition to a low-carbon economy. This is defined as a situation in which climate policies and regulations are introduced late and suddenly, or technological shocks occur, that negatively affect fossil fuel and high-carbon firms' performance, and thus the value of their financial contracts. In a disorderly transition, "carbon stranded assets" could materialize for both firms and investors, potentially leading to large asset price volatility (negative for high-carbon, and positive for low-carbon firms). In this condition, investors cannot fully anticipate shocks on firms' performance and assets. Portfolio rebalancing and hedging could not be fully possible if the economic and market structure is prevalently high-carbon. Thus, investors who are exposed to fossil fuel and high carbon firms will incur losses. Losses from carbon stranded assets could then reverberate in the financial network, with implications on financial stability at the individual and systemic level. 

The Coupled Model Intercomparison Project (CMIPs), produced by the Intergovernmental Panel on Climate Change (IPCC), make available periodic standardised comparisons of the outputs of around 100 academically accepted Global Climate Models (GCMs), developed by approximately 50 different climate research groups worldwide, for climate adaptation, mitigation and resilience planning.

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or a bond.

Decarbonization is the process of reducing or eliminating carbon dioxide emissions from the economy. Decarbonization of the economy is the key aspect of the transition towards achieving the 1.5-2C target.

The goal of diversification is to find the most efficient way to harvest risk premia across and within risky asset, earn the highest expected return for a given risk budget.

Double materiality is an approach to corporate reporting and sustainability that takes into account two distinct but interrelated dimensions of materiality: financial and impact

Financial Materiality: This dimension aligns with traditional accounting principles, emphasizing the significance of information to the financial decisions of capital providers. It encompasses factors directly related to a company's financial performance and impacts on its ability to generate profits and returns for investors.

Impact Materiality: In contrast to financial materiality, impact materiality broadens the scope to consider the impacts of a company's activities on various stakeholders, including the environment and society, irrespective of their immediate financial implications. This perspective acknowledges the wider responsibility of corporations and aims to capture non-financial factors relevant to stakeholders and the broader sustainability goals and policies.

Double materiality, as embraced by the European Sustainability Reporting Standards (ESRS), requires companies to disclose both their material sustainability impacts and any material financial risks or opportunities arising from sustainability matters. It seeks to strike a balance between financial and non-financial considerations, recognizing the interconnectedness between economic and ecological factors in corporate decision-making.

The risk that savings cannot finance as much replacement income in retirement as they could

The Dynamic Integrated Climate-Economy model (DICE), developed by Nordhaus (1992), is an integrated assessment model, modelling economic growth, the resulting CO2 emissions, the climatic response (e.g., temperature impact of these CO2 emissions), and finally the damage of increased global temperature on economic consumption. Its output is a calculation of the resulting current economic welfare, which is the sum of the discounted values of the consumption-based utilities between now and the long-term horizon. By maximizing welfare over the control variables (the savings rate and the abatement function), the DICE model determines the optimal CO2 abatement pathway that maximizes current welfare.

EIRIN Stock-Flow Consistent model is a macroeconomic model with heterogeneous, interacting agents of the real economy and finance, developed first in Monasterolo & Raberto (2018). Each agent is represented by its balance sheet entries, and is endowed with behavioural rules (e.g. regarding investment and consumption decisions) and adaptive expectations.

Environmental, Social, and Governance factors, known as ESG factors, are non-financial criteria used to evaluate companies and countries sustainability. 

ESG investing: An investment process that incorporate some form of integration of environmental, social and governance (ESG) indicators to enhance traditional financial analysis by identifying potential risks and opportunities beyond technical valuations.

The European Sustainability Reporting Standards (ESRS) are a set of reporting guidelines and standards introduced under the Corporate Sustainability Reporting Directive (CSRD). These standards aim to enhance corporate transparency and accountability by requiring listed and large companies to disclose information related to environmental, social, and governance (ESG) issues.

Double Materiality Principle: ESRS align with the "double materiality" principle, which means that reporting entities are obligated to report on both financial materiality (how ESG issues affect financial risks and opportunities) and impact materiality (how ESG issues impact people and the environment). This approach acknowledges the interconnectedness of financial and non-financial aspects in corporate reporting.

An exchange-traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock

Factor investing is an investment paradigm under which an investor decides how much to allocate to various factors, as opposed to various securities or asset classes. 

Factor investing in fixed-income requires to identify the specific risk factors inherent to this market, selecting bonds exposed to the desired factors, and applying an efficient weighting scheme.

Global Climate Models (GCMs) are sophisticated models of the global climate system attempting to capture atmospheric, oceanic, ice, and terrestrial behaviour. A number of distinct models have been built up over the past 30 years, and they are still being improved. The CMIPs (Coupled Model Intercomparison Projects) make available periodic standardised comparisons of the output of these models for climate adaptation, mitigation, and resilience planning.

Goal-based investing (GBI) implements dedicated investment solutions to generate the highest possible probability of achieving investors’ goals, with a reasonably low expected shortfall in case of adverse market conditions.

Fixed-income securities whose proceeds are specifically allocated to climate and environmental projects. Green bonds can be issued by governments, corporates, municipalities and international organizations. 

Greenwashing refers to all the activities companies and investors put in place to convey false or misleading information about their actual sustainability footprint.

Hedge funds are private and not regulated investment funds that use sophisticated instruments or strategies, such as derivative securities, short positions or leveraging, to generate alpha.

The safe portfolio should be efficient at matching risk factor exposures on the asset and liability sides. The proper risk management technique that should be used to ensure protection against systematic risks is not diversification – it is hedging. Just as diversification tells you how to be efficient when taking risks, hedging tells you how to be efficient when you avoid taking risks.

A high carbon intensity portfolio refers to a portfolio of assets that have a relatively high carbon footprint or are associated with high greenhouse gas emissions. These assets may include companies in sectors such as energy, transportation, and manufacturing, which are known to have a significant impact on the environment and contribute to climate change. The carbon intensity of these assets is typically measured by their carbon emissions per unit of output or revenue. A high carbon intensity portfolio may be contrasted with a low carbon intensity portfolio. 

Implicit carbon prices refer to the costs associated with carbon emissions that are not explicitly accounted for through mechanisms such as carbon taxes or emissions trading systems. These implicit costs can arise from various sources, including regulations, subsidies, and other market distortions that affect the true cost of carbon emissions.

The main benefit of insurance is that it allows investors to dynamically allocate to the well-diversified and risky performance-seeking portfolio more than the surplus available after having secured all essential goals.

The IPCC is is the United Nations body for assessing the science related to climate change; it was established in 1988 by the World Meteorological Organization (WMO) and United Nations Environment Programme (UNEP) to provide governments with regular assessments of the scientific basis of climate change, its impacts and future risks, and options for adaptation and mitigation  in order to develop climate policies.

Internal carbon pricing (ICP) involves companies setting a price on carbon emissions within their own operations, which can help them identify their carbon footprint and to engage a transition to a low-carbon economy. The disclosed level of internal carbon prices can depend on macroeconomic, regulatory, industry, and firm-specific characteristics. There is a wide diversity of ICP both by industrial sector and by region, due to the non-existence of global standards for pricing of carbon emissions.

The level risk factor is defined as a long exposure on a long-maturity bond funded by the sale of a short bond expiring at the end of the investment period. 

Liability risks refer to economic and financial actors who have experienced losses from the effects of climate change or climate policies and regulations and seek compensation from those they hold responsible.

We already see examples of liability risks involving fossil fuel extractive companies and sovereigns that passed legislation aimed at preventing new fossil fuels explorations (see e.g. the case of Rockhopper Exploration against Italy)

The Liability-Driven Investing (LDI) strategy consists in combining two distinct portfolios, one dedicated to performance seeking and the other one dedicated to the hedging of liabilities.

A low carbon intensity portfolio refers to a portfolio of assets with a relatively low carbon footprint or lower greenhouse gas emissions compared to the broader market. The construction of low carbon intensity portfolios involves selecting assets from sectors or industries that are considered to have a smaller environmental impact in terms of carbon emissions and climate-related risks.

Machine learning involves fully-automated classification (supervised learning) and identifying patterns in data (unsupervised learning). It embodies the notion that data will tell the story, with an emphasis on massive micro-level data. 

The momentum risk factor is designed to buy assets that performed well and sell assets that performed poorly over the past 3 to 12 months.

The Intergovernmental Panel on Climate Change (IPCC) defines Negative Emission Technologies (NETs) as anthropogenic activities that remove CO2 from the atmosphere and durably store it. NETs are in reality a range of technologies from nature-based practices, such as forestation, soil carbon sequestration and wetland restoration, to technological alternatives such as enhanced weathering, bioenergy with carbon capture and storage, and direct air capture and storage.

Negative screening excludes securities, often qualified as sin stocks, if the company activity is considered unethical or immoral, based on religious or philosophical views. Sin stock sectors usually include alcohol, tobacco, gambling, weapons, animal testing or pornography. 
Negative screening strategies can also refer to internationally accepted norms, such as the International Labor Organization standards, UN Global Compact, Universal Declaration of Human Rights and/or other globally recognized norms. This type of screening, called norm-based screening, is considered to be more objective, as the decisions to exclude sectors or companies are taken in accordance with standards established by international organizations. 

Physical risks refer to the potential impact on a company of event-driven (acute) or longer-term shifts (chronic) in climate patterns. This includes risks associated with extreme weather events such as hurricanes, wildfires, extreme rainfall, droughts, and sea-level changes, which can have destructive effects on industries such as agriculture and infrastructure. Additionally, physical risks encompass threats to the functioning of firm assets, such as real estate and industrial plants, due to flooding, storms, and excessive temperatures. The Intergovernmental Panel on Climate Change (IPCC) expects these physical risks to increase over time as the severity of climate change impacts becomes more pronounced.

Best-in-class or positive screening involves selecting, for each investment sector, the assets with the most positive scores on relevant environmental, social, and governance ESG criteria. An aggregate ESG score may be determined based on combinations of single factors by a third party. External ESG scores can be used to obtain a proxy for a company’s ESG performance through a standardized system and, as such, can prove useful for asset managers or asset owners with a limited understanding of how to design their own selection criteria based on various sustainability factors. Positive screening is based on more objective criteria than negative screening, since there are now rating agencies producing ESG scores based on an aggregation of factors. However, there is still a great lack of convergence between the ratings of the various rating agencies. Source: Le Sourd and Martellini (2021).

The income, expressed in dollars per year, that can be sustained with an individual's retirement savings for their expected lifetime.

The potential source of additional performance because of the simple act of resetting portfolio weights back to the original weights is referred as the rebalancing premium. It is also sometimes known as the volatility pumping effect or diversification bonus because volatility and diversification turn out to be key components of the rebalancing premium

A financial asset that pays fixed income at regular intervals for an individual's retirement period, with a cost-of-living adjustment.

The cost of acquiring income of $1 per year beginning at the retirement date and lasting the expected lifetime.

Retirement investing solutions are intended to meet the needs of future retirees, namely to generate enough replacement income to finance their expenses in retirement.

A risk premium is the extra return above the risk-less rate that must be offered by a security that pays well in good states of the world and badly when investors would need the money.

Characteristic-based portfolios constructed using a dependent, symmetric sorting using whole-name breakpoints.

Pure seasonal effect where investors can grasp abnormal return from being long in the size factor in January and short in the last quarter.

Smart Beta gathers all alternative forms of indexations departing from cap-weighting, that aim to generate superior risk-adjusted returns, compared to traditional indexation.

Stress testing is the assessment of the financial impact on a portfolio of severe but plausible events, of nature or magnitude often beyond what has been observed in the past.

An investment process that seeks to deliver competitive financial returns, while driving positive environmental, social and governance (ESG) outcomes. Sustainable investing goes one step beyond ESG investing by explicitly targeting an enhancement of ESG scores.

A category of mutual funds in which equities are gradually replaced by bonds as the target date approaches.

It means nothing. Really. Nothing.

It is expected to emerge from a disorderly transition to a low-carbon economy. Transition risk is defined as a situation in which climate policies and regulations are introduced late and suddenly, or technological shocks occur that negatively affect fossil fuel and high-carbon firms’ performance, and thus the value of their financial contracts.

For instance, a late introduction of a carbon tax would lead to larger costs and lower profits for firms that extract, produce or use fossil fuels for their business, being fossil fuel combustion a main driver of CO2 emissions. This economic loss can translate then in a financial loss, whereby the loss in firm’s performance translates to a negative adjustment to financial assets or an inability to repay outstanding loans, eventually affecting investors through carbon stranded assets (i.e. assets whose value could decrease abruptly as a result of a phase out of fossil fuels and high-carbon activities).

The unexpected climate news index (UCNI) is a metric used to capture the unexpected component of daily changes in climate change news. It is derived by assuming an auto-regressive AR(1) process for the climate news indices (CNI), where the changes in unexpected climate change news represent the innovations. The UCNI provides a tool for understanding and quantifying the influence of unexpected climate news on equity portfolios, thereby aiding investors and industry professionals in making informed decisions.

The value risk factor is defined as a long exposure to assets that are cheap and a short exposure to those that are expensive, according to a valuation measure.

A yield curve is a chart that represents, at a given date, the yields of similar quality bonds versus their maturities.