MEASURING ENERGY TRANSITION (ET) RISK FOR INVESTORS:
DEVELOPING AN ENERGY TRANSITION ASSESSMENT FRAMEWORK
FOR EQUITIES AND BONDS
The ET Risk project proposal is formally supported by 31 organizations:
•
Two governments including French Prime Minister Office, the French Treasury, and the French and
German Environment Ministries;
•
16 financial institutions including Allianz, AXA, BNPP, Caisse des Depôts, KLP, ERAFP, FRR,
AFD, AP2, AP7, Boston Common Asset Management, Calvert Investment, APG-AM, Öhman, and
more than 300 other financial institutions via investors platforms;
•
Various international organisations, think tanks, NGOs, and experts including UNEP-FI, UNEP
Inquiry on the Design of Sustainable Financial Markets, WWF, Climate Bonds Initiative, Trucost,
South Pole, Minter-Ellison, the Asset Owner Disclosure Project, and the former Development
Minister of France, Pascal Canfin,
ONLINE LINK TO THE PRESENTATION : https://prezi.com/84x33ffa6vcq/et-risk/
OVERVIEW
The consortium will provide a detailed overview of the three main drivers of financial risks and
opportunities associated with the transition to a low-carbon economy for equity and corporate bonds
investors. These drivers are defined as policy (e.g. ETS), market (e.g. commodity prices), and nonconventional (e.g. litigation, reputation, etc.). It will explore whether and how these drivers are currently
integrated into mainstream frameworks for equity valuation and credit risk analysis.
The consortium will construct a physical assets database for seven industries (i.e. car manufacturing, airlines,
airports, shipping, cement, steel, power & heat utilities), including a mapping of ‘locked-in GHGemissions’ associated with each asset and the extent to which sustainable energy investments (e.g. retrofits,
upgrade of technologies, carbon capture and storage)1 can ‘unlock’ these GHG-emissions.2
The consortium will define the trajectory of key quantitative and qualitative policy, market, and nonconventional variables associated with two ET Risk Scenarios (e.g. a ‘soft decarbonization’ and 2°
investing’ scenario3). The trajectory will demonstrate how decarbonisation roadmaps can be translated into
risk variables to inform financial analysis.
The consortium will demonstrate the financial impact, measured in net profitability margins, of the
scenarios on the seven industries. The outputs will be road-tested by S&P Capital IQ and KeplerCheuvreux (equity research). S&P Capital IQ and Kepler-Cheuvreux will further develop their existing
credit risk and valuation models based on their research and the inputs from the previous work packages.
The consortium will facilitate integration of outputs into existing market practice by commercializing the
database and underlying locked-in / unlockable GHG-emissions model, exploring options for policy
frameworks around accounting and disclosure; and defining standardized reporting templates on ET risks
and opportunities. S&P Dow Jones Indices will use the outputs to update at least one index.
1
‘Sustainable Energy Investment’ (SEI) is defined as an investment that either a) replaces or complements GHG-intensive technologies in production
processes with alternative technologies (e.g. replacing fossil fuel power generation with renewables); and / or b) reduces the GHG-intensity of
existing processes (e.g. retrofitting of buildings, carbon capture and storage). For the purpose of this proposal, Sustainable Energy Investment may be
directly in a physical asset or cover the financing of a company that engages in sustainable energy investments.
2
Cf. p. 11 for an explanation of the terminology.
3
The IEA energy technology roadmaps will be used as a starting point for these 2° investing scenarios, linked to the SEI metrics project.
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Challenge addressed: Assessing and responding to financial risks and opportunities associated with the
transition to a low-carbon economy
The transition to a low-carbon economy will most likely impact the economic viability of high-carbon assets,
leading to stranded assets.4 Financial risk associated with this impact can materialize for physical assets (e.g.
coal power plant, steel plant, car and aircraft fleets, etc.), the owners of these assets (e.g. a steel company),
the financial assets associated with these owners (e.g. equity and credit), as well as investment portfolios
consisting of these financial assets. Equity and bond portfolio managers at the end of this risk chain and as
owners of the companies owning the assets play a key role in this ecosystem. Sustainable energy and energy
efficiency investments represent an opportunity to mitigate these financial risks. These opportunities can be
defined at physical asset level (e.g. retrofit of a plant), company level (e.g. emphasizing more energy
efficient production processes), and investor level (e.g. capital reallocation towards ‘green’ companies).
This interplay between risk and financial opportunity is defined in this proposal as Energy Transition Risks
& Opportunities. The project focuses on the extent to which an assessment of ET risk improves the
financability and attractiveness of sustainable energy and energy efficiency investment. To date, research on
the financial viability of sustainable energy and energy efficiency investment has almost exclusively focused
on the risk / return of these investments in isolation. Research has largely ignored the extent to which these
types of investment can act as a direct response to risk management, the key operating framework of equity
and bond / credit portfolio managers. For these managers, the attractiveness of sustainable energy and energy
efficiency investments is derived from their ability to reduce or hedge5 the financial risk related to highcarbon assets. This concept is briefly explained below:
1. Policy makers target limiting global warming to 2°C relative to pre-industrial levels.
2. The 2°C climate objective translates into changes in policy, market, and additional ‘nonconventional’ risk factors (e.g. litigation, reputation).
3. These factors will inhibit the economic viability of GHG-intensive assets. Physical assets may be
shut down or face significant impairments. This is referred to as ‘stranded assets’ (cf. p. 10).
4. Stranded assets are likely to impact the cash flow and profit of companies. This is the first stage
where investors can influence corporate investment decisions by requiring energy efficiency and
sustainable energy investments to reduce their risk exposure.6
5. A negative impact on the cash flow and / or profitability of a company may create financial risk,
specifically a negative impact on the company’s valuation (equity) and/or credit risk (debt).
6. Financial risk is filtered through to investors owning these financial assets. Investors carry the
financial risk from a loss in value and / or credit default of corporate debt and equities.
7. At this stage financial institutions and companies can hedge7 Energy Transition (ET) risk through
investing in companies exposed to sustainable energy and energy efficiency.
4
The term stranded assets refer to assets that are no longer economically viable .
Hedging plays a key role in portfolio management. The investment framework for stocks and bonds is based on broad diversification in relation to
today’s financial markets (and their proxy indexes). The weight of sustainable energy and energy efficiency in this liquid investment universe is very
limited (~1%, based on the DG Klima “Financing the Future” report ), and seizing opportunities outside of the investment universe is not part of the
mandate. As a result stock and bonds investors primarily consider green opportunities as a response to risk diversification and exposure.
6
Hypothetically risk exposure can also be reduced by shutting down the business entirely, for example in the case of coal mining. Given the
associated implications of a corporate shutdown however, this option will not be classified as a risk mitigation measure.
7
The quantification of ET risk allows the portfolio manager to define a hedging strategy involving identifying assets negatively-correlated with high
carbon assets (likely sustainable energy and energy efficiency related assets) and increasing the exposure to this asset to offset the risk.
5
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Core project objective: Improve the attractiveness of sustainable energy investment through the
development of ET risk and opportunity assessment frameworks and tools for equity and bond portfolios.
Objective 1: Help investors & policy makers understand the materiality of ET risk & opportunity
•
•
Inform investors and policy makers on how the price signal sent by governments translate into
financial risks in seven key industries.
Quantify the window of opportunity for sustainable energy investments in response to ET risk
through a bottom-up database and model mapping ‘unlockable’ GHG-emissions.
Objective 2: Help investors assess the materiality of ET risk and opportunity for equity and bond
portfolios
•
•
Allow the integration of ET risks in mainstream models used by financial analysts, providing more
robust assumptions on risk factors, data on corporate risk exposure, and modeling of the impact on
companies margins.
Provide a credible framework endorsed, commercialized, and road-tested by major market players
(S&P Capital IQ, Kepler-Cheuvreux) that can be mobilized by investors.8
Objective 3: Engage with investors & policy makers on responding to ET risk and opportunity and
mobilizing capital for sustainable energy investment
•
•
•
•
Develop an ET risk reporting standard for voluntary and/or mandatory disclosure frameworks.
Where ET risks are material, enable investors to invest on the basis of the risk models through e.g.
access to the ET risk assessment framework (WP2-WP4) and associated index products.
Inform policy makers on the potential impact of policies on corporate margins & investors.
Based on the materiality of risks, help policy makers evaluate the relative merit of the ‘risk avenue’9
(cf. p. 5, e.g. disclosure & management of ET risks) and the ‘incentive avenue’.10
The need for the ET Risk support & coordination action. The growing demand is not associated with an
equivalent response in the supply. This research and support & coordination gap relate to five key drivers:
• For both equities and bonds, building credible ET risk metrics requires covering the whole risk value
chain (including data, scenarios, and models). Individual commercial providers are unable to cover
the breadth along the value chain and mobilize associated meaningful R&D budgets, given question
marks around materiality. Commercial fragmentation amplifies this barrier. Pilots of activities
proposed here have not been connected to a broader ET Risk assessment framework.
• For bonds, climate-related research has been driven by specialised ‘ESG research’ agencies, that
don’t have the expertise, the business model, and the scale to cover the universe.11
• Policy makers focused on accounting and disclosure frameworks, like the initiative in France, need a
model that is not specific to one commercial provider;
8
Most resolutions related to climate risks focus on corporate reporting, management frameworks, and carbon intensity rather than actual risk
mitigation measures. This limits the ability of ‘activist investors’ to get traction on other investors and create a critical mass (cf. 2ii / UNEP-Fi / GHGProtocol on building a critical mass: http://2degrees-investing.org/IMG/pdf/climate_targets_final.pdf.
9
Exploring the pros and cons of these alternatives was a key focus of the project on “Mobilizing private capital for climate friendly investments”
commissioned by DG Clima, It is also a topic of the debate in France in the context of the Energy Transition Law.
10
2ii explored the integration of climate objective in tax incentives on savings products with the French PM economic think thank. The H2020 funded
SEI metrics project responds to this challenge through metrics development on aligning investment strategies with the 2°C climate objective.
11
Examples include MSCI ESG Research, Sustainalytics, Vigeo, etc. On average, the time they dedicate to the analysis is about 2 hours per company.
Most analyst have limited financial analysis skills. Their model is based on sales to investors, who are not ready to pay for more time involvement.
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•
ET risk models, with the exception of The CO-Firm pilot, usually focuses exclusively on risk,
without considering the opportunity for sustainable energy investment to mitigate this risk.
Demand for ET Risk assessment. The past 12 months have seen a growing demand from key stakeholders
for ET Risk assessment12 for the financial sector. Research from a number of actors, most of which are
represented in the consortium13 has put the issue on the agenda of financial institutions and policy makers:
Political demand: In 2014, the UNEP Inquiry has initiated a research stream on the topic of ET
Risk.14 The Bank of England is currently drafting a report exploring the materiality of climate risk
(including ET risk) for the financial sector.15 Its Governor, Mark Carney has publicly commented
on the risk of ‘stranded assets’.16 In May 2015, the G20 mandated the Financial Stability Board to explore
the issue.17 Emerging economies financial regulators, including China’s Central Bank and State Council,
have similarly begun to respond.18 Also in May, the French government passed a law making a variant of ET
risk reporting mandatory for institutional investors and commissioning a climate stress test report at finance
sector level.19 Most initiatives20 are driven, implicitly or explicitly by the objective to mobilize sustainable
energy investment through ET risk assessment, following the above-presented logic. However the exact
potential impact remains under-explored.
Financial institutions: In the United States, 75 institutional investors have joined the Ceres Carbon
Asset Risk Initiative.21 Financial institutions are also increasingly using the concept in public
communication and to justify investment decisions.22 Financial institutions however have not yet
been able to move from principles to action: a landscape review by 2ii23 highlights a limited number of inhouse research activities genuinely focused on risk management. Further development is at least partly
hampered by the challenges of building more sophisticated models and question marks around the
materiality of this risk.24
Market response to demand. Market actors have started to respond to the growing demand around ET Risk.
For example, a number of organizations have begun to attempt to assess ET Risk using a ‘bottom-up’
approach applied at individual asset level (stock, bond, loan to a company) by equity research and credit risk
analysts. These approaches are naturally only as good as the underlying assumptions that are not necessarily
derived on a scientific basis.25 Other organizations have pursued a top-down approach to ET Risk, focusing
on factor exposure and implications for strategic asset allocation.26
12
To date, there is no common terminology around the ET Risk concept used in this report. Alternative terminology includes ‘carbon asset risk’
(WRI), carbon risk (2ii), climate policy risk (Mercer). Unfortunately, these different terms do not always cover the same aspects. Here, ET risk will be
defined as the financial risk and opportunity set of equity / bond portfolio managers directly related to the transition to a low-carbon economy.
13
See. P. 15 and 2ii / UNEP Inquiry report here: http://2degrees-investing.org/IMG/pdf/2dii_risk_transitions_low-carbon_discussionpaper_draft.pdf
14
http://www.unep.org/inquiry/
15
The report is expected to be submitted in July with release to the public in September. The Bank of England is on the Review Panel of the current
2° Investing Initiative study.
16
http://www.theguardian.com/environment/2014/oct/13/mark-carney-fossil-fuel-reserves-burned-carbon-bubble
17
The concept of climate risk also include physical impacts of climate change.
18
The 2° ii is involved in an expert group with the UNEP Inquiry and Chinese counterparts on the topic.
19
http://2degrees-investing.org/IMG/pdf/2o_investing_regulation_in_france.pdf
20
For instance in France, the mandatory disclosure of ET risks is introduced in an article related to boosting sustainable energy investments.
21
The initiative focuses on engagement with companies to improve transparency and disclosure on climate and ET-related risks.
22
http://montrealpledge.org
23
http://2degrees-investing.org/IMG/pdf/2dii_risk_transitions_low-carbon_discussionpaper_draft.pdf
24
The GEF “Carbon Bubble” study found a 1-2% impact for a diversified financial portfolio, assuming an ‘overnight decarbonization scenario’.
25
The GEF study assumed a general 60% drop in valuation for oil & gas companies, independent of company.
26
Top-down’ approaches applied at portfolio and finance sector level rely on historical data and correlation between assets, to ‘stress-test’ the impact
of extreme events (oil shock, financial crisis, etc.). These approaches are not addressed in the scope of this project for two reasons: First, a large scale
research project on the topic by Mercer was completed in June 2015. Second, overlaps are too low and costs too high to fit into a project of this size.
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Concept and approach, quality of the coordination and support measures
The following provides a summary overview of the key concepts of the proposal
ET Risk assessment refers to the financial risk associated with the transition to a low-carbon economy for
physical assets, companies holding these assets, and their equity and debt investors. ET Risk assessment
informs on how changes in policy, market, and non-conventional (e.g. litigation, licence to operate) variables
can impact the financial performance of companies and the potential for sustainable energy investments to
mitigate this impact. According to this definition, the potential for sustainable energy investments can be
seen as the proxy for the adaptive capacity of an industry. ET Risk assessment does not address the financial
viability of sustainable energy investments directly, but rather their potential role in risk mitigation. ET Risk
assessment thus involves two steps:
1. Assessing the financial risk exposure of a company associated with the energy transition
2. Assessing the role of sustainable energy investment in mitigating this financial risk exposure.
According to this logic, the project focuses both on sectors with a high probability of material ET risk
exposure (e.g. high-carbon sectors) and adaptive potential. For instance the selection leads to an exclusion of
fossil fuel sectors, given their limited adaptive potential. Rail, despite significant potential for energy
efficiency investment and the role in increasing the energy efficiency of the transport sector as a whole, is
likely to have a limited exposure to ET Risk. The same goes for pure players in the eco-efficiency business
(e.g. energy savings solutions, insulation materials, etc.).27
Locked-in GHG-emissions and
‘Unlock’ potential. Locked-in GHGemissions are the GHG-emissions an
asset is expected to emit over the
remaining lifetime of its use.28
Locked-in GHG-emissions can relate
to both direct and indirect emissions29
and be considered both in terms of
existing assets or the ‘asset pipeline’
related to long-term production
processes (e.g. the likely future
emissions of aircrafts based on the
order book of a manufacturer, its production capacity, and R&D pipeline). They are a function of the lifetime
of the asset and their carbon intensity (cf. chart). GHG-emissions can be ‘unlocked’ (in terms of not
materializing) through early retirement, energy efficiency retrofit, switch to renewable fuels, or Carbon
Capture and Storage. With the exception of CCS, these actions involve investment in sustainable energy and
energy efficiency either directly or in another part of the supply chain to maintain capacity or reduce
demand.
27
The does not prevent from selecting these sectors at a later stage as add-ons, or applying the approach to these sectors for third party users.
The concept has been introduce in 1999 in academic literature and is applied by the IEA in the WEO (cf. figure). While the concept seems
applicable to a number of assets, it is in practice limited in the IEA work. The project will involve working on the basis of a broad definition and fine
tuning the definition for each target sector..
29
The GHG Protocol distinguishes scope 1 (direct emissions of a power plan), scope 2 (electricity consumption related to a production process), and
scope 3 (all other indirect emissions, related to product in use for instance).
28
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The table below provides as snapshot of the two concepts for selected industries.
Civil
aviation31
Shipping
Road
transport
Power &
heat utilities
Cement
Steel &
iron
Assets associated with the
locked-in effect
Existing fleet of airplanes,
pipeline
or
aircraft
manufacturers, airports capacity
Existing fleet & construction
pipeline of cargo ships, port
capacity.
Car sales, future car production
locked in by production
capacity
and
development
pipeline of manufacturers. Road
infrastructure.
Emissions
associated
with
fossil-fuelled
electricity
production.
Emissions associated with fossil
fuel
burning
and
the
decarbonation of limestone in
cement plants.
Emissions from coke or
charcoal burning, the addition
of limestone as a flux, and the
reduction of carbon in iron
Options to ‘Unlock’ them30
Switch to biofuels; retrofit with energy efficient
engines, winglets, etc. Development of rail
transport associated with decommissioning and
reduction of capacity.
Switch to alternative fuels, retrofit with energy
efficient engines.
Production plant retrofit to switch to more
efficient models for manufacturers, take back
programs to reduce lifetime, switch to biofuels
at car user level, improvement of the fleet and
reduction in traffic to reduce road infrastructure.
Retrofitting of power plants to increase
efficiency or/and use biofuels, decommissioning
and switch to renewable electricity generation,
CCS.
Retrofits of cement plants to increase the
efficiency and allow fuel switch.
Decommissioning due to lower
demand/alternative material, CCS.
Retrofits of cement plants to increase the
efficiency
and
allow
fuel
switch.
Decommissioning
due
to
lower
demand/alternative material, CCS.
Stranded assets are the first brick in the ET risk assessment. Stranded assets, in the context of this project
proposal, refer in the first instance to physical assets that may be economically impaired as a result of
changes in market, policy, or non-conventional variables that can be linked to the transition to a low-carbon
economy. This economic impairment can then have a financial impact on the company owning the asset and
financial institutions holding financial assets associated with the company. This concept has been socialized
by the Carbon Tracker Initiative and the International Energy Agency for fossil fuel reserves, but is actually
applicable to all assets associated with locked-in emissions.32
ET risk scenarios. ET risk scenarios define the key assumptions about future economic and policy trends
that inform ET risk assessment. They can be, and in the course of the project will be, developed ‘bottom-up’
through a mapping and extrapolation of current policy and market trends, and ‘top-down’ through the
development of plausible ‘policy narrative’ set of events allowing to reach the objectives of 2°C climate
scenarios and technology roadmaps in terms of GHG emission reduction. These scenarios are important for
analysts to understand how the risk materializes33 and potential hit the profit margins of companies.
30
Not all the options listed will be included in the scope of the analysis.
The focus in this industry will be on airlines, but may expand to airplane manufacturers, and airports.
The European power sector for instance experimented 70 GWof impairments from 2013 to 2015 (Source: UBS Equity Research), at least partly due
to the development of renewable energy production.
33
For instance, a carbon budget can be translated into a constraint for the oil industry in many different ways: introducing taxes on fuels, on cars, on
production, on transactions, or caps on extraction, etc. Each of them impacts the oil sector margins in a different way.
31
32
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Key variables for these scenarios will include:
•
•
•
Policy: Changes in fuel efficiency standard, carbon tax, introduction of ETS or changes to ETS (e.g.
‘floor’ on prices), caps on GHG-emissions, consumer incentives for low-carbon products (e.g. rebate
on electric cars, etc.).
Market: Changes in commodity prices, market driven changes in ETS prices, relative costs of
various technologies, deployment speed of breakthrough technologies.
Non-conventional: Potential tort costs and mothballing associated with carbon-emission related
litigation, potential caps on fossil fuel extraction, new forms of taxes on carbon intensive
investments, etc.
ET Risk models.34 The project involves the development of three types of models. These models focus on:
•
•
•
ET impact on the ‘net’ profitability of companies, including the gains from sustainable energy
investments.
ET impact on the valuation of the company (share price). An example for the application of this
approach is the experimental Bloomberg Carbon Risk Valuation Tool.35 These types of models are
used by both buy-side (e.g. asset managers) and sell-side (e.g. brokers) analysts.
ET impact on the credit risk of a company. These models are applied by credit rating agencies (e.g.
S&P Ratings Services, Moody’s, Fitch) and banks.
Obstacles to the materiality of ET risk. As outlined above, the objective of the project is not to prove the
materiality of ET risk for investors in general, but to demonstrate whether or not ET risk is material by
industry, under which conditions (e.g. policies), and for which time frame. The project consortium as a
whole is agnostic to the materiality of these risks.
Focus industries. The core focus of the work across the work packages is on seven key industries (cf. table
above). At this stage, the consortium has made a preliminary selection of industries, which will be validated
at the beginning of the project by the Steering Committee at the Kick-off meeting. The chosen industries
represent roughly 20% of the European listed equity universe (and significantly more in some countries,
notably Germany), and an estimated 16% in EU corporate bond universe. Industries were chosen based on
their materiality to climate change36 and their dual role both as high-carbon sectors and key sectors from a
sustainable energy investment perspective. The fossil fuel sector, given the limited role of sustainable energy
investment, is excluded, will however be treated in terms of the implications on the sector in WP 4.4. Real
estate37 is the biggest sector exposure for investors and is highly exposed to ET risk.38 However given the
specificity of this sector39 and the workload required to roll out the framework on this sector, it is out of
scope. The other industries have been excluded either because of the assumed marginal impact of ET risks or
the gaps in decarbonisation scenarios (e.g. transport infrastructure).
34
The 2ii/UNEP discussion paper and the conference organize by 2ii and CDC during the Paris Climate week provide an overview of best practices in
this field.
35
http://www.bloomberg.com/company/announcements/introducing-our-carbon-risk-valuation-tool
36
The chosen industries account for over two-thirds of European GHG-emissions.36 They form a key part of the IEA World Energy Outlook
37
As an asset class, as a sector in the equity (real estate trusts) and bond spaces (mortgage-back securities), and as assets on company’s (buildings)
and banks (mortgages) balance sheets.
38
Buildings are long-term assets exposed to strengthening of energy efficiency norms in buildings and congestion measures in urban transport.
39
Including distribution and diversity of assets, need for country specific policy-analysis, need for sector specific databases, etc.
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Overall approach: integrating ET risk assessment into mainstream risk frameworks.
The overall approach consists in developing a comprehensive and consistent framework to assess the ET
Risks and opportunities of equities and corporate bonds, building from the existing pieces developed by the
consortium. This framework is designed to be integrated into mainstream valuation and credit risk models.
The following demonstrates the pieces and outputs of this framework.
Concept. The project will start by defining the concept of ET Risk, based on the definition provided in this
proposal and the documents referenced.
Framework. Based on this blueprint, the ‘engine’ of the project will be the ET Risk framework that
‘translates’ climate scenarios into risk factors for investors. The framework will combine existing parts (the
CO-Firm net margins model to calculate the impact of ET risks on companies’ profits, Kepler-Cheuvreux
equity valuation model, S&P credit rating model), with new parts: the ET Risk scenarios (providing
policy and market risk parameters), and the Asset@ETrisk database (mapping the locked-in emissions and
unlock potential for physical assets globally). The new parts will feed the impact on net margin model, that
will in turn feed the equity and credit models.
Investor package. Each part of the framework will be turned into new commercial services (a database, an
online tool, S&P indices) and will be integrated into existing equity research and ratings provided by
Kepler-Cheuvreux and S&P. These products and services will form a ‘package’ allowing investors to assess
their exposure to ET risks based on a consistent framework covering equities and corporate bonds.
DIY package. Other equity and credit risk analysts (sell-side peers and buy-side) will have the opportunity to
develop their own approach based on the ET framework, without purchasing (or only cherry picking in) the
investor package. The DYI package and related engagement activities will help them to do so.
Policy maker package. Financial policy-makers and standard organisations will be able to turn the
framework into reporting requirements for companies on the one hand, and investors on the other hand.
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