The enormous damage and loss of life in the wake of Hurricane Ida shine a light on not only how to mitigate climate change, but also how to adapt communities for it. Last week alone there were wildfires in the west, wind destruction, massive flooding, and loss of power.
These increasingly frequent environmental catastrophes are only the beginning. Current climate models predict a 3.0 to 4.0°C increase in temperatures by 2100, rendering low-lying islands, many coastal regions, and most of the low and mid-latitudes uninhabitable. Climate Action 100+, a climate-focused coalition of over 600 investors with $55 trillion in assets under management, estimates that climate change will result in $23 trillion of associated global economic losses—greater than the value of US GDP. 2100 is only 80 years away—approximately the life expectancy of a child born today in North America. For long-term investors, ensuring that investment decisions consider the impact of climate change on long-term value is critical for fulfilling fiduciary duty. Here’s what you can do to not only climate-proof your investment portfolio, but also help meet the climate change challenge.
Developing A Philosophy About the Carbon Transition
The first step to building climate change mitigation and adaptation into an investment portfolio is developing a philosophy about the carbon transition. A shrinking share of assets under management (AUM) are silent on climate. FCLTGlobal Head of Research Ariel Babcock explains: “Investors with this mindset assume that the future will mirror the past, rather than recognizing discontinuous risks, and they overly discount the potential for future investment losses from climate change.”
At the other end of the spectrum are the growing numbers of organizations that have made net-zero pledges by 2050 or sooner. Net zero is when anthropogenic CO2 emissions are balanced globally by anthropogenic CO2 removals over a specified period. Net zero by 2050 is a major component of the Paris Climate Agreement, and a number of investors and companies have made 2040 net zero commitments. In fact, net zero commitments represent 68% of global GDP and 61% of CO2 emissions, including over 40 members of the UN-convened Net-Zero Asset Owner Alliance (representing $6.6 trillion in AUM), 128 signatories of the Net Zero Asset Managers initiative (representing $43 trillion in AUM), and the 160 financial firms representing over $70 trillion in assets in Mark Carney’s Glasgow Financial Alliance for Net Zero.
Along the spectrum, investors recognize that decarbonization represents a major macroeconomic theme. This article is for investors between the endpoints of the spectrum—those seeking to build climate change mitigation and adaptation into investment portfolios. It is also for investors that have made climate commitments and are at the early stages of implementing them.
Knowing What You Own
The first step to building climate change mitigation and adaptation into an investment portfolio is knowing what you own.
Exposure to emissions-intensive sectors and stranded assets. Emissions-intensive sectors include energy and agriculture, and stranded assets are those that at some point prior to the end of their useful life are no longer able to earn an economic return as a result of the changes associated with the transition to a low-carbon economy. Investors can benefit from identifying the carbon-intensive and stranded assets in their portfolios and gauging both the total value of these assets and the value at risk due to climate change.
Exposure to emissions mitigation and removal. It is also critical for investors to identify positive investments in the environment in their portfolios. These investments can be directly into solutions that mitigate emissions, such as clean power, electric vehicles, digitalization, and other areas of innovation into climate change. Because reaching net zero requires strategies that actively remove CO2 from the atmosphere, these investments can also be into natural and technological strategies to capture and remove carbon dioxide from the atmosphere and store it in trees, the ocean, underground reservoirs, and even products like concrete. These investments can also be indirectly into companies with management teams that are sufficiently focused on allocating capital today to technologies and business models that will enable them to thrive in the energy transition. As an example, the automotive sector is scrambling to reinvent itself. Investors can benefit from identifying the value of assets in their portfolio that will at least survive in a low-carbon future.
Incorporating Climate into Portfolio Construction
Once investors have taken a baseline of their portfolios’ exposure to emissions-intensive sectors and stranded assets, as well as to emissions mitigation and removal, the next step is incorporating climate into portfolio construction.
The typical approach to climate-aware investing focuses on divesting from emissions-intensive sectors and stranded assets and making impact investments with dual climate and returns objectives. This approach is silent on the remainder of the portfolio. A more integrated approach that includes strategic engagement and sizing positions based on climate considerations is warranted.
Divestment and exclusions. Eliminating carbon-intensive assets or deciding not to make future investments in the fossil fuel industry, like Harvard Management Company did on Thursday, is an effective way to mitigate some of the value at risk due to climate and ensure that an investor is comfortable with the source of its gains. However, as Ninety One Portfolio Manager Deirdre Cooper notes, “avoiding oil stocks has not put a penny toward the massive structural changes necessary to climate-proof the economy. The energy transition requires far-reaching changes to energy, transport, manufacturing, construction, and agriculture. This entails capital expenditure and innovation by companies across industries engaged in everything from extracting raw materials to providing software.” Also, while divestment may raise the cost of capital for emissions intensive companies, it may simply transfer dirty assets from one owner to another, often from public equity to private equity. This can leave investors with little means of influencing change.
Strategic engagement. Corporate engagement is the most reliable type of sustainable investing for investors seeking impact, although environmental requests have historically had the lowest rate of success, in part due to their greater cost. 2021 was an inflection point for both the number of climate proposals and their likelihood of success.
Climate change was a top shareholder proposal topic in 2021. According to Institutional Shareholder Services, ten climate-related shareholder proposals received majority support out of 24 filed in 2021, up from three out of ten filed in 2020, and none out of 12 filed in 2019, and shareholder support for climate proposals averaged 52.6% in 2021, up from 38.5% in 2020. In particular, proposals for stronger disclosure of alignment of company climate lobbying with Paris Agreement goals secured majority support at Delta Airlines, United Airlines, Phillips 66 Co., Exxon Mobil Corp., and Norfolk Southern Corp. According to Pensions & Investments, shareholders withdrew similar shareholder proposals when companies agreed to disclose climate lobbying at General Motors Co., FirstEnergy Corp., Entergy Corp., Valero Energy Corp., Duke Energy Corp., and CSX Corp.
The momentum with both the number of and support for climate shareholder proposals follows naturally from climate-focused investor coalitions like Climate Action 100. In addition, nearly half of investment management industry assets under management has committed through the Net Zero Asset Manager initiative to implementing a stewardship and engagement strategy with a clear escalation and voting policy that is consistent with the ambition for all assets under management to achieve net zero emissions by 2050 or sooner.
Sizing positions based on climate considerations. Taking a more nuanced approach than divestment and exclusions, investors can overweight assets with climate tailwinds and underweight assets with climate headwinds. Dana Investments Portfolio Manager Duane Roberts explains: “Even investors with sector neutral approaches can seek ancillary and peripheral ways to gain exposure to the carbon transition and overweight carbon-efficient and underweight carbon-inefficient companies across sectors. For example, a number of technology companies have become significant purchasers of renewable energy, and investors can take these differences between companies into consideration when sizing positions.”
Impact investments. Divesting from carbon-intensive industries, incorporating climate into position sizing, and engaging with companies to increase climate disclosure is helpful but not sufficient to climate-proof investment portfolios and accelerate the transition toward a sustainable economy. Investors must invest positively in the environment—not only due to sustainability concerns, but also to tap into fast-growing parts of the global economy. Such exposure to sectors with momentum from changing consumer preferences and regulatory requirements could help to mitigate aggregate value at risk from climate change.
Across the range of potential climate impact investments, emerging markets and infrastructure are worth highlighting—emerging markets because of the carbon-intensiveness of emerging economies like China and India and climate-resilient infrastructure because of the $1 trillion CDP estimate for global value at risk over the next five years due to climate change. In addition, investments in mass transit and renewable energy yield health and other benefits in addition to climate change mitigation.
All Roads Lead to Rome
Climate change is one of the greatest opportunities and risks that investors will see in their lifetimes. It may have an even greater impact on companies and markets than the digital revolution.
Investors can benefit from and accelerate the low carbon transition in a multitude of ways. Divestment, exclusions, and climate-based position sizing can help investors manage the carbon footprints of their portfolios. Strategic engagement and impact investing can drive climate impact. More broadly, investors can generate significant upside returns while catalyzing the solutions needed to meet the global climate challenge.