Climate change is one of the most pressing concerns facing investors today. But most don’t have a complete understanding of the risks that accompany it. This hampers their ability to identify them during their due diligence process.
In this article, we will help investors and portfolio professionals understand the risks posed by climate change and be better prepared to address them.
What is Climate risk?
Climate risk refers to the potential for physical or regulatory changes that may negatively impact an organization’s ability to do business.
In the coming decades, climate change will likely raise a number of questions and risks for investors, especially those focused on long-term investments in resource and energy-intensive sectors.
Climate risk types
Climate risk can be categorized into two areas:
- Physical risks are the potential adverse changes in the physical environment that may adversely affect companies and markets.
- Transition risks arise from the fact that many countries will need to make significant adjustments in their economies as they implement policies to address climate change.
The Carbon Bubble
Taken together, these issues have been referred to as “The Carbon Bubble” — investments made in fossil fuel companies and their supporting industries that may be devalued by future climate mitigation and adaptation policies.
Risk outside the bubble
The associated risks of climate change actually loom much larger than the energy sector. In fact, the vast majority of investment portfolios are already exposed to climate risks to some degree.
Investors need to consider climate risk in order to make sound decisions about which businesses to invest in and divest out of. Yet recognizing and managing these risks is often hard, for a number of reasons:
The climate risk landscape is broad, complex, and evolving rapidly — with time horizons ranging from the immediate future to the next generation and beyond. In an era where predictability is decreasing this wide range of timeframes clearly makes planning a challenge.
Climate systems are supremely complex and only partially understood. While recent research from the past couple of decades has given us a relatively good understanding of certain risk factors, we’ve also learned that what we don’t yet know greatly exceeds what we do, making the overall nature of climate risk unclear. For example, in best-case scenarios, it is possible that future technologies and strategies that effectively mitigate projected climate impacts will provide profitable growth opportunities for companies in the changing environment.
Companies that deal with increased climate risk will likely have to spend more on insurance and may suffer greater losses if they do not adapt their business models to account for new conditions resulting from climate change.
Climate risk differs from many other financial risks in that it is often correlated with geopolitical risk; for example, a natural disaster might cause political instability or disrupt trade relationships. Investors must consider both the direct impacts of climate change and these indirect impacts when making decisions.
How do investors get impacted?
The risks for investors are different from those faced by company operators and employees. Investors may have diverse portfolios while the other stakeholders are likely to be far more exposed to the challenges facing their workplace. Concerns over shareholder value aren’t always well aligned with concerns for employee safety or long-term environmental quality.
Conversely, many investors view efforts to address climate change as a long-term opportunity — something they are eager to pursue despite the fact that it may have not yet matured and materialized meaningfully yet.
Investors need to understand how climate change impacts their assets and what their portfolio companies are doing to manage climate-related risks and opportunities. The good news is a growing number of companies have already started addressing climate issues and are including reporting on their activities and strategies as part of their regular KPIs.
How can you manage your portfolio’s climate risk?
While there’s no way to insulate your portfolio from every possible negative climate outcome, there are ways to manage your climate risk exposure through responsible investment practices and asset allocation decisions.
The most direct way is to use an actively managed fund that specifically addresses climate risk. For example, CC Sage Capital Absolute Return Fund is one of a growing number of funds focused on this area. TIAA-CREF, Vanguard, Parnassus, and Calvert Investments are a few of the more well-known fund companies with actively managed funds addressing climate change.*
You can also reduce your exposure to climate risk by diversifying across regions that are not affected as much by climate change (such as Asia and Latin America). However, this strategy does not protect investors from other types of environmental or social issues such as water scarcity or deforestation.
Another way to manage climate risk in your portfolio is to invest in green funds, which invest in companies that are regarded as leaders in sustainability and low carbon solutions. These funds can also include investments in fossil fuel stocks, but the percentage will be much lower than fossil fuel company stock. Examples of green funds include Pax World Funds, New Alternatives Fund, and Calvert Alternative Energy Fund*.
Where does this leave you?
The realities of climate change dictate that the longer you plan to hold on to a stock, the more concerned you should be about how it will be affected.
In best-case scenarios, businesses that come up with innovative climate solutions will grow faster than expected, and therefore yield greater profits, despite the rising costs associated with mitigating climate challenges.
Unfortunately, the likely scenario for most companies is that while many reliable scientific predictions of what we can expect in terms of climate change effects such as increasing storms, rising water levels, extreme droughts, etc., already exist, most companies remain under-prepared, and are likely to suffer adverse effects in the short-to-medium term.
Our advice is to research any company you’re thinking about investing in and make sure you consider the climate risk linked with it.
If you’re passionate about climate change, care deeply about environmental issues, and want to invest in industries that are going to be sustainable, supporting innovative companies adds an extra layer of reward to your investment.