The bad news? The longer your time horizon, the more climate change risk is compounding. The good news? In our view, effectively managing your exposure can help add alpha and manage risk.
Climate change is demonstrating its effects world-wide in the form of rising temperatures and shifting precipitation patterns. The result is more heat waves and droughts, more potent storms and rising sea levels. Unfortunately, these changes are our shared reality—and the longer an investor’s time horizon, the greater the effect of climate change risk on the investment portfolio.
Risks arising from climate change extend across industries and geographies, and threaten businesses in three key areas:
Physical damage: Land, buildings and infrastructure that are affected by heat, drought and flooding
Increased liability: Financial liability (e.g. insurance claims) and legal damages (e.g. torts and negligence suits tied to climate-related risks)
Reputational damage: Connected to activities that shareholders might deem inconsistent with the climate change issue
For long-term investors, it is critical to understand and analyze these risks to determine their effect on value creation. Also, each sector’s exceptional risk exposures must be considered, such as the impact of waste management liability and scrutiny in the technology sector, and the future impact of regulatory action on Co2 emissions in the utilities sector. In the agriculture sector, most notably, droughts attributed to climate change hinder the ability of farmers to produce food, creating ripple effects across a range of related industries, and endangering human lives.
We factor these variables into our approach to equities investing. Our team incorporates ESG and low carbon criteria (including an analysis of climate change risk) into many of our investments, not merely those that comprise of our ESG ETFs and funds. Currently, more than $650 billion of our assets are committed to UN Principles for Responsible Investment1, and 77% of our managers and investment analysts consider ESG in the investment process.2
Adding alpha by considering climate change
There’s a good reason for this level of rigor. Companies that successfully account for the impact of climate change have the potential to perform in line with, or better than, their peers: Since 2010, the MSCI Low Carbon Target Index modestly outperformed the MSCI ACWI.3 Looking ahead, climate-related risk is predicted to compound over time, meaning that climate-attuned portfolios have the potential to outperform amid tighter regulations, faster technological changes or more frequent catastrophic weather events.
Companies may be able to generate added value for shareholders by offering solutions that meet the needs of a low-carbon economy.
Companies may be able to generate added value for shareholders by offering solutions that meet the needs of a low-carbon economy. In the utilities sector, for example, electricity generators have the potential to reduce greenhouse gas emissions and add alpha by increasing the use of renewables. Renewable energy costs have rapidly been declining, achieving parity with that of fossil fuels in many markets. Solar photovoltaic and concentrated solar power costs have declined especially rapidly, though they still remain above grid parity levels as measured by the Levelized Cost of Electricity (LCOE).4
Similarly, companies in the consumer packaged goods sector are striving to innovate in the water resources management sector in the face of rising global demand and constrained resources. Companies that make strides in water efficiency, particularly for agriculture and other water-intensive uses, will be better positioned to reduce production, operational and investment costs, while minimizing reputational damage. These efficiencies may drive added alpha, as well.
Reducing risk proactively
Companies that proactively manage their exposure to climate change risks demonstrate stronger governance, and serve investor interests by mitigating costs that may address wide-ranging climate impacts. For companies that have failed to adequately manage these risks, the repercussions have been severe.
Take, for example, carmaker Volkswagen’s recent scandal. After admitting to cheating on auto emissions tests, they faced a recall of millions of vehicles, their CEO was forced to resign, and Audi’s CEO was arrested. For several years, MSCI had already been flagging Volkswagen’s declining governance scores based on a number of controversies. Volkswagen was dropped from the MSCI ACWI ESG Index in May 2015.
A lower-profile example recently occurred in the U.S. Utilities sector, with the state-record $25 million fine levied by North Carolina’s environmental agency to punish Duke Energy groundwater contamination. Ash elements found in test wells around the company’s Sutton power plant had broken state standards for as many as five years.
In both of these examples, exercising stronger corporate governance with a particular focus on ESG principles may have forestalled significant financial and reputational damage. Only by taking a forward look — beyond today’s climate-related realities, to tomorrow’s amplified possibilities — can CEOs, shareholders and investors effectively move beyond simply mitigating climate change risks to seize opportunities that our changing world may manifest.
Carbon makes its point
MSCI ACWI Low Carbon Target Index modestly outperformed the MSCI ACWI over the past 10 years3