- Climate change is a 'systemic risk' that will affect every company
- Time horizon uncertainty makes it hard to plan for
- It also creates opportunities you may not want to miss
Europe is going through one of its worst heatwaves on record, but there is still no precise relationship between climate change and investment returns. The MSCI Europe index was up 1.8 per cent in the month to 19 July; factors such as economic growth and inflation have a much bigger impact on the stock market than how sweltering it is in Italy or Spain, even if the latter can ultimately influence the former.
If you do not believe that environmental factors should influence your investment decisions, or are (understandably) sceptical of your ability to make a difference, ignoring the effects of climate change when managing your portfolio can seem like the obvious choice. However, it is not necessarily the wisest.
Climate change as a risk
Max Richardson, senior investment director at Investec, calls climate change a “systemic risk” that will affect every company to some degree, via a combination of both regulatory risk, whereby regulatory changes such as a carbon tax could have a major impact on the revenues of certain companies, and physical risk connected to weather changes. Companies that derive significant revenues from chocolate-based products, such as Nestlé (CH:NESN), are an example of the latter, because the bulk of cocoa production is concentrated in a small area of the world and very exposed to climate change.
Danni Hewson, AJ Bell head of financial analysis, adds that factoring climate change into any portfolio is “just sensible risk management”. “Even if ethics aren’t something you’ve ever brought into your investment decisions, you must be aware that regulations are being tightened and governments have tough targets to meet,” she says.
Much has been said about the risk that oil and gas assets will ultimately become “stranded”, ie, changing energy policy makes them unprofitable ahead of time. There are many other examples spanning a range of different sectors. But if the general case for taking climate change into account when investing is understandable, the details could do with some fine-tuning.
Firstly, the time horizon is a factor. The war in Ukraine has shown us that the energy transition won’t happen overnight and won’t always be the key priority. Depending on whether you are investing to retire in 30 years or buy a house in five, the level of climate change risk you are exposed to might be different.
Yet even if you are invested for the short or medium term, completely ignoring climate change could prove tricky given we are already seeing some of its effects, and we do not know how quickly things will escalate. “When you think about paradigm shifts, it's not uncommon for the status quo to prevail for much longer than you think,” says Richardson. “But then when it changes, it will change very rapidly.”
Richardson adds the insurance industry is one sector showing early signs of climate change's financial impact. In the US, for example, it has become harder for homeowners to get insurance on their properties in areas where climate-related risk is too high. Earlier this year, the largest home insurer in the US, State Farm, stopped accepting new policy applications in the entire state of California, due to the “rapidly growing catastrophe exposure” caused by wildfires, as well as increased construction costs.
Better returns?
The other major issue when dealing with climate change risk in a portfolio is the ‘how’. This is very much a work in progress. Jade Coysh, senior analyst and responsible investment specialist at Momentum Global Investment Management, notes that while almost all fund managers now look at environmental, social and governance (ESG) factors in their portfolio analysis, there is no agreed approach for how they incorporate these factors into their strategies. It can be very hard for private investors to distinguish between greenwashing and a genuine ESG integration, especially if there is a discrepancy between an asset management company’s climate policy and the beliefs and practices of the individual fund manager.
Many believe that ESG should also deliver better returns over the long term. But the arrival of higher interest rates is a reminder that short- and even medium-term performance can never be taken for granted. For example, LSEG Lipper data on global equity funds found that on a five-, three- and one-year basis, the proportion of funds that outperformed their benchmark was higher for conventional funds than for ESG funds.
When ESG portfolios outperform regular funds, most of the factors at play arguably have little to do with climate change. For example, ESG funds tend to be very exposed to technology companies, and therefore growth investments.
If the jury’s out for now, there is the prospect of a greater connection between climate-conscious investing and market returns as climate change starts to have an ever-greater impact on the world economy.
Richardson thinks this is true even for impact funds. While advocates of impact investing often claim you should be prepared to give up some financial returns in exchange for the impact of your investments, that may not always be needed. The sector is “trying to solve some of the deepest societal and environmental challenges we face”, he argues. “It is not a guarantee that every impact investment will provide you with a superior return to the market. But there will be winners and losers, and I think that impact funds and impact companies will be the winners.”
Part of the risk of ignoring climate change when making portfolio decisions also comes from ignoring potential opportunities. Renewable energy is an obvious area to look at, but there are others. Hewson suggests that materials companies such as Compagnie de Saint Gobain (FR:SGO) and even Travis Perkins (TPK) could benefit from the insulation upgrades that will be required to keep people cool if extreme temperatures become the norm, for example.
There is still a lot of work to be done to figure out the best way to account for climate change when running a portfolio and the dilemma is not going away any time soon. “While the road to net zero has most certainly been paved with good intentions and potholes, it is the direction of travel,” says Hewson.
