The Paris Agreement delivered an international treaty on climate change in 2016. It laid out progressive goals to limit the global average temperature increase to well below 2 degrees Celsius, and preferably to 1.5 degrees Celsius by 2100.1 Projections based on current policies anticipate a temperature rise of 2.7 degrees Celsius by that year.2
Limiting global warming is critical to mitigating the catastrophic effects of climate change on ecosystems and humanity, economies and industries, and investment portfolios. Mitigation efforts will impact investors and their portfolios, in the short and long term, representing both risks and opportunities.
However, there are distinct global differences in executing these efforts, often based on regulatory, cultural and fiduciary standards. In the UK, for instance, the regulatory and political climate for retirement plans is more attuned to climate issues. A wider range of assessment tools and approaches are used, including climate scenarios.
“As an investor in the UK, you should be concerned if you hold investments in exposed companies or industries that have insufficiently planned for the transition,” says Tim Manuel, an Aon investment consulting partner based in the UK. “Investors also have an opportunity to benefit from the growth opportunities to invest in climate solutions that have a positive impact on real-world decarbonization.”
Daniel Ingram, North American Head of Responsible Investing and IC Partner, Aon Investments, adds: “For many institutional investors in the U.S., sustainable strategies are permitted if they meet the same thresholds for expected risk and return as any other investment.”
Five Insights for Investors Considering Climate Change
No one-size-fits-all approach exists for investors considering climate change. Rather, investors should assess which strategies work for them based on their objectives, views and circumstances. These five steps can help pave the way for responsible investing:3
1. Integrate climate information as part of the investment process. There is an opportunity for skillful investment managers to outperform by integrating climate information as part of the overall investment process. Many investors don’t wait for climate risks and opportunities to happen — they try to anticipate them in their decisions to buy and sell securities, driving market prices to incorporate consensus views. As a result, climate-related risks can be quickly priced into markets and securities as new information becomes known. Investment managers who are skillful at identifying and balancing climate risks with other risks will see positive results.
2. Tread carefully with scenarios. Regulators in some markets are requiring use of climate scenarios to help investors understand the impact of climate-related risks and opportunities. Even with the unprecedented availability of climate information, investors still don’t know the accurate timing or magnitude of climate impacts. Climate scenarios are an important tool for providing a particular perspective on climate risk. However, investors should proceed with caution and clearly understand the limitations.
3. Take a balanced approach to risk. There is no ideal “hedge” to protect a portfolio from multi-faceted climate risks. Though many investors would like resilience to climate risks in their portfolios, it’s not clear how to do this or what the costs are. Simply investing in securities of businesses with low carbon emissions may not be a direct or effective way to protect the portfolio against climate risks. A better approach involves investment managers who are skilled in integrating climate risks and opportunities into their decisions.
4. Seek long-term opportunities. Not all investors seek “impact,” but those who do should prioritize efforts to decarbonize the real economy over the portfolio. Selling carbon-intensive securities in secondary markets doesn’t mean the companies they sold, or stopped lending to, emit less greenhouse gases. It just means someone else will own the securities. Further, the investor may engage and vote proxies differently. As a result, decarbonizing portfolios is not the most direct or effective way for impact investors to use their portfolios to address climate change.
5. Create a positive impact by investing in carbon-intensive businesses. For impact investors who want to mitigate climate change, a viable strategy is to “steward” outsized emitters to reduce their carbon footprints, exercising their ownership rights to drive change in a variety of ways.
Investors are Considering Short- and Long-Term Factors in their Decisions
Investors face headwinds and opportunities in both the short and long term as they navigate climate risk investing. In the short term, risks are diverse, including:
- Geopolitical concerns
- Regulatory and risk pressures
- Impact of natural catastrophes on physical assets
- Impact of transition risks
Short-term acute physical risks, including heatwaves, floods, wildfires and windstorms, and chronic physical risks, such as rising temperatures, ocean acidification and rising sea levels, could directly impact company operations and fundamentals. This then causes asset price volatility across portfolios.
For investors, there will always be a focus on returns. Investors will continue to use data and analytics through climate modeling to make near-term decisions on opportunities for portfolio optimization. The resolution of catastrophe models is high, and investors can gain valuable insights at individual asset levels to make informed investment and divestment decisions. These models continue to grow in accuracy, paving the way for more sustainable long-term decisions.
In the longer term, investment opportunities will emerge as industries transition from high to lower carbon intensity. Many industries are actively pursuing decarbonization amid growing regulatory and stakeholder pressure. But change requires investment. Exposed sectors, such as oil and gas, commodity traders, utilities, materials and agriculture can accelerate their transition through innovation and investment in new technologies.
These changes could increase exposure to risks, with costly implications if not addressed. This creates indirect impacts across other sectors, including insurers and service providers. Consumer sentiment for greener products may also increase. For investors driving this transition, rapidly changing pressures can make the longer-term financial outlook more difficult to forecast accurately.
As part of this transition, investors are recognizing their role in moving the needle toward decarbonization through investment decisions. By providing capital to emerging technologies and cleaner operating models, investors can support the transition process, while also accessing potentially attractive future returns.
A Spotlight on Retirement: In the UK, pension funds already use climate modeling to build a more robust long-term lens. However, in other regions, like the U.S., the regulations are less specific. Conventions are also more varied in terms of how retirement fund managers consider climate change, though most view it as an economic risk that is yet to materialize.
