The Price of Climate Change

Climate change and its risks are going mainstream. What does the raft of new rules to curb carbon emissions mean for investing? How do you reduce climate risk in portfolios? We debated this with colleagues, clients and industry representatives during a one-day global videoconference in September. Our key conclusions:

• You may or may not believe man-made climate change is real or dismiss the science behind it. No matter. Climate change risk has arrived as an investment issue. Governments are setting targets to curb greenhouse gas emissions. This may pave the way for policy shifts that we could see ripple across industries. The resulting regulatory risks are becoming key drivers of investment returns.

• The momentum behind mitigating climate risk in portfolios appears to be building. Long-term asset owners worry about extreme loss of capital and/or ‘stranded’ assets (holdings that need to be written down before the end of their expected life span). Do securities of companies most susceptible to physical and regulatory climate risks already trade at a discount to the market? We have not observed such a discount in the past – but could see one in the future.

• Global insurers have led the way in pricing natural disaster risks. A huge US storm in 1992 (Hurricane Andrew) almost wiped out the industry, leading to a revolution in how it underwrites risks through an influx of capital, use of big data and increased capital requirements. Other industries may need to catch up.

• We discuss ways for asset owners to promote sustainability, including a focus on environmental, social and governance (ESG) factors. This is not just about saving the planet or feeling good. We view ESG excellence as a mark of operational and management quality. It means responsiveness to evolving market trends, resilience to regulatory risk, and more engaged and productive employees.

• Divesting from climate-unfriendly businesses is one option. The biggest polluting companies, however, have the greatest capacity for improvement. Engagement with corporate management teams can help effect positive change, especially for big institutional investors with long holding periods.

• The focus on sustainability has unleashed a torrent of new data. These can be used to measure physical and regulatory environmental risks, to mine for alpha opportunities or to reflect social values in portfolios. As examples, we analyse the carbon intensity of an insurer’s corporate debt portfolio and discuss research that ties improving carbon efficiency to equity outperformance.

• Securities markets are evolving to include emissions trading and green bonds, enabling investors to limit carbon exposures in portfolios and direct capital to projects that reduce emissions. Putting a price on carbon emissions is key for determining the value of energy-intensive industries, we believe. Carbon prices are mostly driven by policy, however, and currently offer little incentive to force emitters into palliative action and consumers to switch to non-fossil fuels.

• Efforts to mitigate climate change will produce winners and losers – but maybe not always the obvious ones. The oil industry and energy-exporting countries may look like losers, yet low-cost operators should do fine as de-carbonisation will likely be gradual. Assets that may benefit from a transition to a low-carbon economy include renewable infrastructure debt and equity. We also like selected companies specialising in energy efficiency and clean technologies.

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