Why investors need to think about climate change

This issue demands a lot more attention from the investment industry than it has received in the past.

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  1. Rob Morgan

In 2018 a report from the United Nations’ Intergovernmental Panel on Climate Change (IPCC) provided a wakeup call to world leaders, to investors and to all humanity: Global warming is happening much faster than previously thought. The IPCC warned that, based on current emissions trajectories, the “carbon budget” required to keep warming at or below a ‘safer’ level of 2 degrees Celsius – as agreed by many nations at the Paris Summit in 2015 – could be used up in just 11 years.

The report also recommended tightening the aspirational target to 1.5C, noting that average global temperature rises masked greater warming in particular regions, most significantly the Arctic and Antarctica, where ice melting could cause a catastrophic rise in global sea levels. They calculate that even this more stringent target would achieve only a 66% likelihood of avoiding severe adverse climate impacts.

An economic as well as environmental impact

As well as increased flooding, climate change could also increase the size of deserts and mean there are less habitable areas of the planet. Warmer seas and changing weather patterns may also increase the likelihood of destructive storms, floods, droughts and forest fires in many areas, as well as have a hugely detrimental effect on ecosystems.

While we can’t know precisely how the climate is going to change, there seems little doubt that human activity through greenhouse gas emissions is a significant reason behind it.  Addressing this is the biggest societal challenge we face and will require huge efforts to restructure entire industries across the world. Some countries have already embarked on policies to help – indeed 195 countries signed the Paris agreement – but others have taken few meaningful steps.

The toolkits that governments have at their disposal is comprehensive. They can limit high emission activities through regulation or fines, and reward good behaviour or innovation through subsidies and tax breaks. They can also set carbon prices, though this is best achieved on an international basis where agreement has thus far been elusive.

It is hoped that the coronavirus crisis might be a catalyst for more concerted efforts to respond to climate change, especially given that enforced lockdowns have shown glimpses of a lower carbon future through greater online activity and less travel. However, the temporary collapse in emissions has also served to underscore how greatly the global economy, which has shrunk by a remarkable degree, is dependent on fossil fuels.

Covid-19 has also proven an unwelcome distraction to the climate agenda in the sense that most governments are thinking short term to deal with a public health crisis. There is a danger that little changes and once it passes – delays to transition could have a devastating impact on ability to meet climate goals. It’s also affected the balance sheets of many businesses, which are now in a weaker position to make the necessary changes to their activities and businesses models. That’s why there is increasing pressure from green groups and other lobbyists to make ‘green deals’ part of economic recovery.

Overall, the investment industry has also been slow to recognise the urgency. The International Monetary Fund recently warned that the risk to assets posed by climate change is not currently reflected in equity prices, and that when investors’ perceptions change it "could lead to a drop in asset values, generating a ripple effect on investor portfolios and financial institutions' balance sheets".

It has been calculated that to meet the Paris target of limiting global warming to 1.5C, investment of $2.4trn is required each year until 2030. Companies that can help towards this goal may be able to harness considerable growth, while those on the wrong side of the trend could face significant structural and legislative headwinds.

Although progress has initially been slow, momentum is now gathering. Increasingly, there is recognition that helping combat climate change might also help generate superior returns as well as being the right thing to do.

The winds of change

Reducing greenhouse gas emissions by recommended levels will require dramatic changes to how we generate and consume energy. Most obviously, a transition to zero and low emission fuels will impact areas such as energy, mining, utilities and manufacturing, but nearly every industry and business will be affected in some way.

As with any major restructuring, the shift will create both winners and losers, and successful investors will identify them early in the pursuit of maximising returns. It is easy to focus on the downside and the potential disruption, but there are opportunities too. For instance, we are already witnessing huge growth in electric vehicles and renewable power generation. The International Energy Agency (IEA) predicts that renewable sources will account for 50% of all new power generation by 2050, compared with 25% at present. Companies providing positive solutions are well placed, as are those that are planning ahead and adjusting their business models accordingly.

In contrast, companies with reserves of ‘unburnable’ carbon resulting from regulation and the changing competitive landscape may be stuck with “stranded assets” that cannot be developed economically. With solar, wind and others becoming increasingly low cost and reliable, many energy providers are transitioning quickly. Leaders have aggressive targets such as Norway’s Ørsted, previously an oil and gas company, which aims for 99% green energy generation from 2025.

As well as an increasing social imperative for companies to act on climate change, increased regulation is likely to force many businesses to review their business models and improve transparency. Legislation on emission control and energy efficiency standards is tightening, and there is likely to be ever increasing taxation on carbon emissions. Those behind the curve risk not only bad publicity but higher cost of capital as investors view them as less sustainable and higher risk. Analysis from Schroders shows up to 20% of listed companies’ cashflows are at risk if policies strengthen in line with current political commitments.

The cost of failure

The economic costs of failing to act are far worse, though, and most likely poses greater risks to investors than those associated with successful economic transition. Schroders has estimated the current 4 degrees Celsius temperature rise trajectory would create over US$20 trillion in economic losses by the end of the century. That’s three to four times larger than the impact of the 2008 global financial crisis.

The clearest threats are physical. The melting of ocean ice has already raised average sea levels by roughly three inches over the past 25 years. Scientists now project sea level rise of two meters by the end of this century, endangering some of the world’s largest cities, including New York, London, Tokyo and Shanghai. 

How can investors help?

Investors and asset managers are increasingly asking questions of companies surrounding the reporting of carbon emissions and how they can reduce them. By allocating capital wisely, championing good practice and engaging with firms perceived as laggards, investors can play a vital role. Ultimately, money talks and companies deemed unsustainable will likely find capital to fund their activities increasingly scarce.

Individuals can also help by choosing socially responsible investments with strong ESG (environmental, social and governance) credentials, as well as good engagement and voting records on key practices. In this way companies can increasingly be held to account on this and other issues.

There’s more about socially responsible investing on our dedicated webpage.

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