Bracing your financial portfolio for climate change

Bracing your financial portfolio for climate change

short-term financial profit, climate change risks
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Short-term risk, long-term disaster? A look at the financial implications of climate change.

China’s stock market is in free fall, the fed is getting ready to hike interest rates and crude oil’s sharp decline just hit the $40-a-barrel mark.

Suffice to say, investors have a lot on their mind at the moment. Yet savvy money managers willing to put aside short-term noise in the name of long-term profits may be wise to focus their attention on emerging climate risks, most recently highlighted by the Climate Policy Initiative.

The organization released a report last week detailing the ways in which investors are exposed to climate risks, as well as offering a solution on how investors can look toward future climate-resilient investment profits. 

“The key challenge is that timelines for mitigating risk are misaligned between financial markets and climate change,” said Barbara Buchner, senior director of the Climate Policy Initiative and author of the report in an email. “Investors are often more concerned with short-term risks, whereas the risks associated with climate change will continue to emerge over decades.”

Effectively judging investor’s risk to climate change, stranded assets or severe droughts, however, is no easy task. This is in part because there is little regulatory pressure for companies to disclose these risks and this process is largely voluntary.

According to the report, there is also a lack of standardization on environmental, social and governance (ESG) data and information. On top of this, there is a need for more formalized definitions and standards on alternative green investments to determine what is actually considered green. 

“Mandatory disclosure for public companies — through financial regulators, exchanges or intermediaries, and covering a range of asset classes — would afford investors more comprehensive information and greater comparability across industries,” stated the report.

Identifying the risks

As the impacts of climate change are beginning to be felt around the world, companies are increasingly becoming more susceptible to related risks that could have profound financial implications. 

One of those potential risks with severe financial consequences is the concept of stranded assets, which has become particularly intertwined with yet-unused carbon assets and fossil fuels

Part of this risk stems from the specter of new regulations on carbon emissions as world leaders strive to thwart the world’s temperature from rising more than 2 degrees Celsius — a scenario that could make it uneconomical to extract and burn carbon reserves that companies currently possess.

According to Carbon Tracker (PDF), there is a potential that 80 percent of the world’s carbon reserves will become unburnable, which — if this situations holds true — would result in a $20 trillion write-off in losses by fossil fuel companies. 

Adding to the risk of these assets becoming “stranded” is the possibility that greenhouse gas emissions will become taxed, either through a direct policy tax or new cap-and-trade taxes.

The Climate Policy Initiative asks the question: “What are additional costs that Exxon Mobile might have if emissions are taxed?”

However, according to the report, this question cannot be answered without appropriate ESG information and by Exxon Mobile disclosing more information. In order to answer this question, the investor will need to know the “amount of total emissions, by type of greenhouse gas, by source, per unit of revenue, emissions trading activity, amount of emissions reductions.”

By reporting ESG data and by disclosing climate risks, it also presents investors with opportunities to invest in more climate-resilient investments.

“The investment landscape has reached a tipping point, where it’s become clear that managing climate exposure — by both minimizing climate risk and pursuing climate opportunities — is not only good for the climate, it’s also good for bottom line,” said Buchner. 

Finding the rewards

A Guardian article discusses how MSCI, a provider of indexes and analysis tools, found that investors who divested away from fossil fuels outperformed “conventional investors” by 13 percent to 11.8 percent.

For investors looking to cash in on green investments, the report details various options for investors. Beyond investing in individual renewable energy companies such as SolarCity, equity seeking investors can look at indexes that provide numerous green investments. 

The report lays out three types of indexes for public equities: exclusionary; non-exclusionary; and thematic. Exclusionary offers a basket of companies that do not invest in a certain asset class, which is generally fossil fuels. One example of this index is the Fossil Free Indexes US.

Yet the report doesn’t recommend these indexes for the majority of investors because they still leave investors with significant risks.

“Exclusionary indexes don’t allow investors who are concerned about fossil fuel volatility to protect against downstream or supply chain impacts of oil fluctuations or policy changes,” stated the report. 

Instead, the Climate Policy Initiative recommends non-exclusionary indexes, which are highly weighted in low carbon investments such as solar and wind companies, while also still holding on to fossil fuels but by a far smaller percentage than their holdings in low carbon companies.

“Rather than emphasizing the importance of cutting direct financial ties to climate-exposed investments, non-exclusionary indexes reward companies that manage climate exposure better,” said the report. 

While there seems to be ample opportunities to invest in climate resilient investments, the question become when will investors actually turn to these investors and what needs to be done to inform the investing community of these opportunities.

“Climate savvy investors can share best practices for minimizing climate risks and maximizing climate opportunities with other investors who are newer to the space,” said Buchner. “Effective management of climate exposure will require knowledge-sharing, particularly as climate-related risks become more acute over time.”