A few clients have asked about how climate change may affect their portfolio, and what we as advisors can do to mitigate risks.
Will today’s macro global trends change how the market behaves in the future? If the planet keeps getting hotter, how will this affect your investments, specifically those that produce or rely on fossil fuels?
Let’s start by defining two areas of risk:
- Physical Risk is the direct result of changing weather patterns, such as increased flooding along coastlines due to rising sea levels.
- Transitional Risk relates to areas of obsolescence that arise as consumers and governments take steps to move away from fossil fuels to a low-carbon economy.
Today’s status quo will change as levels of carbon dioxide and other greenhouse gasses continue to rise, increasing the global temperatures. Parts of the world may become uninhabitable, such as in countries along the Persian Gulf and in North Africa, where ultra-high temperatures and high humidity combine to make evaporation of perspiration and, therefore, human life impossible.
Should you divest from owning companies that rely on fossil fuels? (Or that are based in Africa?) And if so, when should you do it?
Green vs. Brown Companies
In their 2019 paper, “Sustainable Investing in Equilibrium,” Lubos Pastor and his co-authors define two types of firms. “’Green’ firms generate positive externalities for society, ‘brown’ firms impose negative externalities,” they wrote. “In equilibrium, green assets have low expected returns because investors enjoy holding them and because green assets hedge climate risk. Green assets nevertheless outperform when positive shocks hit the ESG [environmental, social, and governance] factor, which captures shifts in customers’ tastes for green products and investors’ tastes for green holdings.” Also, they write, “[i]f the climate gets worse than expected, green firms theoretically act as a hedge and therefore, have lower expected returns, because they’re not exposed, or they’re a hedge for that specific type of risk.”
But, what happens to investments in brown companies that are trying to change their ways? Presumably, these businesses do long-range planning and see the writing on the wall. If you buy brown companies at today’s discounted prices (compared to the often-higher valuations of green companies), over time you should benefit from their efforts to decrease use of fossil fuels or other planet-polluting substances.
Globally, regulators are encouraging companies to disclose sustainability risks. For example, asset managers and institutional investors in the European Union must disclose how they integrate these risks into their recommendations.
Evidence exists that market prices reflect all public information about existing risks. For example, cities exposed to flooding face higher borrowing costs. A company exposed to global warming risk may receive a lower stock price. Yet surprises can happen; if the pace of climate change or imposition of carbon taxes differs from what investors expect, asset prices will change accordingly.
Sustainability Investment Strategies
If your interest is to invest with a focus on reducing exposure to the key drivers of climate change, we can help.
Here’s how the investment experts at Dimensional explain this portfolio strategy:
“Companies with high emissions intensity and potential emissions from reserves are underweighted, and companies with low emissions intensity and potential emissions from reserves are overweighted. The strategies may also exclude companies involved in coal, palm oil, factory farming, and certain environmental-related controversies. With this methodology, investors can achieve significant reductions in exposure to greenhouse gas [GHG] emissions within broadly diversified portfolios. Having a clear priority and a systematic process also allows investors to understand why our strategies are positioned the way they are. Furthermore, we provide regular reporting on how much reduction in exposure to GHG intensity and reserves our sustainability strategies have relative to conventional benchmarks. In our experience, this transparent reporting allows investors to better evaluate whether their sustainability objectives are met.”
Diversification across industries and countries can mitigate the physical and transitional risks of climate change. We live on the same big planet, but natural disasters don’t happen globally all at once (at least not yet).
While scientists and economists agree that climate change poses material economic risk, the timing is unknown. Repositioning your portfolio too quickly could mean many years of significant underperformance. Remember:
- We believe all available information is already factored into the price of stocks, and these macro global trends are known by institutional investors.
- Investors require a positive premium for putting money into stocks. If stocks didn’t have a positive equity premium, people would invest in Treasury bills or keep their assets in cash. If the future brings more uncertainty due to these global trends, expected returns should increase, as well, since investors would require additional return to take on that risk.
- We believe in focusing on what we can control—diversification, keeping costs low, and ensuring your portfolio is aligned with your willingness and ability to take risk.
Bottom line: If you are aiming to reduce your portfolio’s exposure to greenhouse gas emissions and climate risk, we can work with you to strategically and effectively accomplish this goal in a way that doesn’t compromise on sound investment principles. However, if you are already invested in a diversified portfolio, a new investment strategy will likely mean realizing capital gains.
- Dimensional, “Addressing Climate Risks in Portfolios,” May 7, 2021
- Dimensional, “Climate Change and Asset Prices,” March 31, 2021
- Dimensional, “The Sustainability Opportunity,” March 5, 2021
- Colin O’Connor, “Humid Heat Already Exceeding Human Tolerance in Some Regions,” American Association for the Advancement of Science last updated May 8, 2020, accessed July 27, 2021, https://www.aaas.org/news/humid-heat-already-exceeding-human-tolerance-some-regions.
- Lubos Paster et al., “Sustainable Investing in Equilibrium,” December 2019, https://www.nber.org/system/files/working_papers/w26549/w26549.pdf
- Benjamin Felix, Cameron Pasmore, hosts, “Episode 156: Climate Change vs. The Stock Market.” Rational Reminder (podcast) July 1, 2021, https://rationalreminder.ca/podcast/156