Issues around carbon are growing in importance for investors as critical factors in climate change trends become part of comprehensive investment analysis.
On June 1, 2017, the United States announced its withdrawal from the Paris Agreement — an accord hashed out between nearly 200 countries to slow the world’s rising average temperature. Per the agreement, the United States had agreed to reduce its greenhouse gas emissions by up to 28 percent from 2005 levels by 2025. The decision to withdraw was largely credited to the potential impacts this agreement could have on the U.S. economy.
In spite of this announcement, several American state, local and business leaders made moves to continue to support climate action in line with the Paris Agreement. One example of investor interest in climate change came just one day prior, in an announcement at ExxonMobil that 62 percent of shareholders voted for better reporting on the risks that climate change poses to the business. This news reflected concerns held by a growing number of investors: The oil and gas giant was not effectively accounting for the prospect of reduced demand that could result from restrictions on long term fossil fuel production or greater accessibility to renewable energy sources.
What appears clear is that many stakeholders are engaged with concerns around climate change, and a growing number of members of the investment community are addressing climate risk concerns through their investment portfolios.
“Increasingly, mainstream investors are looking at climate change issues in a different light,” says Emily Lawrence, an environmental, social and governance (ESG) senior product specialist with Northern Trust Asset Management. “Investors may view carbon risks as tangible, troubling risks, and are considering how the companies in their portfolio are preparing for challenges to their operations, like an increase in big storms, rising temperatures or water levels, shifts in technology, and the potential for stranded assets.
For example, there is concern around untapped fossil fuel reserves, as there is a high probability a significant proportion of reserves may remain unexploited as regulations change and technology shifts lessen the demand for fossil fuels. The value of these assets will, therefore, be reduced and effectively become stranded.”
“Investors may view carbon risks as tangible, troubling risks, and are considering how the companies in their portfolio are preparing for challenges to their operations.”
A growing hot market
As environmental awareness among company leaders has grown, Lawrence says that market expectations around the related risks have ratcheted higher. In turn, large investors have increasingly pressured companies to expand the data they publicly share. And investors have put that information to use.
According to a 2016 trends report published by US SIF: The Forum for Sustainable and Responsible Investment, an independent industry trade group, money managers and institutional investors said they accounted for environmental factors in about $7.79 trillion they managed. Of this, about $1.42 trillion specifically integrated climate change-related analysis.
By comparison, the 2014 trends report noted environmental impact analysis was used in $2.94 trillion of assets under management, including $275 billion focused on climate change.
Lawrence suggests that the sharp growth rate between 2014 and 2016 stems from a number of factors, including:
- Growing concerns around environmental issues: In addition to individual investors, an increasing number of large investors are questioning how companies that contribute to climate change are working to reduce their carbon footprint. These investors are also interested in how investments in renewable energy currently fit — or do not — into investment portfolios.
- Heightened risk awareness: If a company’s value is based partly on resources such as untapped oil, gas reserves or unmined coal, that value could significantly diminish as regulatory changes, shifts in marketplace trends and other factors reduce the demand for fossil fuels.
- Tech-driven savings: As renewable energy systems and energy storage options evolve and improve, pricing tends to drop, which prompts consumers to shift to renewable energy choices — not just because it is in line with a broader concern around climate change, but because it makes good financial sense.
Furthermore, Lawrence adds that the influence of environmental concerns has risen to a level that can withstand any political cross currents that may arise at the federal level.
“From my perspective, interest seems to be coming from every angle and across all demographics,” she says. “From large institutional investors who see it as an important part of their risk analysis, to individual investors focused on climate change in their personal investment portfolios, to foundations that wish to address climate change concerns in their investments.”
A Broader Push for ESG Insights
More companies are paying attention to their environmental impact and social responsibility.
Before joining Northern Trust Asset Management in 2016, Emily Lawrence spent nearly a decade working for a dedicated environmental, social and governance research firm that profiled corporate performance on issues like climate change for thousands of companies a year. Yet for much of that decade, she found that companies largely shrugged off the impacts.
“We would compile a report on what their ESG performance looked like, call the company to discuss our findings, and nine out of 10 would decline to comment,” Lawrence recalls. “ESG investing as a whole has come a very long way in the past 10 years.”
As evidence, she points to the publication rates of corporate sustainability reports, which generally outline company policies and disclosure on environmental, social and governance issues. According to the Governance & Accountability Institute, just 20 percent of companies in the S&P 500 Index published such a report in 2011. By 2015, that figure had jumped fourfold, to 81 percent of S&P 500 companies.
And through growing transparency and company cooperation, this development has translated into increased acceptance by professional money managers, according to US SIF.
Investment opportunities vary
Investors have different goals for addressing climate-related risks in their portfolios, and as such, there are different ways of incorporating a response to climate change in the investment process. One of the first places investors may consider climate risk is in their core equity portfolio. ESG investment strategies entail a broad analysis of risk exposure and management for relevant environmental, social and corporate governance issues, including an analysis of carbon related risks.
This approach also incorporates an assessment of how companies position themselves relative to market opportunities, including the development of renewable energy technologies. Companies that are working to mitigate these risks and capture these opportunities will perform better in an ESG framework. From a climate risk perspective, these businesses may be poised to take advantage of state-level commitments to develop a renewable energy infrastructure and minimize the risks presented by a transition to a low carbon economy.
Investors looking to address fossil fuels specifically may want to consider one of two approaches: divestment or carbon footprint reduction. Fossil fuel divestment, which is a decision to systematically avoid investing in companies that own fossil fuel reserves, has been growing in interest. Wholesale exclusion of fossil fuels may have economic drawbacks, as this approach represents a strong sector bet at a time when the transition to a low carbon economy has not been fully shaped.
Alternatively, a nuanced approach to divestment, based on a carbon footprint analysis, entails minimizing exposure to companies that are the biggest contributors to the portfolio’s carbon footprint. Based on measurement of company emissions and potential emissions, this approach allows for a portfolio that has limited exposure to high greenhouse gas emitters as well as limited exposure to fossil fuel companies.
“There’s a growing understanding of the investment risks related to climate change in addition to being a real concern for our planet.”
Maintaining portfolio exposure to select fossil fuel companies allows investors to maintain diversification in the portfolio, while allowing them to take part in one of the most powerful tools available to them: shareholder engagement. Many climate focused funds and strategies go beyond leveraging environmental data in the portfolio construction process to use that ownership stake as a means of engaging with portfolio companies on relevant issues, including proxy voting, as illustrated by the success of the ExxonMobil climate reporting resolution.
Lawrence notes that Northern Trust’s experienced ESG team frequently engages clients on the array of opportunities stemming from these environmental trends. In particular, one of Lawrence’s key roles is to help clients understand the depth and breadth of the data and its potential influence on the investment process.
"There’s a growing understanding of the investment risks related to climate change in addition to being a real concern for our planet," Lawrence shares.
While climate change was once the province of ecology-minded individuals and other progressives, considerations have merged into the mainstream for many investors large and small. And as the demand for ESG insights grows, it is anticipated that balancing environmental concerns with investment approaches will also continue to grow.