Why Sustainability Strategies Need an Extra Focus on Climate Risk

Harnessing additional data and developing rules to manage climate risk can position portfolios for transition to a low-carbon economy.

Addressing climate change is the top priority for many investors seeking sustainable-investment strategies — and they’re not alone in their concerns. Governments around the world are increasingly adopting new regulations to help reduce global greenhouse gas emissions or make companies accountable for their contributions to climate change. Major asset managers also now include climate risk when devising their capital markets assumption.

Environmental, social and governance (ESG) investing includes climate considerations under the environment pillar, but issues such as a company’s greenhouse gas emissions are just one part of the overall environment score. Given the current and potential future impact of climate change on the economy and stock prices, investors can benefit from sustainable strategies that use additional methods to manage climate-related risks and opportunities in their portfolios.

Here’s a closer look at why companies in all sectors face risks and opportunities as the world transitions to a low-carbon economy — and how to identify sustainable strategies that employ additional measures to address climate risk.

The impact of climate change across the market

Many investors equate climate risk with the energy and utilities sectors, with good reason. Both sectors are major sources of greenhouse gas emissions that are driving climate change, and are exposed to higher levels of risk as the world transitions away from fossil fuels. For example, energy companies have large amounts of carbon-related assets on their balance sheets, like oil fields, that may lose value as demand for oil falls.

But the global push to address climate change will impact many other sectors that are major emitters of greenhouse gases, such as real estate and agriculture. Companies that build and operate residential and commercial buildings will face pressure to reduce their energy consumption, while large-scale animal husbandry operations are under scrutiny for the methane that’s produced by raising cows, pigs and other livestock.

Carefully selecting companies in these sectors based on their carbon footprints may reduce long-term risk, but there’s also potential opportunity for investors. Consider a real estate company that operates more energy-efficient buildings.

Their facilities may have lower operating costs, higher health and safety ratings, longer tenancies and other benefits that translate into more stable, sustainable financial performance.

Beyond the need to manage greenhouse gas emissions, the entire market is also susceptible to the physical risks of climate change.

“Growing prevalence of wildfires, hurricanes, floods and other natural disasters can disrupt any company’s operations and hurt stock prices — leading to increased risk even in sustainable portfolios.”

A holistic approach to managing climate risk

Given the widespread impact of climate change on markets and the global economy, it’s important for sustainable investing strategies to take a holistic approach to managing climate risk in their portfolios. Some of the approaches to look for when comparing sustainable options for your clients include:

• Climate-related exclusions as part of ESG criteria. Limited exclusions for certain companies, such as companies involved in thermal coal, can help reduce a portfolio’s overall carbon footprint without eliminating exposure to entire sectors such as energy and utilities.
• Additional scoring to manage climate risk. Strategies can employ additional methodologies on top of their ESG criteria to specifically assess the carbon footprint and climate risk of companies on a sector-by-sector basis. These scores can help identify companies with the best climate-related risk/opportunity profile versus peers in the same industry, and can help target goals such as reducing the portfolio’s overall carbon footprint.
• Adoption of a stewardship mindset. Asset managers who create and manage sustainable strategies can use their influence to accelerate companies’ efforts to address climate change. For example, look for asset managers that are members of organizations such as Climate Action 100+, a group of institutional investors and asset managers that engage directly with companies on their plans to reduce carbon emissions, and FAIRR, a similar group of investors focused on creating a more sustainable animal agriculture industry.

Addressing climate risk on multiple fronts helps accomplish the challenge of building portfolios that avoid idiosyncratic risk in pursuit of sustainable goals. It allows fund managers to balance climate risk reduction with other goals, like maintaining similar exposures to broader market benchmarks and avoiding large bets on certain sectors or individual companies.

When added to baseline ESG criteria, this thoughtful approach to portfolio design is aligned with major trends in sustainable investing: It helps address clients’ concerns about climate change, while preparing portfolios for the long-term changes that climate risk will bring to the economy and the financial markets.