Is Climate Change Risk a Consideration in Your Portfolio?

Cristi-Kerekes / Shutterstock
Cristi-Kerekes / Shutterstock

The revelation that Europe's largest car maker cheated on emissions tests can tell us a lot about an investment risk that is seldom discussed. Ewen Cameron Watt shares his views from London.

What should we fear most?

‘Events dear boy, events,’ was British Prime Minister Harold Macmillan’s answer. This rings true when surveying the VW debacle.

The company’s cheating on emissions tests has instantly crashed its reputation and, to some extent, that of an industry and entire country. Investors have been reminded that risk and opportunity are, by definition, uncertain.

Climate change risks stretch beyond the familiar areas of utilities and fossil fuel producers. Cutting corners to avoid compliance just got much harder. Investors will need to think more deeply about these risks and how to manage them correctly.

Many industries were already coming to terms with the reality that climate change regulations are getting more stringent. The UN Climate Change conference in Paris this December—catchily named Cop 21—will focus investors on resulting opportunities and risks. VW has simply upped the ante.

Linking climate change and investment risk

The insurance industry has been pricing extreme weather-related risks for many years. Every few years a ‘mega cat’ comes along, resulting in rises in general insurance and reinsurance rates. Direct man-made environmental disasters such as the chemical explosion in Tianjin have far-ranging consequences, as RSA owners found out recently. In auto-land, the VW problem has handed a golden opportunity to the electric vehicle industry, provided it can bring costs down and performance up. Driverless cars may use less fuel and could cut into the 10 percent of global oil demand generated by North American motorists.

How should investors react? The simple answer—invest in low-carbon companies only—is appealing but challenging. For starters, excluding companies from portfolios automatically means a different return from holding the full range of a market. Allocating capital to an industry for reasons beyond monetary returns also lowers the cost of capital for investors and, maybe, potential returns for the beneficiary. Put more simply, fashions create bubbles and can reduce underlying investor pay-outs because too much capital chases limited opportunities.

Paying a high price for opportunity involves making judgments well into the future, a skill that has eluded many corporations and investors over the years. And prices fall as adaptation rises, as investors in solar panel makers have found. Today’s margin of scarcity is tomorrow’s competitive opportunity for a disruptor.

Technology should nevertheless be a focus for investors. This applies not just for disruptive technologies, such as electric vehicles and alternative energy, but also to fossil fuel producers and utilities. Carbon capture and storage, for example, is a proven but currently expensive technology that can materially reduce emissions. If adapted, it could be a game changer, as could coal-to-gas switching for power generation.

How investors are trying to manage climate change risk

Plan sponsors want portfolios screened for emissions exposure—which in itself may be far greater than immediately apparent. Investment managers engage with corporations to ensure regulatory and environmental risks are managed properly. The VW disaster underlines the considerable sense of this and the price of not doing so. It is an easy bet that positive engagement will receive much increased focus.

The VW scandal shows that managing risk is in itself uncertain. Successful investment is often as much about avoiding losers as picking winners.

 

Ewen Cameron Watt is London-based Chief Investment Strategist for BlackRock and the BlackRock Investment Institute. He is a regular contributor to The Blog.

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