Investors can no longer ignore climate change. Whatever one believes about the science behind it, there is no escaping the financial impact of a rising tide of climate-related regulations, changing social attitudes, extreme weather events and technological disruption.
So, how can climate-change awareness be integrated into the investment process? The BlackRock Investment Institute provides a roadmap for climate-savvy investing in our new paper “Adapting portfolios to climate change.” We detail how climate change presents market risks and opportunities, how these factors are likely to play out for long- and short-term investors, as well as how all investors can — and should — take advantage of a growing array of climate-related investment tools and strategies to manage risk, seek excess returns or improve market exposure.
Climate-related market risks and opportunities
We see climate change affecting investment portfolios in four areas: physical, technological, regulatory and social. Scientists believe global warming is leading to growing physical climate risks in the form of more frequent and extreme weather events, such as storms, flooding, droughts and wildfires, as well as creeping rises in temperatures and sea levels over time.
Meanwhile, technological advances and cost declines in renewable power and electric grids, electric vehicles (EVs), LED lighting (see the chart below) and batteries pose a threat to incumbent industries and demand for fossil fuels. Investors burned by the disruption of the shale oil revolution can expect more of the same in the power generation, automotive and energy industries as a result of these advances.
Regulatory risks stemming from efforts to combat climate change are also increasing. There was enormous and significant emphasis placed on this topic at the recent G20 summit in China, and China and the United States just jointly announced that they have formally decided to ratify the Paris Agreement, a multi-nation plan to limit global warming. We believe many governments will follow through on their emissions-reduction pledges, and we could see them ratcheting up targets over time. But unlike slow-burning and sporadic physical climate events, regulatory risks are here and now. They can have an immediate — and often negative — effect on cash flows by raising the cost of doing business.
Finally, social and corporate awareness of climate change are increasing amid a recent spike in global temperatures. Non-governmental organizations (NGOs), shareholders, activists and consumers are pressuring companies to make their supply chains more sustainable (e.g., using less energy and water, and producing less waste). The same groups are putting climate change on the agenda of all asset owners.
Time horizon matters
The relative importance of these four factors depends on the trajectory of the pathway toward a low-carbon world and an investor’s time horizon. The longer an investor’s time horizon, the more climate-related risks compound. Long-term investors are likely more exposed to physical risks and the impact of climate change on economic growth. Yet we also see them as better positioned to invest in new technologies that take time to bear fruit. However, even short-term investors can be affected by here-and-now regulatory and policy developments, technological disruption or an extreme weather event.
How to incorporate climate-change awareness
We believe climate-aware investing is possible without compromising on traditional goals of maximizing investment returns, and indeed is necessary to the achievement of those goals. Our research suggests there can be little downside to gradually incorporating climate factors into the investment process—and even potential upside. Benchmarks that take climate into account have the potential to perform in line with or better than regular counterparts. The MSCI Low Carbon Target Index, for example, has modestly outperformed the MSCI ACWI since 2010, MSCI data show.
Another approach is to optimize benchmarks for climate factors. This means overweighting green companies and underweighting climate offenders, while keeping a portfolio’s return profile as close to the benchmark as possible. An even more proactive approach is to invest in climate-aware companies that use resources efficiently, mitigate weather-related risks and exploit climate opportunities. Our research has found that U.S. companies with higher climate scores—our measure of companies’ resource efficiency and exposure to climate-change related risks and opportunities—tend to be more profitable and generate higher returns on assets.
Bottom line: We see climate-proofing portfolios as a key consideration for all investors. Read more on how to mitigate climate risk and exploit opportunities in our full paper on adapting portfolios for climate change.