Climate Deeply Embedded in Risk and Opportunity
Australian Market Strategist
Summary: The climate agenda will bring a shift in policy priorities and climate change itself brings numerous physical risks that corporations must prepare for. Here we note the importance of these risks and consider the implications for asset markets. Which sectors are most at risk and who stands to gain.
In our view the prior decade, which has been the hottest in history, marked peak indifference on climate change. Australia is ground zero for climate change, and the current bushfire crisis has given the world a glimpse into what the coming decade may bring if mitigating steps are not taken.
Without taking a stance on the science of climate change, it is evident that the status quo comes with a giant price tag that cannot be maintained. We are now approaching an inflection point, where the aggregate effects of climate change are beginning to constrain economic growth and welfare, such that the cost of inaction is fast beginning to outweigh the cost of action.
The planet’s finite resources have been exploited beyond their limit, and the impact of climate change via lost homes and livelihoods to natural disasters, agricultural productivity, coastal resources, water security, and air quality is taking its toll. The cascading effects resulting from these supply constraints, like food price spikes, water security concerns, migration and other severe disruptions induced by the increased incidence of extreme weather events will see credible climate policy and increased action in an attempt to mitigate climate related risks. For investors these changes pose a number of questions, opportunities and risks.
The World Economic Summit in Davos begins next week, and ahead of the gathering the World Economic Forum’s Global Risks Report is dominated by the environment. That means for the first time in history the agenda meeting of the world’s elite in the idyllic Swiss mountains will be governed by climate change as the biggest risk the world faces, with extreme weather conditions being the top priority.
Climate Action could be one of the most transformative and disruptive challenges faced by the global economy, and by the same token the long term risks posed by climate change are also the largest faced. Societal, political and shareholder pressure is mounting ferociously for the corporate sector to align their practices with emissions reduction targets and warming thresholds. If governments are to follow through on their pledges to reach net zero emissions by 2050 or before, a wave of emission targeting regulation should be about to sweep through the private sector.
Quantifying the effect of climate change on investments via damage to infrastructure and property, reduced economic output or lost productivity, and also mitigating policy actions is a crucial undertaking.
Physical Risk: An increased incidence of extreme weather events, like floods, tropical cyclones, and extreme temperatures will physically impact business operations. Longer term threats include rising sea levels, lost ecosystems, pollution, natural disasters and higher temperatures making land uninhabitable and/or no longer fit for purpose.
Transition Risk: Inevitable policy shifts aimed at tackling climate change and decarbonising means that emission-intensive companies will become less competitive, and therefore trade a valuation discount. Most companies are poorly equipped for an abrupt change in mitigating policy so transition risks also arise throughout the adaptation process. This can include the potential for increased operational cost, refinancing issues, relocation/supply chain alteration, reduced output and reduced demand for product as consumer preferences change.
As the 3rd decade of the millennium begins and we move past peak climate indifference, it is clear that climate risk is now heavily embedded in both investment risk and opportunity.
Sectors at Most at Risk
In some sectors the physical and transition risk is more apparent than others:
As the foundations for a sustainable finance ecosystem are laid a huge reallocation of capital will be underway. Investors and corporates who do not gear their portfolios towards more sustainable business models risk facing large losses in the coming decades, holding stranded assets, flooded properties or businesses whose operating model is no longer viable due to regulatory burden/environmental impact.
Ultimately, companies who do not meet the requirements of new and improved sustainability and positive impact mandates or regulatory environments, where climate is a top consideration, will trade at a discount. For example, it is not unforeseeable that as the coal phase out obligations of the Paris Agreement in OECD countries by 2030 are implemented some companies and investors will end up holding stranded assets via reserves of un-burnable coal. These companies then become much more risky investments over the next decade.
An example of the mounting pressures sweeping through the corporate sector, last week a group of institutional investors in Barclays, Europe's biggest financier of fossil fuels, filed a resolution calling for it to stop financing firms not aligned with the Paris climate agreement, which aim to limit global warming to 1.5C. The resolution will be voted on at Barclays' annual meeting in May, and would require the bank to stop funding any company that has not aligned itself with the Paris targets.
Sectors most at risk include financials, REITs, Utilities, Resources, Transportation and Agriculture, the graphic below identifies some of the key considerations (physical and transition risks) these companies face in reducing their carbon footprint and adapting to a world where climate change and sustainability becomes a top policy priority.
Climate risk, real estate, and the bottom line (Source: Four twenty seven and Geophy)
- U.S. markets most exposed to sea level rise include New York, San Francisco, Miami, Fort Lauderdale, and Boston. The Top 2 REITs most exposed to sea level rise in the U.S. are Vornado Realty Trust and Equity Residential.
- Globally, REITs concentrated in Hong Kong and Singapore display the highest exposure to rising seas. Sun Hung Kai Properties, worth $56 billion, has over a quarter of its properties exposed to coastal flooding.
24 of the largest and highest-impact publicly listed oil & gas companies ranked on business readiness for a low carbon transition:
The green transformation will also drive many positive advances as the need for adaptation will spur the adoption of policy solutions aimed at funding clean energy projects, water security, sustainable and energy efficient infrastructure developments and green technological innovations like emissions capture and energy storage breakthroughs. These new climate industries not only provide jobs and economic gains but also generate a positive impact to society and the environment.
A millennial push: A vast sum of intergenerational capital will be shifting throughout the next decade into the hands of a group of investors for whom financial performance as a sole investment goal, is being replaced by positive impact.
The climate crisis is defining a future generation, and as the cohort of millennial and Gen Z investors grows financial performance will no longer be the only investment goal, increasing demand for positive impact investments that align with the broader sustainable objectives of society.
It will pay to go Green
Cleaner, greener companies with heightened moral capital and those taking steps to tackle climate transition risk are poised to gain in 2020 and beyond and will warrant a valuation premium as investors and asset managers become more discriminating and focus on integrating sustainability concerns into their investment mandates.
For more - Saxo’s Climate basket was released early this week by Peter Garnry
Fiduciary Duties to Drive Change
A key driver for expanding ESG mandates (for which climate is #1 consideration) is the redefinition of fiduciary duty and the growing cohort of millennial investors, for whom financial performance as a sole investment goal, wanting change and settling for nothing less!
As the voice of the climate crisis grows louder, it is inevitable that policy makers will mandate a requirement for institutional investors to include ESG as part of their fiduciary duty. If this change occurs this would make climate change, which is the primary issue for ESG asset managers according to US SIF (The Forum for Sustainable and Responsible Investment) a number 1 driver of investment mandates.
Blackrock have recently announced that it will add companies generating more than a quarter of their revenues from thermal coal production to its investment exclusion list in the next 6 months. At this stage, the policy will apply only to BlackRock’s $US1.8trn of active funds. Therefore, the divestment will affect just $US500mn of holdings out of BlackRock’s total $US7trn (0.007% of assets overall.)
Although this initial change may be small, Blackrock are the biggest financial institution in the world and the impact via signal effect is huge. Others competitors like State Street, JPM, Fidelity Vanguard etc. will follow suit (Groups including Columbia Threadneedle, PIMCO, Schroders, Aviva are already ahead of Blackrock in this respect). Passive allocations will be next, it is only a matter of time.
Climate change is the primary issue and takes centre stage for ESG asset managers according to US SIF (The Forum for Sustainable and Responsible Investment). More than one third of assets under management globally are now being invested according to the premise that ESG factors can affect a company’s performance and valuation, that makes climate a top 1 priority for investors. The number of asset managers investing with some form of ESG mandate is only growing and already trillions of dollars exclude companies that do not measure up in terms of sustainability. This will only grow larger as fiduciary duty is redefined.
Some of the world's largest asset managers already invest with a clear ESG mandate including the Government Pension Investment Fund (GPIF) of Japan, Norway’s Government Pension Fund Global (GPFG), and the Dutch pension fund ABP. The Government Pension Investment Fund (GPIF) of Japan, who manage more than US$1.5trn, last year moved $40 billion of its equities portfolio away from a traditional passive index based on market capitalization to one weighted for ESG themes, and primarily decarbonization. L&G, one of the U.K.’s largest asset managers, also attracted attention last year when it divested some holdings in ExxonMobil because of the company's inadequate response to climate change. Change is a foot.
Fiduciary Duty Re-defined
A key hurdle to financial institutions adopting ESG principles is the mistaken belief that fiduciary duty means focusing solely on returns, allowing ESG principles to be sidelined in favour of sacrificing return. However, recent legal opinions and regulatory guidelines state otherwise, instead arguing that it is a breach of fiduciary duty not to consider ESG principles. As the voice of the climate crisis grows louder, it is inevitable that policy makers will mandate a requirement for institutional investors to include ESG as part of their fiduciary duty. The UK, Canada, Sweden, Switzerland and other EU authorities are already ahead of the game in this respect.