Environmental Social Governance (ESG)

How climate change is creating risks and opportunities for investors

By AMP Capital

Changing the climate for investment

"The battle to halt climate change can be won, because the green revolution delivering clean energy is both bigger than the industrial revolution and happening faster than the digital revolution.”

Al Gore, Former-US Vice-President

Professional investors are increasingly focusing on both the impact their investment choices have on climate change, and also on how their investments will be impacted by it. This reflects a wider understanding of, and concern for, the impact of climate change, not just on the environment, but also on the sustainability of company earnings. In turn, this is creating significant financial risk, but also some interesting investment opportunities for asset managers who genuinely understand these issues.

Climate change will change the economy

The structural changes within the global economy that will be required to adapt to climate change are significant. In Australia alone, greenhouse gasses must be reduced substantially over the next generation for the country to play its part in limiting the rise in average global temperatures to 2C. This will require fundamental changes across the economy.

This adjustment to a low carbon economy will require much greater energy efficiency, a switch from fossil fuels to low carbon electricity, electrification of road transport and reduced non-energy emissions in industry and agriculture.

Investors should consider carefully their holdings in dirty industries and carbon-intensive energy generation. However, investors can choose to be exposed to positive as well as negative impacts on climate change through their investment decisions.

Most investors genuinely want to make a positive contribution to the environment and society, and climate change is giving rise to opportunities and not just risks. However, investors and their managers need to fully understand the extent of the economic and investment risks of climate change. This starts with acknowledging that a do-nothing approach will not be cost-free in terms of the impact on long-term earnings.

Increasing importance of climate change to investors

Investors are increasingly understanding climate change and its impact on the environment and global economic activity. This is important as diversified investors, especially large institutions, are ‘universal owners’ with portfolios exposed to the full range of environmental risks, especially climate change. They can however, have a positive impact, by both minimising these externalities and managing their clients’ exposure to these risks.

Sophisticated investors are viewing climate change on two levels. Firstly, they are considering the impact of the activities of companies, properties and infrastructure assets they are invested in on climate change. This may lead investors to make an ethical decision to avoid a certain investment, or to at least consider the impacts of carbon regulation. Examples of this might include avoiding environmentally-contentious toll roads as an infrastructure investment or divesting from, or reducing holdings in, coal mining companies.

Secondly, investors are analysing how a company’s earnings will be impacted by climate change, through physical risks, regulatory or public policy change and technological disruption. Examples of this might include the taxing of or banning certain types of transport activity or the potential impact on the earnings of an insurance company as it looks to adjust premiums to reflect increasing storm damage.

Sectors most impacted by climate change

Climate change will lead not only to rising sea levels, more frequent extreme weather events, increasing risk of disease and geopolitical instability, but also result in major economic impacts.

The sector of the economy that will probably be most affected by climate change policy is energy, which is the largest contributor of greenhouse gas emissions in most industrialised countries. Electricity generation accounted for 33% of carbon emissions in Australia in 2017 according to Federal Government data published by the Climate Council1. It also holds the best prospects for emissions reduction of all the major emitting sectors.

Emissions contributions by sector, Australia, year to December 2017

Business models along the energy supply chain, from electrical power generators to coal miners, oil companies, and liquified natural gas (LNG) suppliers, along with the ecosystem of support companies, will either be transformed, or will cease to exist. Earnings from their current operations are likely to prove unsustainable over the long-term, representing a major risk to investors. 

However, companies that deliver carbon-free energy such as wind, and especially solar, which has seen material cost falls in recent years, face significant opportunities. Favourable financial winds are also supported by an increasingly supportive public policy environment.

At a micro level, companies are taking advantage of improving technology and falling costs to enable households and small businesses to better store the solar power that they generate and even sell it on to the grid.

Transport is the other major emitter of greenhouse gasses across advanced nations, accounting for 18% of Australia’s emissions1. The transition to zero-carbon economies will see a transformation in the use of personal vehicles, as they switch to being electric, automated and shared.

The expansion of the global middle class is expected to lead to the demand for air travel to continue to grow significantly faster than global GDP for many years. Yet air travel represents a major source of greenhouse gas emissions as well as noise and air pollution. Hence, the fortunes of aircraft manufacturers and airlines are likely to depend upon their ability to innovate and deliver fuel-efficient air travel.

Subject to less scrutiny so far than energy and transport, agriculture accounts for a material level of greenhouse gas emissions. This is especially true in countries such as New Zealand that are highly concentrated in the farming sector. This will impact companies along the food value chain if demand for agricultural goods changes as dietary choices and regulations evolve.

Tourism represents a large part of the economy of many countries including Australia, and it is especially significant in certain developing markets. Climate change can be highly detrimental to the natural environment, threatening tourist attractions such as the Great Barrier Reef or low-lying Pacific islands. It will also impact vulnerable antiquities such as those in Venice as sea-levels rise and extreme weather events become more frequent.

These major sectoral impacts can be transmitted right across a country’s wider economy through the exchange rate. For example, should Australia’s coal and LNG exports earnings rapidly fall, then the currency would likely depreciate, impacting domestic inflation.

Drivers of investor behaviour change

Australia now has the highest number of rooftop solar panels per capita of any country. This enlightened self-interest of the ordinary consumer is having a significant effect on businesses that have an impact on climate change, either negatively or positively.

Recent growth in home energy systems reflects falling costs and improving reliability, but consumer concern for climate change has been a critical factor. In addition, government policy has been shown to accelerate these trends, such as when certain state governments in Australia pay higher rebates than others upon the installation of solar panels in homes.

Government policy can also play a wider role in moving the economy away from carbon emissions. Decisions on the required mix of power generation derived from fossil fuels and renewables will strongly influence investment decisions by corporates and investors.

Fund managers unsurprisingly allocate capital where they can maximise sustainable risk-adjusted returns for their clients. This has encouraged institutional investors to encourage governments to structure policies that will better facilitate the investment required to support a switch away from fossil fuels. Ongoing policy uncertainty in Australia remains a particular challenge for investors.

Similarly, aircraft regulations are highly influential in determining the environmental characteristics of aircraft that are produced by manufacturers and flown by airlines.

Investors are increasingly coming under scrutiny from public opinion to justify investments in those companies that negatively impact climate change. For example, recent plans to develop new coal mining projects in Australia have brought intense focus on the companies that have provided capital or other support for the projects. This gives rise to direct reputational risk for lending institutions.

Institutional investors are therefore taking a robust approach when engaging with companies in which they invest. This is because institutions that make commitments on climate change policies to their underlying investors are under a strict fiduciary duty to deliver on their promises. Therefore, managers must think about changing public expectations and their long-term responsibility as stewards.

1 Climate Council: Australia’s Rising Greenhouse Gas Emissions, (2018), p8.

 

  • Environmental Social Governance (ESG)
  • Opinion
  • Responsible Investment
  • Sustainability

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