When financial advisors think about portfolio risks they usually consider at minimum the economy, other macro factors, interest rates, credit quality and earnings. Add climate change to that list.
“We believe climate change represents a portfolio risk and opportunity that can no longer be ignored,” BlackRock Chief Investment Strategist Richard Turnhill wrote in his latest weekly commentary.
“The financial impacts of a rising tide of climate-related regulations, extreme weather events, technological disruption and changing social attitudes have the potential to affect all portfolios.”
Turnhill sees “little downside” to addressing what he calls “climate-change awareness” in the investment process, and potentially some upside. The greatest risk, he said, is to do nothing. These seven areas are the most important to focus on:
1. Time Horizon
Much of the impact of climate change on portfolios will depend on an investor’s time horizon. The longer it is, the more climate-related risks compound, and long-term investors could suffer a permanent loss of capital. But, noted Turnhill, long-term investors are in a better position to profit from new technologies that address climate change but take time to succeed.
A recent BlackRock report, “Adapting Portfolios to Climate Change,” lays out the problem and potential solutions, noting that climate factors have not only been “underappreciated” but also “underpriced.”
2. The Costs of Climate Change
• Reduced GDP: Damage from climate change could reduce global GDP 5% to 20% annually by 2100, according to the report, which cites the Stern Review prepared for the U.K. government in 2006. Economic growth in states hit by extreme weather events is 10% to 15% lower than usual in the month of the event and remains below trend 12 months afterward, according to National Oceanic Atmospheric Administration (NOAA) and Federal Reserve data covering the past 35 years through 2015.
NOAA found there were 35 extreme weather events causing damage of $1 billion or more over those 35 years and the frequency has been increasing.
• More Regulation: Even climate change skeptics can’t escape the increasing number of related regulations already impacting industries, and further regulation could cause more disruptions in the future as a result of technological advances. At the same time regulation can increase demand for other, more climate-friendly products and services.
“Regulatory risks are here and now…[and] can have an immediate effect on cash flows by raising the cost of doing business” and raising the risk of compliance failures, according to the report.
Among the risks are carbon taxes, which BlackRock favors over subsidies as incentives to reduce carbon emissions and develop green technologies.
“New regulations can pop up at any time, surprising investors. They can upset the status quo, favoring some industries and companies over others,” the report noted.
In California, for example, utilities are facing tough regulations that may increase their costs, raise credit risk and reduce dividends, but those same regulations could position utilities to be more competitive in the future.
“Many utilities that have adapted to the shift to renewables are thriving,” according to the report.
Subsidies, too, can have both negative and positive effects on companies and sectors. Reducing fossil fuel subsidies can hurt company revenues initially but also spur them to innovate. And subsidies that are too generous can backfire after initially providing support, which is what happened in the U.S., German, Spanish and Japanese solar industries in the past decade.
• Stranded Assets: Many fossil fuels could potentially become stranded assets—assets that are no longer usable or too expensive to use or extract because those costs exceed potential revenues.
But the current market doesn’t necessarily reflect that future and “assets that may be stranded in the long run can be attractive on shorter horizons,” according to the BlackRock report.
In addition, “not all fossil fuels” contribute equally to climate change. Natural gas, for example, is a relatively clean fuel compared to oil, and companies with major exposure to natural gas will perform well in the “medium term,” according to the report.
3. Solutions for Investors
BlackRock recommended all asset owners consider climate-proofing their portfolios, which “does not mean giving up returns.”
The MSCI Low Carbon Target Index, for example, has modestly outperformed the MSCI ACWI index (for large and mid-cap companies in 23 developed and 23 emerging markets) since 2010, according to BlackRock.
Investors should consider first if their priority is to protect their portfolio against the adverse impact of climate change or favor companies that are poised to benefit from a lower-carbon economy, or both. “Motivations matter.”
4. Overweight Green Companies; Underweight Climate Offenders
BlackRock suggested investors who want to adjust existing portfolio overweight the securities of green companies and underweight those of climate offenders while keeping the portfolio return profile as close to the chosen benchmark as possible.
There is a tradeoff, though. The more climate friendly the portfolio, the larger the potential tracking error.
5. Favor Companies With High ESG Ratings
BlackRock recommended, for purposes of addressing climate change, investors focus on the “e” for “Environmental” in ESG and consider excluding companies reliant on fossil fuels.
Its Scientific Active Equity (SAE) team found global companies that reduced their carbon footprints mostly outperformed carbon-cutting laggards in recent years.
The team developed a climate score using 17 measures to rank U.S. companies for resource efficiency—generating more sales with less carbon, water and waste—for climate risks, which ranged from the impact of carbon taxes to extreme weather, and for climate opportunities to capture corporate shifts toward alternative energy sources as well green patent filings.
It then simulated a portfolio that overweighted Russell 3000 index companies with the highest climate scores on a monthly basis, keeping the annualized tracking error within 1% of the index. That portfolio beat the Russell benchmark by seven percentage points over the period from 2012 to 2015.
6. Buy Green Bonds
The green bond market, which uses the proceeds of bond sales to finance environmental projects, has grown to $130 billion as of July 2016 and could add another $50 billion in the second half of this year, according to BlackRock. But it remains just 0.15% of total global fixed income market and cannot yet accommodate large-scale portfolio allocations.
Still, these bonds could help finance the estimated $90 trillion of global infrastructure development needed by 2030 to limit climate change if governments choose to meet that challenge.
7. Prepare Now
In the meantime, BlackRock recommended investors prepare for higher carbon prices and their potential impact on portfolios and be selective when choosing securities based on their environmental impact.
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