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December 27, 2016 at 07:00 PM
A March 2016 Gallup survey found that 64% of Americans are either worried “a great deal” or “a fair amount” about climate change, up from 51% in 2011. Although climate change may seem like a secondary consideration for most financial advisors, a number of recent studies highlight the risks to financial assets posed by changes in weather, consumer and investor preferences, and environmental regulations. Individuals also face geographic threats that could affect the value of real estate or of local economies.
Some advisors may be inclined to ignore the significance of a warming climate. Recent scientific studies of climate change suggest that this would be a mistake.
As our ability to predict global changes in temperature has improved through advancements in climate science and technology, it is becoming clear that temperatures will increase at a consistent rate in the coming decades (although there is some evidence that temperatures could rise more quickly than static models can predict).
Oceans will rise, and many industries that are impacted by climate change will be affected. Greater awareness of the risks of climate change is also increasing the likelihood of regulations that will apply to some industries more than others.
The politicization of climate change is unfortunate, but the reality is that corporations from Exxon to Allstate are considering climate change when making decisions about how to allocate their future capital, and most clients are worried about global warming. Advisors who are serving the best interests of their clients will need to consider both how climate change will affect their portfolios and whether their recommendations are consistent with the wishes of clients who want to ensure that their investments are not contributing to the problem.
In 2005, a group of institutional investors participating in the United Nations Environment Programme Finance Initiative agreed to evaluate environmental, social and corporate governance (ESG) as part of their fiduciary responsibilities to the long-term well-being of investors. The agreement followed a general acceptance among financial economists that companies adopting more socially responsible business practices generally did not underperform firms focusing solely on maximizing profits.
To a traditional financial economist, it makes sense that corporations with boards of directors looking out for the best interests of investors would outperform over time (thanks to the G in ESG). Considering social welfare (such as human rights) and manufacturing processes that are friendlier to the environment could, theoretically, have a negative effect on returns by shifting the focus away from profit maximization.
This puts investment fiduciaries in a rough spot, because they need to decide whether the long-term interest of society is more important than the net investment performance of their clients. In reality, however, there may not be much of a tradeoff.
The iShares MSCI KLD 400 Social Index, which screens for corporate social responsibility and has a track record that now spans 25 years, outperformed the S&P 500 index during this time period. Why might investment performance be related to social responsibility?
Think of Tesla versus a legacy carmaker. If investors place some value on a firm’s environmental practices, they may be more willing to provide them with capital at a lower cost in the short run. In the long run, socially conscious investors are rewarded with both a return on investment and what economists refer to as a “warm glow” feeling of satisfaction in knowing that their capital is making the world a more livable place.
Economists argue that this is exactly how capitalism should solve problems such as bad corporate practices without the need for government intervention. Investors are less willing to provide capital to firms they don’t want to support, for example, tobacco companies, which makes it more difficult for these companies to earn a profit (their cost of capital is higher). Other companies that investors want to support receive more capital and are more likely to survive and expand in the marketplace.
Performance, Volatility & Engagement
A recent study in the Journal of Sustainable Finance & Investments found that companies with higher ESG factors not only outperformed firms with lower ESG scores, they were also less volatile. It could be that investors who care more about performance alone are less willing to sell their shares when the stock market rises and falls.
One of the most convincing reasons to recommend a portfolio that overweights ESG funds is simply to increase the client’s resilience to volatile markets, because they’re more emotionally attached to their investments. Who wants to sell a fund that helps support a business that could save the planet?
Clients who are concerned about global warming can benefit from investing in portfolios that overweight firms with higher ESG ratings. Morningstar recently unveiled a new ESG scoring system that allows advisors to evaluate the corporate responsibility of investments held in client portfolios.
Tricia Rothschild, head of Global Advisor and Wealth Management Solutions at Morningstar, points out that awareness of environmental, social and governance ratings among investments can be an important source of value for advisors looking for ways to strengthen relationships with clients.
“Clients have other options for low cost or even no cost investment solutions,” says Rothschild. “Advisors are looking for ways to engage clients to meet their specific needs.”
Risks, Rewards
The bottom line is that advisors should consider overweighting firms or funds that score higher on ESG factors if either (a) their client expresses an interest in aligning their portfolio with their values or (b) they want to hedge the potential risks faced by firms whose business model may become less competitive in the future.
How significant is the risk that firms and sectors affected by climate change will struggle to survive? In a recent report on the potential impact of climate change, the Blackrock Investment Institute points out that shifts in both the regulatory environment and in the physical environment could have profound impacts on business sectors (such as energy stocks) that have been historically safe havens for investors.
