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Portfolio > Portfolio Construction > ESG

The Risks & Rewards of ESG-Based Investing: Finke

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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.

In fact, the authors point out that the general lack of concern about climate change among investors overly focused on near-term results might present an opportunity for long-term investors who overweight firms that will benefit from a cleaner economy.

Globally, fossil fuels receive nearly four times as many dollars in subsidies as clean energy. Pressures on government budgets, coupled with international recognition of the importance of reducing the use of fossil fuels, will likely result in the erosion of these subsidies and the increased competitiveness of alternative energy sources.

The biggest risk of the gradual shift away from fossil fuels is that such a shift could have a devastating impact on companies with net worth closely tied to energy assets that haven’t yet been pumped out of the ground. The imposition of a carbon tax and continued innovation in renewable energy could result in a glut of so-called “stranded assets” for which cost of extraction and use is less than the market price.

Although economies will continue to rely on fossil fuels, even a modest decrease in demand could have a big impact on energy prices. More than half of new global power generation installations now derive energy from renewable sources, and the trend has been rising consistently from around 20% in 2007.

Firms that have made investments in clean energy may be reaping modest rewards today, but increasing consumer and investor demand suggest an even larger payoff in the future. Greater screening for ESG factors among institutional investors will add to the capital flow toward firms that move toward environmentally friendly energy sources.

Since BlackRock began tracking firms by carbon emissions intensity in 2012, the top 20% of firms that made the greatest improvements outperformed the bottom 20% by about 10% over this four-year period.

Geography Matters

The use of satellites and more advanced computing and modeling techniques allows scientists to better predict how sea levels will rise in the 21st century.

None of the more recently published articles from researchers measuring actual changes in temperature and ice volume suggests that worries about sea level change are overblown. The newest simulations show at least a three-foot rise by the year 2100 and increasing evidence that melting is occurring more rapidly than expected.

Advisors should also consider the risk of home equity in areas vulnerable to rising sea levels. The mayor of South Miami, biology professor Philip Stoddard, has even counseled residents whose financial well-being is tied to their home equity to sell before markets begin recognizing the risk. Although the real estate market is currently robust, it is not hard to imagine that values could turn negative quickly if flooding becomes impossible to ignore.

How big is the risk? Coastal areas are already seeing the effects of more frequent flooding and higher tides. Clients who own property near the coast, especially in areas that are prone to flooding, should be aware that their valuable real estate is exposed to the mounting idiosyncratic risk of global warming.

Warming temperatures have also led to drier conditions in the western United States, increasing the likelihood of drought and wildfires. Interestingly, private-sector insurers are charging higher premiums as a result of rising claims in areas prone to wildfire risk, while political barriers to proper underwriting in flood insurance mean that homeowners on the coast may not be feeling the economic pain of their increasing vulnerability (at least, not yet).

Climate change could also affect municipal bond prices if cities or even states are less able to generate revenue. Florida stands out as a uniquely large source of potential climate change risk. With no income tax, much of the state’s tax base comes from property taxes on coastal real estate.

This dependence on property taxes should make any investor in long-duration munis think twice. And cities such as Miami and Fort Lauderdale are already experiencing the effects of rising sea levels.

How can an advisor help a client recognize geographical risks? How much of a client’s portfolio is held in real estate that is exposed to significant risk from rising sea levels?

If a client holds a significant amount of wealth in home equity, strategies such as the use of a reverse mortgage can allow a homeowner to shift the risk of a significant drop in home equity value to an institution.

Clients holding significant business interests in areas affected by global warming should consider diversifying their real estate portfolios. And workers in industries that rely on carbon-based energy may be well served by recognizing the potential volatility of future earnings and moving investments into sectors that will benefit from a move to clean energy.

Ignoring climate change isn’t going to make the risk go away. Advisors need to consider how vulnerable a client’s portfolio of investment and human capital is to changes in temperature and in the regulatory environment.

The good news is that investing in environmentally conscious companies can help a client stay committed to a long-term investing strategy without a big sacrifice in returns. And recognizing the importance of socially conscious investing provides an added value to clients looking for more than just net returns in an investment strategy.


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