How to Reduce Investment Risk From Climate Change and Other ESG Woes

“Climate change is increasingly a risk that investors cannot afford to ignore,” writes Richard Turnill, BlackRock’s global chief investment strategist, in a recent commentary, noting that those potential losses “are not baked in” current market prices.

If no counter action is taken, such as reducing fossil fuel use, close to 60% of U.S. metro areas will lose 1% of more of gross domestic product, which will not be offset by comparable growth in other metro areas.

(Related: Investors Underestimate Climate Risks: BlackRock)

Turnill focused on potential losses in municipal bonds — where a rising share of issuance comes from regions facing climate-related losses — commercial mortgage-backed securities (CMBS) that support properties vulnerable to Category 4 or 5 hurricanes and the stocks of U.S. utilities operating in danger zones.

The New S&P 500 ESG Index

The new S&P 500 ESG Index takes a broader approach to U.S. stocks at risk from climate change and from other environmental, social and governance issues. Its purpose is not to outperform the S&P 500, however, but to more closely align with the investment objectives and personal values of investors concerned about climate change and other ESG-related issues.

Its risk/return profile is similar to that of the S&P 500, but the index excludes companies that place in the bottom 25% of their industry group’s market cap and those that don’t operate in line with ESG principles. More specifically, it excludes companies that:

• derive more than 10% of their revenue from tobacco-related products or services
• are involved in controversial weapons including cluster bombs, landmines and biological weapons and nuclear weapons
• score in the bottom 5% for compliance with UN Global Compact, which supports businesses whose practices favor the environment, human rights, labor and anti-corruption.
• score in the bottom 25% of ESG scores within their GICS industry group

As a result, the S&P 500 ESG index, developed by S&P Dow Jones Indices, includes just 333 stocks compared with 505 (not a typo) in the S&P 500, and excludes such companies as Boeing and General Dynamics (for weapons), Philip Morris and Altria (for tobacco) and Occidental Petroleum and Marathon Oil (low ESG score).

It also excludes the two share classes of Google (Shares A and C) for their low ESG scores as well as Berkshire Hathaway B shares and Netflix shares due to the companies’ low level of compliance with the UN Global Compact.

Despite these exclusions, the S&P 500 ESG index closely tracks the performance of its broader index counterpart. Its five-year annualized total return through December 2018 was 8.47% versus 8.49% for the S&P 500, but its three-year and one-year annualized returns were slightly higher than those of the S&P 500: 9.44% versus 9.26% and -3.9% versus -4.38%, respectively.

Reasons to Invest Outside the U.S.

Investors most concerned about ESG and sustainability might want to invest in companies based outside the U.S.

According to Morningstar’s latest Sustainability Atlas, Finland, the Netherlands and many other western European countries plus Colombia score much higher for sustainability (which combine ESG and controversy scores) than the U.S. and Japan, which rank in the fourth quintile for sustainability, and China and Russia, which rank in the bottom fifth quintile. Controversies involving Amazon, Apple and poor governance in Facebook and Alphabet contribute to the relatively low sustainability rating for the U.S.

The U.S., however, ranks in the middle for ESG and in the top quintile for carbon risk, which measures the vulnerability of corporate valuations during the transition to a low-carbon economy. The reason the U.S. is considered among the least vulnerable has less to do with the practices of U.S. companies than with the relative market cap of the U.S. energy sector. Energy stocks account for roughly 5% of US. equity market cap, while health care and technology companies combined represent more than 36%.

The Morningstar rankings are based on Sustainalytics’ ratings of Morningstar country equity indexes.