Jim Whittington on How Investors Can Manage the Risks of Climate Change

Originally published in LAPF Investments Magazine.

Concern for the environment might be the most obvious, but many investors also believe that long-term risk management must incorporate climate risks; be they the physical risks of a warmer planet, or the transitional risks as we adapt to a carbon-neutral economy. Regulators around the world are also demanding better management and disclosure of sustainability risks. When it comes to addressing exposure to climate risks in a portfolio, we think investors should start by applying several basic principles.

Ample empirical research supports the belief that market prices are forward-looking and incorporate the collective views of market participants about material risks and opportunities. There is no reason why climate risks and opportunities should be an exception.

Much about climate change is still unknown. But given two otherwise identical businesses, if one is expected to become less competitive as new climate regulations are enacted, or the physical impacts of global warming are expected to pose a greater risk to its operations, market participants will surely apply a lower valuation to that business. And as new information becomes known about expected global warming, the policy response or other material developments, prices will adjust.

Given the uncertainty involved, there is much debate about whether climate change risks are priced correctly by the market. This debate is not unique to climate change risks. After all, the future is uncertain. But this uncertainty doesn't mean that markets systematically underprice climate risks. Numerous studies show investors have a poor track record of outguessing market prices and the collective wisdom of the market is typically better than any individual investor at pricing risks and opportunities, including those related to climate change.

The effects of climate change may be far-reaching and global in scope. For some companies, the risks associated with climate change are material for their businesses. For other companies, changes in technology and consumer preferences represent very real opportunities. Stated simply, the potential risks and opportunities of climate change differ across regions, companies, and industries.

By diversifying across geographies, exposure to company-specific physical risks (such as localised flooding) is reduced. By diversifying across companies and industries, exposure to company-specific transitional risks (such as changes in consumer preference for a company's products) is also reduced.

Diversification can also bring opportunity. If some assets become stranded, others may become more valuable; if some business models become obsolete, others will become more dominant. A diversified portfolio will hold both winners and losers from the climate transition.

Boards that truly represent the interests of shareholders should pay attention to material climate-related risks and opportunities. Shareholders can elect board members that have the appropriate skills to oversee and mitigate climate risks and can vote against directors whom they believe are not providing effective oversight.

Sustained, ongoing dialogue with portfolio companies can make a difference. When a portfolio company's oversight of climate risks, or disclosure of those risks, seems unclear or inadequate, engagement is an effective avenue to start raising concerns.

Investors that follow these steps should be well-equipped to manage material risks in general. When it comes to certain categories of climate risks, however, some investors may have specific concerns.

Some companies generate much of their revenue from extracting or burning fossil fuels. For investors who prefer less exposure to the types of risk these companies bear, reducing or eliminating exposure to them may be appropriate. While we believe these risks are reflected in market prices, our experience suggests it is possible to reduce an investment strategy's allocation to such companies while maintaining broad diversification and sound investment principles.

We must recognise, however, that divestment alone may not address climate change. In fact, there may be unintended consequences. For example, if investor action were to force fossil fuel assets into the hands of owners with lower environmental standards and less oversight than public companies, climate change and the associated risks may worsen. Governments, consumers and producers all have a critical role to play in curbing emissions.

Risks linked to climate change are significant, but existing tools associated with sound portfolio risk management are a good place to start: using market prices, diversifying, and encouraging strong corporate governance.