Going green: Consider the implications of climate change on your investment strategies

We’re encouraged to see the physical and economic impacts of climate change becoming widely accepted.

Where uncertainty has lay is in the implications for markets and investors, here in Australia and around the world.

While regulators are beginning to highlight the financial risks associated with climate change, and some of the larger global asset owners have stated they are adjusting investments accordingly, the debate around sustainable investment is often framed in moral terms.

That’s why we partnered with a climate change expert (Climate Insight) to undertake an intensive research project to assess the implications of climate change policies for investors. Our joint report models future world scenarios where the full force of climate change is no longer abstract but very much present in our daily lives. The bushfires that spread through much of our nation this summer is a stark reminder that this reality may arrive sooner rather than later.

JANA exists to serve our clients by reducing risk and improving outcomes over the long-term. At the same time, our central philosophy is sustainable practice is always best practice.

That’s why you may have seen reports out last week in the Sydney Morning Herald, Financial Standard, Sustainability Report and AusBiz covering the work. While the report was shared exclusively with our clients, our commitment to and the importance of addressing climate change means we want to play a bigger role in driving the wider policy debate. Minimising the harm of climate change is the responsibility for all of us.

What does the future look like?

Invest in what you know is a guiding principle for many in our community. Look at the trends and history to inform your decision-making. However, climate change is perhaps the odd one out. It’s hard to compare the long-term and forward-looking impact of climate change to any previous market experiences.

So, where do you begin in a scenario that has infinite pathways and potential? We’ve landed on two positions set out by the International Energy Agency which encompasses futures at different ends of the spectrum and will help to kickstart investment considerations and future returns.

Quite simply, the scenarios chosen represent a good and bad climate change-related path over the longer-term. It must be noted that there are almost infinite other future pathways, but these two do provide a sense of the wide range of potential investment outcomes.

The ‘bad’ scenario is the International Energy Agency Stated Policy Scenario which looks at policies that are already in place or have been announced. These will equate to a more than 3 degree global temperature increase relative to pre-industrial levels. It is important to note that the existing policy settings upon which this scenario is founded will not meet the targets outlined in the 2015 Paris Agreement on climate change.

The ‘good’ scenario is the IEA Sustainable Development Scenario, which models a more aggressive, globally coordinated policy response which results in the temperature increase projected to be limited to around 1.8 degrees by 2100. This anticipates stronger actions against climate change by governments across the globe in order to meet the targets enshrined in the Paris Agreement.

What does the modelling show?

It is clear from our research that climate change presents a systemic financial risk that is likely to impact the returns of risk assets. An inevitable transition towards a less carbon intensive global economy will present intermediate and longer-term financial risks and opportunities for investors.

Policy action to reduce emissions and transition to a low carbon economy, or the lack of action, is the key variable. We also believe using internationally recognised scenarios was the most robust approach. Our analysis used both scenarios and looked at the investment impacts to both 2030 and 2040.

The main message from the modelling is that we expect climate change and climate-related transition and physical risks to impact on future investment returns. Under both scenarios there are winners and losers, with the physical impact of climate change and the transition to a lower emissions economy impacting regions, assets and sectors differently.

However, whilst the specific impacts will differ, both scenarios were negative for a typical institutional investor’s diversified portfolio.

In the shorter-term, a more aggressive, sustainable policy response will have a more significant impact on investments, largely because this scenario is not anticipated by investors and not reflected in current market prices. However, over the longer-term, this scenario provides both a superior climate change and investment outcome.

Under the Stated Policy Scenario, the impact to 2030 is minimal, but becomes far more severe out to 2040. This is because, under that scenario, the physical risks of climate change are becoming clearer and more extreme action will also be required to be taken later to attempt to address the unfolding impact of climate change.

Put simply, over the longer-term, the cost to investors of doing nothing is greater than the cost of doing something.

What climate change considerations should I factor in my portfolios?

In our research we classified ‘green’ and ‘brown’ assets, and how we anticipate that policy and technology developments will gradually shift the risk/return prospects in favour of ‘green’ (lower emissions) relative to ’brown’ (emissions intensive) assets over time.

Investors should look to hedge some of these risks and target investments that benefit from the transition to a lower carbon economy. Domestic and global policy certainty will assist this process.

It is important to acknowledge the challenges of modelling the financial impacts due to climate change, such as unknowables related to future policy, technology developments and physical impacts. Notwithstanding the uncertainty, climate change is an important consideration for a clients’ long-term investment strategy and will become more influential on investment strategies over time.

This post covers just the headlines. We’d urge you to take the time to review it in full and ensure that climate-related financial risk is meaningfully considered and monitored in your practice going forward. Contact your consultant for an introduction to our Responsible Investment team to discuss further.