I'm looking for...


Why investors are watching climate developments

By: Jack Dominy


The transition to a low-​carbon future is disrupting many different sectors and supply chains, and new ‘clean’ technologies are emerging.

With companies needing to adapt their business models, some will be more successful than others. For investors, this presents both significant challenges as well as opportunities.

Investors are becoming more focused on climate change allocations in their portfolios. In fact, climate change has been the number one ranked ESG issue among discretionary fund managers and investment advisers for the past two years[1].

However, they need to be sufficiently aware of the threats to sector returns by changes in regulation and taxes as governments move toward a carbon-free future. Also, their portfolios need to be ready for the technological shift to a low-carbon economy as well as from the impact of climate change itself on companies’ business operations.

Action through policy

The European Union has been implementing an increasingly radical decarbonisation agenda, including instituting environmental regulations, the world’s biggest emissions trading system (ETS) and carbon taxes.

In September 2020, the European Commission agreed to raise the 2030 greenhouse gas emission reduction target, including emissions and removals, to at least 55% compared to 1990 as part of the European Green Deal – its growth strategy.

The aim of the European Green Deal is to make the EU climate-neutral by 2050.

The European Parliament has also voted to include greenhouse gas emissions from the maritime sector in the EU’s carbon market from 2022. Shipping is currently the only sector that does not have EU targets for cutting emissions, and shipowners would be forced to buy EU carbon permits to cover their emissions.

The EU shipping industry believes it can decarbonise but wants to ensure the mechanism is fair for all ships and routes. More contentious is the EU’s proposed border adjustment carbon tax to prevent ‘carbon leakage’ whereby EU production is moved to non-EU countries with less ambitious emissions rules.

The tax is aimed at levelling the playing field for EU firms by holding imports accountable for their greenhouse gas emissions similar to how domestically produced goods are.

However, many countries are questioning how complicated it would be to implement, while developing nations have labelled it as unfair to them.

The policy-asset link

Among the biggest risks that investors face from the decarbonising environment is that of ‘stranded assets’ or assets whose economic life is cut short or severely curtailed.

For instance, Fitch Ratings says: “International policy commitments to limit climate change by cutting greenhouse gas emissions, a rapid decline in the cost of renewable energy and social change will lead to a marked decline in the demand for coal, oil and then gas over the coming decades.

“This will render some of these natural resource and production infrastructure as ‘stranded assets’ that will never be fully utilised.”

These ‘stranded assets’ could lead to substantial downgrades in exporters’ sovereign credit ratings.’

“As demand for fossil fuels declines, major exporters will face a loss of GDP, government revenue and export receipts in the absence of offsetting trends, such as economic diversification,” FitchRatings contends.

Meanwhile, the fossil fuel companies themselves have been accelerating write-​offs of reserves in recent years. However, much of these reserves support these companies’ credit ratings and their share prices.

Also, the balance sheets and, ultimately, profitability of those companies heavily exposed to the cost of fuel such as aviation, shipping, transport and utilities will all be impacted. While other industrial sectors will be affected to varying degrees as they adapt to new forms of energy and cleaner operational practices.

Investors need to ensure they take into account climate risk analysis within their portfolios or choose fund managers that focus on this. Climate change could potentially disrupt sectors and supply chains not commonly thought of as being highly exposed to climate risk. Only as we go forward, will they become clear.

Fund managers are developing new tools to navigate and understand this new environment of carbon reduction.

Another way to invest

Investors should be aware of emerging “green” asset classes for their investment potential. New asset classes are gaining prominence, such as green bonds, solar asset-backed securities and carbon emissions allowances.

The transition to a low-carbon economy presents myriad investment opportunities in new ‘clean’ areas. This can be in companies involved in clean energy production and its supply chains, agricultural productivity, water treatment, green buildings to adaptation infrastructure that help manage the effects of climate change.

Credit Suisse highlighted in a recent paper that investing in adaptation is also important in that it can be a hedge against climate change if policy efforts fail.

“Effective action on climate change will require coordinated action by hundreds of governments around the world, and significant enhancements in technology across a variety of sectors. If the policy and technology levers are insufficient to keep warming within the 1.5°C to 2°C range, then we will need significantly more investment in adaptation,” the bank’s analysts said.

“Within the sustainable finance space, only 5% of investments focus on adaptation, which is arguably too little, given the human cost of extreme weather and other climate-​related impacts.”

[1] According to the Research in Finance UK Responsible Investing Study, published in February 2021

Related Reading