Crucial for investors to price in climate risks
THE science is unmistakable: climate change is happening and will bring new risks. Awareness is growing in the financial sector on the importance of identifying and preparing for climate risks. These include not just more extreme weather and natural disasters, but also regulatory and social pressures. Yet, not all investors are prioritising climate risks and this gap needs to be bridged.
A recent report by Australian activist group Market Forces showed mixed views towards climate risks among investment professionals at major global financial institutions. Of the 150 investors surveyed, 84 per cent said that they were moderately to extremely concerned about climate change.
But, a lower proportion of 57 per cent said that climate risks had a high or very high level of influence on their company’s investment decisions. The climate change impacts of the investee’s activities – such as coal mining or oil production – ranked even lower as a concern, with only 51 per cent citing it as a highly influential factor.
The findings suggest that while a good portion of investors are taking climate risks into account, there is still a significant way to go in moving the issue up the agenda. One US hedge fund manager interviewed for the survey described climate risks as being “largely irrelevant” to the investing process, and said that such risks have “very little impact on asset performance”. Fund managers are less concerned about climate risks than they are about political or activist pressure, the interviewee added.
Yet, research consistently indicates that failing to address climate risks now will eat into future investment returns. For instance, a 2021 report by state investor GIC and tech company Ortec Finance illustrated the outsized impact that climate change can have on an investment portfolio of 60 per cent equities and 40 per cent bonds.
In a scenario where the world manages to limit global warming to 1.5 degrees Celsius, the cumulative returns of the portfolio over 40 years would be 10 per cent lower than a baseline without climate impacts. But, if the rise in global temperatures reaches almost 4 deg C, the portfolio returns would be 30 per cent lower than the baseline. Investors may thus be caught off-guard by the long-term underperformance of the portfolio.
Why are climate risks still not top-of-mind for some investors? One reason might be a sense that any impact would be a bit too “far off” to affect immediate or near-term returns. Certainly a lack of data and internal capabilities to make climate-related projections add to the slight haze or shroud around the issue.
Another “inhibitor” might be the broader scepticism towards the environmental, social and governance (ESG) industrial complex. As marketers and opportunists throng into this space, investors have been inundated with a flurry of new products and recommendations, and it can be hard to spot cases of greenwashing. There are signs of a pushback with the recent exodus from ESG funds, where US investors withdrew a net US$5.1 billion in the final quarter of 2023.
It will be important for investors to better assess and price in climate risks. More can be done to help them understand the nature of climate risks, with education initiatives and access to data for climate-risk modelling. For sure, it will be difficult to beat the raucous debate around climate change and ESG investing. But, empowering investors to cut through the noise will be a crucial step forward.
