By Lee Clements, director, SRI Research, State Street Global Advisors
Climate change is now central to politics and public discourse. But a surprising number of investors continue to take a business-as-usual approach to investing, presenting a blind spot that can put portfolios at risk.
Those who are looking at the issue often find the debate framed around the risks of exposure to carbon-intensive industries, while the downside of missing out on the green success stories of the future are less discussed.
By our measurements at FTSE Russell, the green economy comprises 6% of the market capitalization of global listed companies, valued at approximately $4 trillion. By any standard this would represent a significant investment opportunity, while ignoring it could be a very substantial investment risk.
Investors are increasingly being forced to act, highlighting the leaders and laggards
Portfolios are not created in a vacuum. Every portfolio is tied to stakeholders, financial advisors need to meet evolving client demand, and pension fund managers must answer to fund trustees. As concerns about climate change have become more widespread, portfolio exposure to climate risk has come under increased scrutiny. Ignoring climate risk in portfolios can be problematic, leading to uncomfortable conversations with stakeholders.
Climate change is increasingly being addressed on a policy level, with many regulators looking to financial institutions to both drive green investment and disclose climate risks. For example, initiatives such as the Task Force on Climate-related Financial Disclosures (“TCFD”) have put increased pressure on financial institutions to disclose their risks associated with climate change.
Ultimately pressure from stakeholders and regulators will increasingly expose both investors and companies who are climate change leaders or laggards or are “greenwashing” (making misleading or unsubstantiated claims about the environmental benefits of a portfolio).
While climate change—and investors’ approaches to it—is an evolving process where the impacts may be far in the future, fund managers who fail to evolve are likely to feel an increasingly heavy pressure of investor disapproval.
Investors ignore at their peril the risks and opportunities created by the impact of climate change on economies around the world
Climate risk can ultimately cause investors the most pain precisely where it hurts most: in investment performance. Green investment can be compared to other, long term thematic trends such as globalization, demographic change or the rise of technology and the internet since the 1990s, all of which have fundamentally affected both economies and investors’ portfolios.
Be it from changes to the energy and transportation sector, new environmental regulation or the rising tide of “green” conscious consumers, a business-as-usual approach to portfolio management could leave investors with a so-called “Betamax portfolio,” composed of obsolete, devalued securities with little or no growth opportunity.
It’s important to note that investing through a green lens is no longer solely about excluding fossil fuel exposure from portfolios. Increasingly it is about looking for investment opportunities related to climate change. Many investors are now taking a proactive approach to sustainable investing by increasing flows to green activities—in other words, by investing in the “green economy.” And while the case for green economy investing might be self-evident, the right approach to it can be less straightforward.
Proactively investing in the green economy first requires properly defining it. There’s a widely held perception that green investment is niche, small cap-focused, undiversified and underperforming. And while these might be characteristics of some parts of the green economy, as shown below, they’ve largely been proven to be misconceptions for a more comprehensively defined green economy.
“Colonize Mars,” urges Elon Musk. While the prophets are warning for the coming ecological collapse, the wizards are praising technological breakthroughs as the way out of natural resources scarcity. Low carbon technologies are certainly required but the ability to successfully fight climate change depends on much more challenging skills.
First comes the urgent need to reduce energy demand, though massive deployment of energy efficiency in electricity consumption, buildings and transportation. As highlighted in the early 2000s by Prof. Socolow of Princeton University, energy efficiency would represent two thirds of the GHG emissions reduction to be achieved, whereas renewable energy and carbon capture and sequestration would only account for the remaining third.
One could argue that beyond energy efficiency additional behavioral changes in standards of living are also required. By 2040, the International Energy Agency estimates that the energy needs of the water sector will have risen by 140% vs. 2014, partly driven by new needs associated with water transfer and desalination.
At FTSE Russell, we’ve been measuring exposure to the green economy—and capturing it in our indexes—since 2008, offering benchmarks for investors to access it. For a deeper dive into how we’ve done this, please see our recent report on our green economy classification system.
This article was first published on the FTSE Russell blog on September 6.
Photo Credit: NASA Goddard Space Flight Center via Flickr Creative Commons
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