Investment Institute
Portfolio Construction

Thinking beyond financial objectives when building an investment strategy

  • 22 September 2021 (5 min read)

The IPCC’s 2021 report on global warming delivered a stark message on the pace and extent of climate change. The near 4,000-page analysis labelled humanity’s effect on climate change “unequivocal” and concluded the situation is worse than initially anticipated.

Climate change is the biggest threat facing us all – it poses a grave risk to health, food security, and to the integrity of the global economy. The abundance of recent extreme climate events has highlighted the risks we face; record temperatures in North America, wildfires across the Mediterranean and California, as well as flooding bringing devastation to parts of China and Europe.

In November, leaders from 197 countries will convene in Glasgow for COP26 to discuss how they can make good on the Paris Agreement goal to limit global warming to no more than 1.5˚C above pre-industrial levels. This is still achievable, according to the IPCC, but only just.1

Responsible investing

It will require a concerted and united move towards to a cleaner economy to reduce the amount of carbon we produce. There is momentum now to deliver this and I believe it will lead to a stronger and more sustainable economic future – and potentially improve long-term financial returns.

We have the motive and the power to address environmental challenges through our investments and we can use our capital to help finance business and governments transitioning to a net zero carbon world. The question we all need to ask is whether our portfolios today are aligned to a sustainable future for the planet and society, or are they contributing to further environmental degradation and social inequality?

Investors need to be aware of the risks of investing in businesses that will underperform because of their environmental footprint. In our view, delivering climate-aware investments is not something that challenges the primacy of financial objectives. It complements and enhances our understanding of those objectives. Fundamentally, it’s about better management of financial risk.

Thankfully, it is increasingly possible to use analysis, data, and portfolio construction techniques to align portfolios with the ambition of a net zero carbon world. When it comes to selecting securities, it is vital to assess how climate change could impact a particular business and its future profitability. How would a firm be impacted by flooding and other disruptive weather events? What would it mean for its operations, supply chains and workforce?

Any recent newsfeed will illustrate how companies can be – and are – severely impacted by climate change. And that’s just the here and now; as we go forward and extreme weather events become more frequent, the risk only escalates.

There are regulatory and fiscal risks too. Governments can increase taxation to address the impact of emissions. If companies are going to have to pay more to emit greenhouse gases (GHGs), then that will hit their profitability and, subsequently, investor returns. Consumers can vote with their feet too. They can reduce demand for a company’s goods and services if it is seen to be at risk from climate change or if it is contributing to rising emissions.

Risk analysis

We have the ability to look at companies and analyse emissions at all levels of their business. We can assess what risks they are taking, and what they are doing to mitigate their carbon footprint. For example, the Task Force on Climate-related Financial Disclosures has put significant pressure on corporations to disclose in detail how their operations are affecting the environment.

Another valuable tool is the Greenhouse Gas Protocol. Established in 2001, it is the most widely recognised international accounting tool for measuring GHG emissions. According to the Protocol, companies produce carbon via their direct operations (Scope 1 emissions), through their own use of electricity and heat (Scope 2) and through their entire value chains, via the purchases of goods and services they use (Scope 3). This breakdown helps investors better understand what their money is financing.

In addition, a rising number of companies are publishing plans for their own carbon footprint, many of which are increasingly being accredited by independent third bodies, giving investors the ability to track progress through ever-more detailed data.

We can also use environmental, social and governance (ESG) and carbon data to allocate capital to the best-in-class companies in certain sectors and exclude the worst. In aggregate this can shift the dial as the worst performers from an ESG perspective will face an increased cost of capital. This means targeting at a portfolio level the best-in-class companies so that in aggregate, a portfolio has a better environmental score.

New opportunities

But it’s not just all about risks and exclusions – there is the opportunity to invest directly in green assets: Green bonds, green real estate, forestry and so on. Equally, the new technology being employed to help the transition to a cleaner economy provides an abundance of investment opportunities for investors. This technology, that is both directly and indirectly related to the energy transition, is evolving rapidly. We are already seeing fairly mature developments in solar and wind and other renewable energy sources, but they still have to scale up massively to contribute fully to the fight against climate change.

Electrification is a particular area of interest to investors – from transport to heating in residential homes, to eventually some of the larger industrial processes. Alternative fuels such as hydrogen and its related technologies are very exciting – I believe there are lots of investment opportunities in that space. And increasingly everything will need to be smarter. Electricity distribution grids take their primary power sources from a variety of renewable energy providers; we need to manage those grids more efficiently.

The big picture

The International Energy Agency (IEA) has set out a pathway to reducing carbon emissions over the coming decades and has attached some milestones to this journey, some of which have very significant implications for investors – and the potential growth of certain sectors.

According to the IEA, by 2025 there should be no new sales of fossil-fuel domestic boilers for residential use, implying there is a vast amount of investment in alternative heating systems to come.

Equally, the organisation posited that by 2030 and 2035, 50% of global new car and heavy truck sales respectively, should be electric. Presently, we are nowhere near those targets.

And by 2040 around 90% of today’s industrial capacity, much of which relies on carbon fuels, will reach the end of its investment cycle. This means massive capital requirement is needed.

At its heart this is about investors understanding and adapting to the risks that climate change poses for business models. Companies with poor environmental footprints and poorly thought out carbon pathways may underperform, while at the extreme end we may well see stranded assets rendered un-investable by the pace of policy or consumer change. Thankfully, investors appear to be moving quickly – sustainable investment strategies are attracting record amounts of new money.2

Risks and opportunities sit side by side, and there are plenty of businesses and themes that will prosper from the transition. I believe transition-leading firms will be the growth leaders across all sectors. But we need to start now. If we get it right collectively, our view is that long-term financial performance can be superior as we move forward. To deliver wealth over the coming years requires us to align our portfolios today with that more sustainable future ahead.

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