The message from climate scientists is stark. Recent reports from the UN Intergovernmental Panel on Climate Change say it is now virtually certain that human activity is warming the planet and that we are on course for dangerous changes in temperature unless we take drastic action.
That means cutting greenhouse gas (GHG) emissions by 40 to 70 per cent from 2010 levels by mid-century and to virtually nothing by 2100 if we are to keep temperature increases to manageable levels of 2C. At current rates, we are on track to increase temperatures by 3.7C to 4.8C by 2100. And the more GHGs we emit now, the more difficult and expensive it becomes to rectify the problem later.
But this is not just a scientific issue. It will have a significant impact on investors and their returns. So how should they react to the warnings?
The Asset Owners Disclosure Project estimates that roughly 55 per cent of the average pension portfolio is exposed to climate risks, so investors simultaneously have a lot at stake and the ability to make an enormous difference to how companies tackle the issue.
The IPCC report provides another urgent signal for investors to step back and revisit the investment implications of climate change in an economic context, says David Blood, co-founder of Generation Investment Management, the asset manager. “An important first step for investors is to evaluate the carbon-related risks in their portfolios and make active decisions about how to manage those risks.”
Some parts of their portfolios will be affected more than others. China, the US and the EU are the biggest emitters, so they can be expected to impose regulation first to cut emissions and encourage clean energy. Those industries most reliant on fossil fuels such as utilities, oil and gas, metals and mining and heavy industry will be most exposed to such regulation. The IPCC says investment in fossil fuels should fall by 20 per cent over the coming decades.
Mr Blood says that “while regulation will inevitably become an important factor in the stranding of carbon assets, it is far from the only factor. Other dynamics, such as market forces and societal pressures, will also play an important role. As renewable energy becomes increasingly cost competitive and reliably available, we believe the valuation of carbon intensive assets will face ever-greater downward pressure.”
Some investors have started demanding that the companies they invest in find out what their climate risks are and explain how they are dealing with them. Perhaps the biggest fish of them all, ExxonMobil, the US oil group, has just published its assessment of its carbon risks after pressure from investors. While many were dismayed by its view that it faces no risk of its assets becoming stranded because governments lack the political will to implement the policies needed to limit temperature rises, it gives investors a platform on which to engage the company.
And despite Exxon’s apparent complacency, it is becoming more and more difficult for governments to ignore the pressures caused by climate change, says Stuart McLachlan, chief executive of Anthesis, the sustainability consultancy. “The evidence for climate change is such that there is growing certainty that governments are going to react.”
Martin Schoenberg, head of policy at Climate Change Capital, the investment and advisory group, adds that “people need to reassess valuations, particularly of oil and gas companies. Managements are not completely acting in the interests of shareholders.”
Mr McLachlan says that “businesses are also seeing climate risks start to affect their own operations, so for them the risk is not really about having to comply with new regulations, it is that there will be disruptions to their supply chains. This is a fundamental business threat.”
A small but growing number of investors, including Rabobank, the Netherlands-based lender, and Storebrand, the Norwegian insurer, are selling out of fossil-fuel stocks because of the risk that the companies’ assets will become stranded in a low-carbon world. So far, the divestment campaign is mainly confined to university endowment funds and local authority funds, but Norway is considering whether its sovereign wealth fund, the world’s largest at more than $840bn, should divest its fossil-fuel stocks, which make up about 8 per cent of its portfolio. If it does so, the ramifications will be felt around the world.
As well as being aware of the risks of climate change, investors should be ready to take advantage of the considerable opportunities created by the need to adapt to climate change and to decarbonise the economy.
“Investors need to consider investment opportunities in renewable energy and low-carbon infrastructure,” says Kate Brett, a responsible investment analyst at Mercer, the consultancy. “There are other ways they can hedge climate risks, such as carbon-tilted indices, which strip out the most carbon-intensive stocks from the benchmark.”
One way to buy into low-carbon opportunities is climate bonds, which fund only emissions-reducing projects. Until recently almost all climate bonds were issued by multilateral financial organisations such as the World Bank and the European Investment Bank, but there is a growing market in corporate green bonds, says Sean Kidney, chief executive of the Climate Bonds Initiative. The market has grown from $3bn in the whole of 2012 to $9bn in the first quarter of 2014 alone.
“I think we are on track for $40bn by the end of the year and the market will hit $100bn in 2015,” Mr Kidney says. “Any issue that is green has been way oversubscribed”.
However, he argues that more corporate bonds are needed because there is currently a dearth of higher-yielding issuance. “There has been a lot of AAA issuance, so portfolios are sated at that level but there is huge demand for higher-yield A-minus green bonds,” Mr Kidney says. “Investors want green bonds but cannot sacrifice yield.”
There is also a need for a green securitisation market, he argues, so that funds can be recycled into new projects.
Climate bonds are a useful tool for investors who are ready to reallocate capital to green projects, but there is a limit to what institutions can do without the right policies in place, argues Eric Borremans, sustainability expert at Pictet Asset Management and vice-chairman of the International Investors Group on Climate Change.
“We need decarbonisation but we cannot put private capital to work on the problem without investment-grade policy measures,” he says.