Consider this: the Gross Domestic Product (GDP) of the United States was 36 times larger in 2017 than it was in 1960, two years after Charles David Keeling began making regular measurements of atmospheric CO2 that results in climate change. The good news is that the amount of carbon dioxide we emit per dollar of GDP is 64% lower now, compared with 1960. The bad news is that the rate of economic growth has outstripped the rate of decarbonization.
Our carbon emissions are still far too high, and we are still on a path to warming the globe by around 3⁰C this century, even with the pledges countries have made to reduce emissions. We know how to decarbonize, but economic growth has outpaced that progress, and more concerted effort toward decarbonization progress will be necessary to avoid the economic and financial consequences of a warming world.
This underscores the importance for investors to address climate change risks and the associated financial realities. In this article, we’ll consider implications for investors by illustrating climate change costs, risks, and opportunities.
Estimates of the economic impact of climate change in the future vary widely, but even at the most optimistic levels the impacts are concerning. Table 1 shows some of those estimates. While they differ, they all point to one thing: the costs of inaction are enormous.
Those who argue that it will be dreadfully costly to address climate change tend to ignore the fact that the cost of doing nothing is even more costly, not only in dollars, but in lives, livelihoods, and cultural value. Every one of the studies listed in Table 1 notes that they do not capture the full range of costs that climate change is likely to impose, especially if we are not successful in reducing emissions.
For instance, none of them really looks at what societal and economic costs might be imposed by forced migration, or by climate tipping points or economic feedbacks or multipliers. Those things are fiendishly difficult to forecast, which is why most studies don’t attempt to do it. The argument that it will be expensive to mitigate greenhouse gas emissions enough to avoid climate chaos is akin to arguing that it is time-consuming to go to school. True. But the alternative is worse.
Report and Date
|Stern Review, The Economics of Climate Change, 2007||
|Risky Business, The Economic Risks of Climate Change in the United States, 2014||
|Nature Climate Change, Global non-linear effect of temperature on economic production, 2015||
|The Economist Intelligence Unit, The cost of inaction: Recognizing the value at risk from climate change, 2015.||
|OECD, The Economic Consequences of Climate Change, 2015||
|Nature Climate Change, ‘Climate value at risk’ of global financial assets, 2016||
|Federal Reserve Bank of Richmond, Temperature and Growth: A Panel Analysis of the United States, 2018||
Anything that has the potential to affect the economy so deeply is likely to have financial implications as well. What do we know about what kinds of risk climate change poses for investors? First and foremost, climate change is capable of creating risks for investors in practically any sector and industry—and much of that risk is unhedgeable. Cambridge University’s recent work noted that about half the risks created by climate change, if we are not successful in mitigation, can be hedged through diversification and investment in less-affected industries, and the other half is systematic, and something investors do not have tools to hedge.
We also know, though, that working to mitigate climate change reduces the risks and improves the prospects for economic growth. The Cambridge study forecasts that in a world with no mitigation of climate change, we may look forward to a three-year recession over the next five years, “shrinking the global economy by as much as 0.1 percent per quarter.” Considering that global GDP grows at something between 1 and 3 percent per year in non-recession years, that reduction is substantial, especially on a cumulative basis. But if we are successful in limiting warming to 2⁰C by paying for emissions reduction, while GDP growth is slowed for several quarters, over the longer term, the economy outperforms the baseline scenario.
This theme is reaffirmed in another recent body of work from the Stanford Energy Modeling Forum’s recent modeling effort aimed at examining the impact of a carbon tax with revenue recycling. Eleven modeling teams all found, using different scenarios, that a revenue-neutral carbon tax would have a modest dampening effect on global GDP growth, but that slowing would be more than offset by the savings from cutting pollution and slowing global warming. The bumper-sticker message from both of these, as well as other work, is that the transition to a low-carbon economy will be costly—but much less costly than staying on the catastrophe-as-usual path. That is why all Pax World Funds avoid investing in companies significantly involved in coal and tar sands, the most carbon-intensive fossil fuels, and why we established carbon-intensity thresholds for our smart beta funds well below the carbon intensity of their passive benchmark. It also shapes significant parts of our shareholder engagement and proxy voting.
For long-term investors whose time frames span years to decades, then, investing as though the low-carbon transition is a necessity is simply smart investing. How one does that depends on the sector, the industry, and the risk involved: climate change is a family of risks, and it behooves the company strategist or financial analyst to know in depth what those are, for the specific company or investment opportunity in question. An exhaustive list would be, well, exhausting to read, but below is a brief description of some of the major ones.
Climate change can create risks for investors in almost any sector or industry. While it is customary to think of the risks as pertaining mostly to the big emitters, it’s increasingly the case that companies across the spectrum may be vulnerable. The first three risks–litigation, reputational and regulatory—are higher for bigger emitters; other risks can apply anywhere.
Litigation risk: Win or lose, lawsuits can be expensive to defend, though losing is generally more costly than winning. The number of climate-related lawsuits is rising fast, up from the occasional suit prior to 2000 to over 100 today, and most of it is in the United States (Figure 1). So far, the primary defendants in those lawsuits have been governments, but the second most common defendant is a corporation.
Source: Jeremy Hodges, Lauren Leatherby and Katrikay Mehrotra, “Climate Change Warriors’ Latest Weapon of Choice is Litigation,” Bloomberg, May 24, 2018.
Reputational risk: McKinsey describes this risk as “the probability of profitability loss following a business’s activities or positions that the public considers harmful.” While most large companies espouse a commitment to sustainability, it doesn’t change the public’s perception of a company’s reliability unless it really does what it says. Most corporations, according to a recent law review article, do not lie outright, but rather bend the truth or misrepresent. The damage, if a company is widely seen as greenwashing its actual performance, can be significant, as it was in the case of Volkswagen.
Regulatory risk: An example of regulatory risk might be a coal-burning electricity utility operating in a country that decides to put a cap on greenhouse gas (GHG) emissions, having never done so before. China, for instance, announced in late 2017 that it would impose a price on carbon emissions starting in 2019. That specific pricing will determine how significant the risks are for big emitters, but any price above zero will create new incentives and change cost curves.
Physical risk: Beyond litigation, reputational and regulatory risks, which primarily affect big emitters, there are climate-related risks that can affect any firm. Foremost among them is physical risk, which encompasses the physical manifestation of rising global temperatures: increasingly severe storms, increasing incidence of floods, fires, droughts, and heatwaves, and sea level rise.
How much of an effect any of these might have on a company depends on a lot of things that defy pinpoint prediction. While forecasters and climate modelers are confident that these risks are becoming more severe and/or more frequent, and much more proficient at attributing any specific event to climate change, we are still unable to pin down when the next weather disaster will be, in time and space. All we can say is, for example, that a 100-year storm may now be a 30-year storm. But while pinpoint forecasts are not possible, some attendant risks can be anticipated. For example, one thing that we do know, and is more predictable, is that insurance rates for property and casualty are likely to rise significantly in geographies that are expected to face higher physical risks, such as coastlines (tropical storm and cyclone risks) and the Southwestern U.S. and California (increasing drought and fire risk).
The one type of physical risk that is more predictable, in one sense, is sea level rise. It is relatively easy to tell which locations are most vulnerable: anyone located on a seacoast within a few feet of sea level. That means essentially every business along Florida’s coastline, and a lot of the Gulf Coast, and any business that depends on infrastructure in those locations. It includes many petroleum refineries as well, many of which are located on coastlines in order to receive oceangoing shipments of crude oil. It includes the 13 nuclear power plants in the U.S. that are near sea level.
Supply Chain Risk: Even for businesses who are not themselves in particularly vulnerable geographies, their supply chains may be. Twice in the past few years, supplies of coking or metallurgical coal were disrupted for steel producers in Asia by tropical cyclones Debbie and Haiyan. California’s prolonged drought, which is something that climate models all tell us to expect more of, affected agricultural supply chains. California’s fires in 2018 have put the squeeze on prices of lemons, for all the downstream companies that use them.
While these may seem obvious, some of the risks really aren’t: the Internet, for instance, depends on thousands of miles of buried fiber optic cable, and much of it is in densely populated coastal regions that are increasingly vulnerable to sea level rise.
Understanding the impact of climate change risks is, as this whirlwind tour through some of the categories illustrates, not something that can be understood at the general level. It is something that must be understood at the company level, and often at the scale of individual facilities. What that means for investors is that it’s a family of risks that will require some expertise and diligence to understand and price correctly; it isn’t something that will come in a spreadsheet that can be neatly plugged into a quantitative model to price risk.
It’s also not wise to simply use the increasingly-available numbers on corporate GHG emissions and emissions intensity as a proxy for risk. Even for big emitters, the degree of risk depends on many other factors, including the availability of choices to mitigate or pass through, and the degree of pricing power. That kind of assessment, for instance, is used in Impax’s Smart Carbon system. But emissions intensity has no relationship to physical risk, and not much of a relationship to supply chain risk. Turning raw numbers into risk takes some thinking.
It’s thinking that’s worth doing. Understanding risk gives investors the ability to price it correctly—and pricing risk correctly will increasingly be the difference between investors who are unpleasantly surprised by climate risk, and those who use it to improve portfolio value. Already we are seeing why. For example, S&P Global’s paper on the effects of weather events on corporate earnings reports that in 2017, 15% of the companies in the S&P 500 Index reported effects on earnings from weather events. As the climate continues to warm—and it will, even if we stop emitting today—that number can only grow.
Meanwhile, climate-friendly portfolios are already showing positive outcomes for investors. Carbon-efficient portfolios have outperformed carbon-inefficient ones since 2010, and low-carbon indexes have generally outperformed mainstream benchmarks. These studies show that mitigation of emissions already has financial value, even though the companies most at risk from high emissions are concentrated in only four sectors.
Capitalizing on the opportunities climate change presents is also financially promising, though there have not been many studies done on the financial outcomes of investing in a wide range of opportunities presented by climate change. Most of the focus to date has been on the performance of renewable energy stocks and funds, and that has mostly been lackluster or disappointing. In large part, that can be traced to Chinese policies that keep prices of equipment too low for non-Chinese companies to compete. Depressed prices for fossil fuels over the past few years has hindered the renewable energy investment returns.
Despite these financial headwinds, though, renewable energy has made remarkable inroads into electricity markets, based on the rapidly dropping costs to produce electricity using solar and onshore wind in particular. But climate change presents opportunities in every sector, from engineering to health care to consumer products, and as the climate grows warmer and concern and regulation grow, opportunities should grow ever more attractive.
Every climate risk is something investors can anticipate and address with the right strategy. In some cases, it may be possible to simply avoid the risks by avoiding investment in activities that contribute disproportionately to the problem, as we do when we avoid investing in coal and tar sands. Other risks may be addressable with better pricing. Engagement with companies to encourage them to develop better resiliency to climate risks can also be effective, as can investing in companies that contribute to resiliency and a low-carbon economy.