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Should the Latest Climate Research Catalyze Change in How Investors Think About Risk?

Sarah Edwards

Yes. According to a recent report released by the Intergovernmental Panel on Climate Change (IPCC), “climate change is a threat to human well-being and planetary health,” and the window of opportunity to “secure a livable and sustainable future for all” is rapidly closing. Working Group II report Climate Change 2022: Impacts, Adaptation, and Vulnerability, Intergovernmental Panel on Climate Change, February 2022. 1 The new report highlights the considerable risks posed by climate change to investment portfolios and the world itself. While integrating climate science into investment frameworks is not straightforward, we believe that ignoring it exposes portfolios to undue risk.

Much of the conversation around integrating climate change into investment policy and portfolios is centered on transition risks, which arise from the transition to a low-carbon economy. But the latest IPCC report addresses physical risk, which considers the physical impacts associated with climate change that are both acute (e.g., severe heat waves and flooding) and chronic (e.g., biodiversity loss and sea level rise). Regardless, investors need to consider both types of risk. At a high level, we believe all investors would benefit from taking the following four steps in their portfolios:

  1. Assess carbon emissions and climate exposure. Third-party data providers enable the assessment of certain direct and indirect emissions in public equities, as well as the economic value at risk from the impacts of climate change. These techniques are improving as methods and company disclosures evolve. While imperfect, these tools are critical for understanding where risk lies in portfolios and can offer actionable guidance for investors.
  2. Review energy transition opportunities. Given the IPCC’s warning that time is of the essence to reduce our dependence on fossil fuels, incorporating both adaptation and transition risk into investing is paramount. Investments in climate and other transformative technologies, thematic investments in public and private asset classes, sustainable real assets, or in new investment vehicles in blended finance that leverage public, private, and philanthropic capital are all viable options for institutional portfolios today.
  3. Consider climate justice. As well as describing the “widespread, pervasive impacts to ecosystems, settlements, and infrastructure” already arising from climate change, the IPCC estimates there are more than 3 billion people living in the most vulnerable areas, predominantly in developing nations. Investing in adaptation and resilient urban and rural communities—such as in renewable off-grid energy, healthcare, and digital infrastructure—is critical to supporting the continued functioning of the global economy and an important cornerstone of managing investment risk.
  4. Take action. There are many paths an investor can take to integrate climate change. One may choose to exclude companies with fossil fuel reserves in passive portfolios and, rather than exclude fossil fuels outright, engage with active managers where there is high carbon exposure to understand how those companies are managing climate risk. Further, a climate value at risk assessment of the public equity portfolio can lead to targeted engagement with investment managers and potentially greater shifts in the portfolio. At a minimum, asset owners should look to partner with managers that incorporate the physical risks of climate change into investment decisions.

This latest compendium of scientific review highlights the threat climate change poses today. By considering climate change as a core investment risk and recognizing that there is no one correct way to address the challenges it presents, investors are far more likely to position their portfolios for long-term success.

 

Footnotes

  1. Working Group II report Climate Change 2022: Impacts, Adaptation, and Vulnerability, Intergovernmental Panel on Climate Change, February 2022.