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Finance & economics | Buttonwood

The risks mean investors have to take climate change seriously

Dec 3rd 2015
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FEW people place great store in the ability of negotiators to reach a meaningful deal during
the conference on climate change that began in Paris this week. One problem is that some
politicians refuse to admit the problem is real. But those who work in the financial markets
have to take the issue seriously: ever since being hit by losses from Hurricane Andrew in
1992, insurance companies have been modelling climate risks. Bank of America Merrill
Lynch (BAML) just weighed in with a 332-page report on their economic and financial
impact.

A changing climate, and the eventual efforts of governments (however reluctant) to deal with
it, could have a big impact on investors’ returns. Companies that produce or use large
amounts of fossil fuels will face higher taxes and regulatory burdens. Some energy producers
may find it impossible to exploit their known reserves, and be left with “stranded assets”—
deposits of oil and coal that have to be left in the ground. Other industries could be affected
by the economic damage caused by more extreme weather—storms, floods, heatwaves and
droughts. “Investors have to worry about a material and unexpected loss of capital,” says
Ewen Cameron Watt, chief investment strategist at BlackRock, a fund-management group.

Moody’s, a rating agency, has tried to quantify the impact for bond markets. It puts three
industries (deregulated power generation, coal mining and coal terminals) at “immediate and
elevated” risk from climate change; between them, these sectors have $512 billion in rated
debt. Another eight sectors (including carmakers, miners and oil refiners), with $1.5 trillion
of rated debt, have “emerging, elevated” risk. A further 18, with $7 trillion of debt, face risks
over the medium term, defined as more than five years ahead. That leaves the vast majority of
the corporate-bond market, encompassing $59 trillion of rated debt, in the low-risk category.

Broadly speaking, investors who are concerned about the issue follow three approaches. The
first is an outright boycott of the dirtiest industries. The latest example is Allianz, a German
insurance group, which said it would no longer invest in companies that “derive more than
30% of revenue from coal mining or generate over 30% of their energy from coal.” The result
will be a divestment of €225m ($238m) in the shares of coal groups; Allianz will continue to
hold its €3.9 billion of bonds in such companies, but not buy any more. More than 400
investment institutions have made similar commitments, according to 350.org, a green lobby
group.

The second approach is to maintain stakes in carbon-producing firms but to try to engage
with their management in an attempt to change their behaviour. Research by BlackRock
shows that companies that have reduced their carbon intensity (defined as emissions divided
by sales) have outperformed the market since March 2012, when proper data on corporate
emissions first began to be collected.

A third approach is to skew portfolios towards the companies that will do well out of attempts
to curb carbon emissions. Some low-energy technologies have already had success. Light-
emitting diode (LED) bulbs consume less than 15% of the energy of incandescent bulbs.
They had just 1% of the lighting market in 2010. This year their market share is 28%;
Goldman Sachs forecasts it will be 95% by 2025. Then there is renewable energy. So far, it
generates only a small proportion of global power. But BAML says that, globally, wind and
solar power made up nearly half of the additional energy-generating capacity installed in
2014 and may comprise 70-80% of new capacity between now and 2030.

There is little evidence that following these strategies has had a big positive impact on returns
so far. Standard & Poor’s has identified the 100 highest and lowest emitters in its index of
1,200 global stocks. As the chart shows, the highest emitters have done marginally better
since 1999. That reflects the strong performance of energy companies during the period of
rising commodity prices; in recent years, as the oil price has dropped, the low emitters have
caught up. But falling energy prices have also hit the shares of renewable energy producers,
many of which need high power prices to be competitive: over the past five years, S&P’s
Global Clean Energy Index has suffered an annual return of -9%.

Picking the right strategy will not be easy, therefore. But all investments have their pitfalls.
Ignoring the climate issue altogether looks like the biggest risk of all.

Economist.com/blogs/buttonwood
This article appeared in the Finance & economics section of the print edition under the
headline "Weatherproof"