Long-term investors must prepare their portfolios for the changes ahead, says Steven Desmyter, Co-Head of Responsible Investment, Man Group.
We live in a warming world. As investors, we need to recognise this and start thinking now about how to position our portfolios for a future of higher temperatures and more extreme weather events. The climate crisis will revolutionise the way we model risk and value companies: every investment decision ought already to be adjusted for the potential impact of global heating. Few, though, have looked in depth at the practical implications for the firms they invest in of a world that is hot and getting hotter.
Let’s start out with the most optimistic outcome possible: that we achieve the Paris Agreement targets and temperature rises are kept to 1.5 degrees Celsius above pre-industrial levels, that carbon emissions are cut aggressively and that the planet is bailed out through a mixture of human ingenuity, collaboration and technological innovation. Even then, we will have to live with changes to global temperatures that will dramatically alter life in many countries. We are currently around 1.2 degrees above pre-industrial levels and are already witnessing the havoc that comes with global warming – droughts, floods and wildfires.
Accepting global heating can feel like an admission of defeat at a time when all of our efforts are ranged against it. But, as investors, we need to be realists and to recognise that we should both hope for the best while preparing for more challenging outcomes. Even in the best of all possible worlds, we have to prepare for some level of global warming: indeed, it’s already here.
Investing in a warming world requires investors to manage a number of risks. Firstly, there’s the cost of natural disasters. According to Climate Action, researchers estimated that the catastrophic floods that hit Germany and China earlier this year were up to 200 times more likely because of the 1.2-degree change in climate we have already experienced. Insurance premiums can rise sharply, real estate prices will see climate-related adjustments and new risks will have to be factored into the ways we do business. We believe investors should look at firms whose operations are concentrated in areas particularly exposed to natural disasters and adjust valuations accordingly. This can be done at a highly localised level, recognising that different countries face very different risks.
Then there’s the economic cost of rising temperatures. Our in-house climate model estimates the impact that global heating will have on different countries in 2100, presuming temperature rises are kept to less than 2% (Figure 1). This ranges from around an 80% drop in GDP/capita growth in countries including Saudi Arabia and India, to a markedly positive impact for countries including Finland, Russia and Canada. The clear message here is that inequalities between less developed and developed nations will be accentuated by climate change, leading to greater migration, civil unrest and, necessarily, lower earnings for firms operating in these countries.
But we should not lose sight of the fact that there will be those who benefit from the change in temperatures. Large swathes of Russia and Canada, which were previously more or less uninhabitable because of their cold winters, will now be economically viable. There will be new routes opened up for ships through the Arctic Ocean, cutting transportation times for freight between Europe and Asia by up to a week.
Adjusting valuation models
Alongside the more common metrics of ESG performance and traditional valuation models (Value, Momentum, etc), we believe investors should look at a number of other factors. Many firms will have assets valued on their balance sheets that are ‘stranded’ – rendered worthless by the move to a zero-carbon future. This will be particularly common in the energy and mining sectors. The physical cost of climate change is the revenue and labour force implications of a warming world twinned with the impact of more frequent and catastrophic natural disasters. The transition cost represents the investment required to overhaul business models to operate in a world radically altered by climate change – this incorporates both the move to zero carbon and the geographical changes required to adapt to a new economic order.
In the end, this analysis leaves us with two key conclusions. The first – which should go without saying – is the necessity of addressing the climate crisis before it’s too late. The second point is that as stewards of capital and long-term investors, we need to be clear-eyed about the fact that change is coming and prepare our portfolios accordingly. There will be winners as well as losers in the great climate revolution, and new tools are required to negotiate a world whose priorities will alter unrecognisably.
Disclaimer: Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any ﬁnancial instrument or in any product to which any member of Man’s group of companies provides investment advisory or any other services. Any forward-looking statements speak only as of the date on which they are made and are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. Any data services and information available from public sources used in the creation of this material are believed to be reliable. However accuracy is not warranted or guaranteed. Unless stated otherwise this information is communicated: in the European Economic Area by Man Asset Management (Ireland) Limited which is authorised and regulated by the Central Bank of Ireland under number C22513. In Austria and/or Germany by Man (Europe) AG, which is authorised and regulated by the Liechtenstein Financial Market Authority (FMA). This material is of a promotional nature. In the United Kingdom, by Man Solutions Limited which is authorised and regulated in the UK by the Financial Conduct Authority under number 185637.In Switzerland, by Man Investments AG, which is regulated by the Swiss Financial Market Authority FINMA. In the United States this material is presented by Man Investments Inc. (‘Man Investments’). Man Investments is registered as a broker-dealer with the US Securities and Exchange Commission (‘SEC’) and is a member of the Financial Industry Regulatory Authority (‘FINRA’). Man Investments is also a member of Securities Investor Protection Corporation (‘SIPC’). Man Investments is a wholly owned subsidiary of Man Group plc. (‘Man Group’). The registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed Man Investments. In the US, Man Investments can be contacted at 452 Fifth Avenue, 27th ﬂoor, New York, NY 10018, Telephone: (212) 649-6600 MKT001985-020/NS/GL/W