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.
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