After a year dominated by a global pandemic, political elections, social protests and crazy stock market returns, climate change is finding its way back into headlines.
Scientists from the National Oceanic and Atmospheric Administration reported in January that 2020 marked the second-hottest year on record, just 0.04 of a degree Fahrenheit below the 2016 record. The 10 warmest years on record have occurred since 2005. The seven warmest years have taken place since 2014.
Environmental, social and governance, or ESG, investing and sustainable investing “have become significant factors as we face growing concerns impacting our society, the economy and our environment,” says Sarah Bratton Hughes, head of sustainability for North America at Schroders. “Investors can no longer afford to ignore sustainability.”
We spoke with Bratton Hughes about how investors can incorporate climate change and other ESG factors into their portfolios. Here are edited excerpts from that interview.
Why is there greater urgency today for sustainable investments and ESG factors?
Traditional investments analyze two elements: risks and returns. We believe that the future of investing accounts for a third principle: impact. As we move toward a greener and more equitable world, our surveys project investors are becoming increasingly aware of the impacts their portfolios have on the environment and society.
People have become increasingly cognizant about the sustainable choices they make in all facets of life, from where they shop to the food they eat to their traveling habits. Our data shows that roughly half of people in the U.S. are motivated to invest in sustainable funds due to environmental and societal impacts, and a majority of U.S. investors are motivated to invest sustainably due to higher returns.
With the global population projected by the United Nations to grow to 9.7 billion people in 2050, demands for food, water and energy will ultimately rise. Goals to curb fossil fuels and carbon emissions, calls for racial and socioeconomic equity, and increased scrutiny of how companies treat employees and all stakeholders have quickly shifted the investing universe’s increased appetite for ESG. Building investments from a carbon and climate perspective are crucial elements for investors to drive long-term value and hedge against the economic, societal and environmental concerns facing our world today.
What is the cost to investors if they don’t incorporate sustainable investment practices?
In 2020, sustainable equity funds closed the year performing well ahead of their traditional equity fund counterparts and market benchmarks, disputing the myth that ESG investing means sacrificing returns.
When building a portfolio, we look for companies and issuers that integrate ESG principles in their business models and strategies. And we look for companies that understand their impact on their stakeholders and the communities in which they operate. Firms don’t operate in a vacuum. Their operations have ripple effects on the economies and societies surrounding them. Therefore, companies that do good will inherently impact the value provided to stakeholders and their shareholders.
Schroders created its own proprietary tool, SustainEx, which is designed to quantify the social and environmental impacts across individual companies, industries and geographies, translating these impacts into financial costs or benefits. It asks the question: If companies were given a bill for the costs they impose or the benefits they create, how large would that credit or debit be?
How will the trend of rising temperatures impact investor portfolio alphas?
Increased temperatures impact economic outputs, making it challenging for people to conduct basic tasks. This will also lower crop yields and raise costs of production through added heating or air-conditioning bills.
Rising temperatures most negatively impact return forecasts for warmer countries. Our economics team recently incorporated climate change into their forecast for 30-year investment returns. They found that countries with hotter climates such as India will be the worst affected. Without taking climate change into account, inflation-adjusted returns of India’s stock market were forecast to be 6.2% per for each year versus 2.3% with climate change incorporated.
For colder climates, such as those in Switzerland, Canada and the United Kingdom, climate change may actually boost returns from their domestic stock markets in the near term. Although these projections paint a positive picture for the next 30 years in such climates, a longer term picture of rising temperatures points to a less rosy outcome and increased widespread economic loss worldwide.
What are the key climate change factors advisors and investors should incorporate into investment strategies?
It’s important to have a robust climate risk assessment framework that holistically incorporates both physical and transition climate risk, as well as the steps an investment has taken to tackle the climate threat.
An area of our transition framework that we expect will continue to make headlines this year is carbon emissions – and the potential regulations and carbon pricing schemes aimed at curbing them. According to research from our Carbon Value at Risk framework, which predicts how carbon costs will affect companies, almost half of global listed companies’ earnings will be impacted by more than 20% if carbon prices rise to $100 per ton. For reference, a carbon price is the cost applied to pollution created by companies to encourage reduced greenhouse gas emissions. A 20% earnings reduction would have widespread impacts on industries and financial markets for investors globally.
Our model predicts that firms that are positively impacted from lowered emissions will significantly outperform broad indices. Given this data, we are seeing opportunities in companies generating renewable energy and low-carbon outputs. We have identified several subsectors that should be top of mind for investors, including energy efficiency, sustainable transport, clean energy, environmental resources and low carbon leaders.
What are the essential social and environmental factors investors must analyze when building portfolios?
We have developed five broad themes investors should incorporate in allocations: environmental, government, customers, employees and communities. Within each theme lies more granular issues such as customer innovation, government taxation and subsidies, access to water and sanitation and biodiversity loss. What is most important is that investors are focused on the material factors for the security they are assessing.
While climate tends to dominate the headlines, human capital management and diversity and inclusion are key issues in the United States. Companies that employ a quality jobs framework see growth potential in providing employee opportunities and benefits that can improve their well-being and career.
Investing in companies that create quality jobs generates a double bottom line return of enhanced operational efficiency and driving alphas while improving the livelihood of employees.
Investors should also pay attention to companies that are transparent in their ESG reporting, as this will be critical to achieve corporate responsibility. ESG reporting is more than just a shiny PDF issued each quarter. There needs to be clear measurement of impact, as well as transparent plans for how they are tackling the biggest ESG goals and their progress in achieving them.
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