Ethical Investors Should Understand That Investing In Climate Change Is Volatile And Not Without Risks

Thursday, 04 November 2021
By Bob McDowall

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From my position as a Member of the Investment Committee of a Learned Society which is a registered Charity and committed ethical investor, I have, during the last quarter experienced, witnessed non-sustainable stocks (including fossil fuels and other extraction industries) outperforming most of the sustainable stocks. This bounce is undoubtedly a response to the consumption demands of global manufacturing and construction industry in the slip stream of economic revival following the Covid-19 economic recession.

Ethical investors in the form of Charities, Foundations and other Not-for-Profit Enterprises have historically been at the forefront of ethical investment. This type of investment embraces climate change combating products and services, which have a very strong reliance on investment gains, dividends and interest income.

With exception of grants and donations, many of these institutions have few sources of revenue. Trustees and Investment Committee Members tread a fine line between “God and Mammon”- espousing ethical investment whilst demonstrating an historical reliance on healthy dividends from oil and mining stocks! That stance is becoming more precarious, certainly over the next 20 years, as investment in climate change becomes more complex.

The immediate issues are:

  • Anticipating the impact of geo-political follow through from any COP 26 agreement

Translating political commitments into practical applications is a hazardous process over the short-term but is exponentially hazardous over a 25-30 year period, globally, regionally and by jurisdiction even where the commitment is supported by treaties, legislation and Memoranda of Understanding. Politics is a fickle beast, and commitments can change and vary, or even be entirely set aside .To that extent, investment can only be managed with a relatively short-term perspective bounded by the scope of current geo-political agreement. Change and variation must be considered a certainty based on historic behaviour.

  • Assessing the calibration of change at a global/regional and jurisdictional level.

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Moving from the big-picture to issuer-specific considerations, a distinction has to be made between physical and transitional risks. In the physical dimension for example, higher seas can endanger plant and infrastructure or restrict or close transportation routes for goods and human capital. Severe storms and disasters can damage or destroy physical assets, disrupting supply chains and causing second and third order impacts around the world. The pandemic demonstrated this unambiguously: Following decades of focusing on ‘just in time’ procurement strategies, many distributors of finished goods were devastated: The continual focus on efficiency created its own costs in terms of a lack of redundancy and capacity. Firms and investors have focused time taking slack out of the system; and in turn, the system became brittle. Linking all the component elements threads together to assess and ameliorate risk is a complex undertaking: an enterprise may have the bulk of its plants in central Europe, but its supply chain may stretch to Asia, whilst its clients are located in North America.

Transition risks arising from the evolution toward a low-carbon economy are even more complex. Regulations change, including border carbon taxes and cap-and-trade policies which are ostensibly designed to drive up the cost of carbon, but may also cloak protectionist policies. Technology evolves, and new products, production processes or power sources may alter the business equilibrium. If governments don’t act decisively to protect the environment, lawyers will almost certainly likely find a way to do it through liability and litigation.

  • Assessing the timing as well as the benefits of low carbon products and services

Timing and good fortune are required. History is littered with examples of technologies which launched too early – electric cars seemed set to become the norm in 1900, but the rise of the internal combustion engine eclipsed them and battery technology took over a century to catch up. Many companies which provide intrinsically beneficial products and services to tackle climate change will come to market. The key question is whether the timing is right with respect to the supporting technologies and infrastructure as well as the complex regulatory environment of climate change.

How effectively can these risks be managed?

  • Commerce and industry acknowledge the big gap in risk management skills, which needs to be closed through training. The failure to understand climate-related risks is not only directly related to the shortage of capacity and skills within financial institutions but also among investors, regulators, and others. It is not that tools don’t exist for risk managers to better understand climate risk. Advancements in climate-risk analytics have evolved rapidly in a short time, and multiple climate-risk software analytics tools exist today. It is complicated because different investors may need to employ different approaches to assessing and quantifying how climate change poses financial risks to their investments over time horizons that are meaningful for them, be they short, medium, or long-term. For the time being the application of these tools remains bespoke. Only a small number of investors are integrating such tools into the risk management functions or using them consistently in their investment decision-making processes.
  • Applying the tools, interpreting the data and integrating this information into effective investment decision require a great deal of skill. Risk management capacity in the form of trained risk managers is lacking for almost all investor types. The same comments may be applied to policymakers and regulators. These capacity gaps present headwinds for investors or policymakers seeking to engage in sound climate-related risk management or seeking to scale up their investment in resilience or sustainability. The upsides for addressing such capacity gaps will be significant, not only in terms of better managing climate risks but possibly also in financial terms including a lower cost-of-capital
  • The significant physical impacts of climate change are already starting to be seen, and will become more prevalent in the second half of this century. However, financial markets could be affected much sooner, driven principally by the projections of likely future impacts, changing regulations and market sentiment. Regulators and financial markets react in light of new information about climate change, such as major events such as storms, floods and droughts; policy decisions; and the success and failure of companies. The changes are partly visible in the present, but they are likely to accelerate as the physical impacts of climate change become deeper and more regular. The acceleration of change will influence financial market behaviour gradually. Initially, the acceleration will be led by the most informed investors and then, potentially, in a more disorderly fashion when markets seek to dispose hastily of at-risk assets.
  • Some but not all of the economic losses incurred by investors in this transition can be avoided or hedged through asset reallocation strategies. Others require system-level intervention through policy or regulatory action. The psycho-social dynamics of financial markets cannot be modeled even with the ready availability of risk information, Physical impacts and consequences for the macro economy can be modeled under different scenarios of climate change mitigation identified by the Intergovernmental Panel on Climate Change (IPCC) climate science and are characterised in detail by the complexity of the multi-faceted impacts of climate change on different asset classes and geographies.

My conclusion is straightforward. Ethical investors have to develop an interrogatory style which probes the scale, depth and integrity risk management skills of those who manage their funds. Where risks cannot be managed with sufficient depth, confidence or even experience Ethical Investors need to examine how well they have balanced their ethical duties with their financial duties: a balance between God and Mammon!

Bob McDowall

November 2021