From rising sea levels to catastrophic weather events, investors can’t afford to ignore the risks of climate change. Since many companies would be vulnerable if current climate forecasts materialize, asset managers may want to consider climate change in their equity research process and engage management teams on the subject.
The Earth’s average surface temperature has risen about 1 degree Celsius since preindustrial times. More than 100 countries pledged as part of the 2015 Paris Agreement to limit further warming to 1.5 degrees Celsius by 2030, but that goal may be impossible if current trends continue. By 2100, the planet could be as much as 4.4 degrees Celsius warmer than it is today.
For context, consider that a 1-to-2-degree drop in the Earth’s average surface temperature kicked off the so-called Little Ice Age between 1300 and 1850. And a 5-degree drop 20,000 years ago encased a chunk of North America in ice.
Does this matter for equity investors? We think so. Below, we consider the four most important questions investors may want to consider when evaluating how climate change may impact a company.
1. How vulnerable is the company to extreme weather events?
Climate experts say that continued rising concentrations of greenhouse gases in the atmosphere will create adverse weather effects. That includes more intense hurricanes, more frequent storms, rising sea levels, flooding, drought and heat stress. Extreme weather threatens to damage critical infrastructure and endanger food supplies. We’re already seeing how it can affect corporate operations.
Persistent drought in California led to devastating wildfires that helped drive PG&E Corp. to bankruptcy. Smithfield Foods had to shut down operations in North Carolina during Hurricane Florence, and the storm’s floodwaters breached some of the company’s waste lagoons, polluting the surrounding area. The medical community suffered a critical shortage of intravenous bags and fluids after Hurricane Maria knocked out capacity at medical supply company Baxter International’s Puerto Rican plants.
The first step in assessing a company’s exposure to climate change is locating all its physical assets, including manufacturing plants, research and development sites, and retail stores, and determining how vulnerable they are to extreme weather. Tracing exposure down the supply chain is more difficult, but equally important.
2. How well can a company adjust to tighter climate regulations?
We think all companies—not just energy companies and utilities—will be required to cut carbon emissions in the future. But why would, say, a large technology company be concerned about that? While Microsoft, for example, doesn’t directly emit significant amounts of greenhouse gases, it does employ massive data centers to power its fast-growing cloud computing business. Such data centers are expected to rank among the planet’s largest users of electrical power by the mid-2020s.
Companies that are transparent about their carbon footprints, and actively trying to reduce them, are better positioned to succeed if climate policies get stricter. More than half the world’s companies publicly disclose their carbon emissions. Some also disclose whether their emissions are direct, indirect or made at the supply chain level.
Emissions levels don’t mean much on their own, however. We compare companies to their peers by calculating carbon intensity, a measure of total greenhouse gas emissions weighed against total sales. Think of it as a GDP-per-capita measure for the environment.
Finally, it’s important to determine what a company has already done and what it plans to do to lower emissions. Ideally, companies should aim to reduce their carbon output at a pace that would help keep global warming below the 2-degree threshold set by the Paris Agreement.
Companies that take climate risk seriously, however, strive to be carbon neutral. Microsoft, for example, charges each business unit a carbon fee for the emissions they produce. The company then invests those fees either in internal efficiency projects—such as buying renewable power or making buildings more energy efficient—or by purchasing offsets for the remaining emissions. (Offsets typically fund clean energy projects.)
But investors need to press on even the most progressive companies. It’s important, for example, to know how much companies actually rely on renewable energy, the reputation of the entities they work with to buy carbon offsets, and whether companies are committed to retiring their offsets.
3. Can a company benefit from an increasing focus on climate change?
Climate change is also creating opportunities for investors. The International Energy Agency predicts that renewables will produce 31% of the world’s electricity by 2050, up from 18% in 2018. Coal’s share of the market will shrink from 28% to 17%. This shift will directly benefit solar and wind power companies, as well as battery manufacturers.
Meanwhile, some companies will enjoy direct and indirect benefits from research into carbon-capture technologies, more intelligent farming, minimizing waste through recycling and reusing materials, and managed retreats from coastlines. Verisk Analytics, for example, incorporates climate change forecasts in its analyses to help insurers identify homes at higher risk of storm damage.
4. How do management teams assess and manage climate risks and opportunities?
Few companies disclose detailed explanations of their approach to climate change. Serious investors must engage with management teams to understand exactly how they evaluate and manage climate risks. Are companies planning for the long term, or simply managing the business as best they can from quarter to quarter?
That’s the tricky thing about investing in the age of climate change. The stakes are enormous, but the framework for assessing the risks is new and requires a great deal of spade work. Independent fundamental research is time consuming and difficult, but it’s the only way to determine which companies are truly preparing for what could be the biggest existential risk in many generations.
