Sustainable Portfolio Management Under Climate Change
Climate change has understandably been a trending topic for years now due to its countless consequences to many aspects of our lives and the future. Its potential consequences include presenting complex risks to the global economy, and more specifically, to portfolios or financial investments.
What are Financial Portfolios?
A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents, including closed-end funds and exchange-traded funds (ETFs).
Climate change can affect a portfolio in two ways: directly and indirectly. It directly causes the rate of risk for weather-induced damage to assets to increase, leading to higher risk in the market in equity shares with physical assets located in weather-sensitive regions. It indirectly prompts more severe environmental regulations which cause the cost of emission to increase while the cost of green technology decreases. These cost changes lead to less inclusion of carbon-reliant industries within equity portfolios.
Mingyu Fang, Ken Seng Tan & Tony S. Wirjanto contribute to the existing literature on the topic of climate change and portfolio management by directly evaluating how the three main carbon reliant industries (utility, energy, & material) performed with ongoing climate change, presenting carbon potency as a unit of measure for risk exposure resulting from climate change, and presenting a framework as an example of how to sustainably manage equity management portfolios.
The results of their efforts are applicable to “financial and insurance products backed by managed funds” and provide crucial standpoints in the process of building sustainable equity portfolios and modeling those returns. They found that the performance of the three carbon-intensive industries were not as adequate as other industries, meaning they cannot be considered essential components. This adds to the argument towards decarbonizing equity portfolios by proving the benefits empirically through statistical tests on data taken from the Canadian and U.S. markets. And, it even touches on the issues about the lost returns in stripping shares of carbon-intensive industries in exchange for a lower risk exposure from climate change. Therefore, correctly decreasing access to these emission heavy industries is a strategy that could alleviate the climate change risk exposure. Additionally, the measure of carbon potency is used to sort the stocks by how heavily reliant they are on carbon emissions, in which those with the highest measure would be omitted from the portfolio. Both of these are employed in their framework for developing portfolios that are sustainable.
Insights for the Future
What could this mean for future investments? Many companies including Morgan Stanley predict that 2021 is a keystone year for a significant increase in sustainable investing. With increased attention to sustainability-linked bonds and an increase in social investing, it is likely that we will see a noticeable shift to a new landscape focused on environmental and social issues.
Written by: Lynn Deng | IQ Associate
