While a growing percentage of Americans believes the effects of climate change are harmful, most perceive it as a somewhat distant threat. Just less than 50% thinks it will affect them or their families, but 70% believes it will affect future generations. Yale surveyed the general population, not fund investors, but that subset of the population and its take on climate change is probably not too different.
Given the risks posed by global warming, what should you do about it as a fund investor? Is it something that will affect your portfolio in the near term or intermediate term? Or is it a distant threat that you don’t need to worry about?
Regardless of one's own views on the subject, it would be nice if we could let our fund managers assess climate risk for us. And increasingly, that’s what is happening. More fund managers see climate change as a set of risk factors that should be accounted for in the investment process. While some individual fund investors may doubt climate science as a matter of opinion, asset managers simply do not have that luxury. As stewards of investor capital, they are in the business of risk management and therefore must assess the near- and long-term risks that climate change may pose for their portfolios.
What are those risks? They include increased incidences of extreme weather events and rising sea levels, which are costly to real estate, utilities, and insurers and can disrupt the production and distribution of goods for all kinds of companies located in physically vulnerable areas. Regulatory and social demands for companies to lower their carbon emissions pose risks to fossil-fuel-dependent utilities and energy companies, especially those with large carbon reserves that may need to be written down, and to firms throughout the economy that must find cost-effective ways to lower emissions. Technology advances spurred by the transition to a low-carbon economy in transportation, energy efficiency, and renewables pose risks to some companies and opportunities for others.
If your asset manager isn't paying attention to climate risk, you should be concerned. One easy way to check on it is by reading what they have to say about the subject on their websites. Are they sharing thoughtful information about their approach to climate risk or avoiding the topic altogether? It doesn't take long to get a feel for the fund companies that are taking climate risk seriously and those that are not.
I searched the websites of the 10 largest U.S. fund companies and found a range of responses. American Funds, Fidelity, and Franklin Templeton have no discussion at all on their sites about climate risk or, more broadly, about sustainable investing. Vanguard has a report
on corporate engagement that briefly mentions climate risk as a topic that its team recently discussed with an oil company. While lack of information on a website does not mean these firms are ignoring climate risk altogether--which is virtually impossible for me to believe--it does suggest that they may not see it as the priority that other firms do.
Among the other six fund giants, T. Rowe Price, TIAA, Dimensional, and PIMCO all have more-detailed discussions on how they address sustainability issues. BlackRock and JP Morgan Asset Management were the leaders in discussing climate risk specifically. BlackRock's "Adapting portfolios to climate change" and JP Morgan's "Sustainable Investing: Investment Perspective on Climate Risk" are both well worth reading.
If you aren’t satisfied with how your fund managers are addressing climate risk, there are other approaches, which I outlined in more detail in an earlier column. Fossil-fuel-free portfolios avoid companies that own oil, natural gas, and coal reserves. From a returns perspective, this approach has been successful in recent years as fossil-fuel companies have underperformed the broad market, and, going forward, companies with fossil-fuel reserves are at risk of having those assets written down. Cutting out about 4% of the U.S. market, of course, does result in somewhat higher tracking error and the risk that those companies will outperform at times. Over the five-plus years since its inception, the S&P 500 Fossil-Fuel Free Index has been highly correlated with, and has outperformed, the S&P 500.
Another option is low-carbon funds, which tilt toward companies with lower carbon emissions. Such portfolios may or may not also be fossil-fuel-free. Most low-carbon funds don’t necessarily avoid fossil-fuel exposure altogether but instead focus on companies across sectors with lower carbon emissions. Companies with lower carbon footprints relative to their peers may be addressing climate risks more effectively. A BlackRock study, in the paper referenced above, demonstrated that it is possible to lower a portfolio’s carbon footprint relative to a broad-market index by 70% while maintaining a tracking error within 0.3%.
Finally, there is our Morningstar Sustainability Rating and the underlying Environmental Pillar Rating. While the Environmental rating does not focus solely on climate change, its measurement of how well companies are managing environmental issues includes a range of relevant indicators. In addition to carbon emissions, these include evaluations of a firm’s environmental policies, management systems, reporting, and any environmental controversies in which a firm is involved. If a fund has an Environmental Rating of High, that means its portfolio places in the top 10% of its Morningstar Category based on how well the underlying holdings are handling various environmental issues, including those directly related to climate change. A High Environmental Rating does not mean the fund is fossil-free or even low-carbon, but it does mean the fund’s holdings are managing environmental issues relatively well compared with companies typically held by funds in the same Morningstar Category.
By investing in a fossil-fuel-free, low-carbon, or otherwise environmentally aware manner, you are taking things into your own hands to ensure that climate risk is reflected in your investments. Otherwise, based on my survey of the 10 largest firms, it can be hit or miss depending on the funds you hold. That said, I do expect to see more and more fund companies incorporating climate risks into their process and communicating their approach more clearly to investors. More communication would be a win for all fund investors regardless of anyone’s personal opinion about climate change.