What if global warming does spiral out of control? Our children will ask us whether any of that could have been avoided.

A deep question is a powerful motivator. The one at left was posed by Matts Andersson, former CEO of Swedish pension fund AP4, to his colleagues and fellow researchers. It affected Marielle de Jong, head of fixed income quant research at Amundi Asset Management, so strongly that she began to research low-carbon initiatives. Patrick Bolton, a professor of business at Columbia University, redoubled his efforts looking at environmental factors as part of long-term risk. In 2016, de Jong and Bolton each co-authored a significant paper on hedging climate risk in the May/June issue of the Financial Analysts Journal (FAJ).

“Despite all the climate science, there still is considerable uncertainty about how climate change will unfold. How fast will temperatures rise? What will be the effects and response to rising temperatures? Nobody can claim to know all the answers, and there is room for disagreements, even among scientists,” says Bolton. There’s no shortage of skeptics in the financial management industry, either, but “even a climate skeptic has to think in terms of risk management. Investors don’t want to wait until they have a definitive answer.”

“Uncertainty is too often used as an excuse to ignore problems and do nothing,” adds de Jong. “The starting point of our study is to do the contrary: to make climate a tangible issue for the investor.”

But there’s a positive side to uncertainty; it’s actually a virtue, de Jong says. “The more uncertainty about the well-being of the planet, the more it will become identified as a risk and the more it will be accounted for in the price of capital.”

She takes the view that “market mechanisms can be used to mitigate global warming.” In the same way that production inefficiencies tend to be straightened out by price competition, companies that pollute more than necessary will have a tough time finding financing.

Another uncertainty is the difficulty in identifying who’s responsible, she says. “Take a bank, for example, that finances a polluting company. Does the bank share in the responsibility? To what extent?” She adds that providers of sustainability data like TruCost and South Pole Group are working to resolve this issue.

Long-term view

How should large long-term institutional investors think about the risk-return trade-offs they face? The two papers in the FAJ shine a light on managing climate risk in the years ahead. “What surprises me most is that low-carbon investing hadn’t been invented long ago,” says de Jong. “We have been stuck with the idea that pollution control is…disconnected from economic activity.”

“Long-term investors have to think harder about risks that do not yet appear material to short-term investors,” says Bolton. Climate risk is part of ESG (environmental, social, and governance) risk. “What is common about these risks is that they grow slowly but eventually can have a large impact,” he adds.

Low-carbon bond portfolios

In their paper, “Weathered for Climate Risk: A Bond Investment Proposition,” de Jong and co-author Anne Nguyen, a fund manager at Amundi, analyzed what a bond portfolio would look like if the low-carbon principle were adopted. “The purpose of low-carbon investing is not to penalize companies that produce a lot of CO2 ,” Nguyen explains. “The question is whether the production line is carbon-efficient….That is why the selection criterion is the intensity, the tonnage of CO2 per added value—not the tonnage itself.” They reduced the carbon footprint by over half, yet had the same rate of return and tracking error as the regular portfolio.

Their analysis was carried out during the run-up to the COP 21 Conference on Climate Change in Paris. De Jong remembers their research was a “wildly hot topic with our usual business partners,” such as data providers and credit rating agencies.

Low-carbon equity portfolios

Similarly, Andersson, Bolton, and co-author Frédéric Samama, deputy global head of institutional clients at Amundi, applied a carbon filter to standard market indexes in their paper, “Hedging Climate Risk.” “A simple way of implementing this filter is to remove from the index the worst performers in terms of carbon intensity and stranded assets in each sector, and compensate by increasing the portfolio weights in the remaining constituent stocks in the sector,” Bolton explains. A stranded asset is an asset whose value has plummeted, thereby triggering a write-down. The researchers found it was possible to reduce investor exposure to carbon intensity by more than 50 per cent while obtaining the same performance as that of the benchmark market index, which was “by far the most surprising aspect.”

Whether stocks or bonds, the story on decarbonizing portfolios comes down to a story on data. Companies’ carbon emissions are now being reported systematically. The major index providers (S&P and MSCI) provide decarbonized indexes, Bolton says, “so that any index investor can now hedge climate risk at no cost by holding the decarbonized index, rather than the reference index.”

By decarbonizing, the investment community is “effectively sending out a pricing signal. Securities issued by corporations that are inefficient in their handling of greenhouse gases may lose value,” de Jong points out. “Such a pricing phenomenon…would be a very powerful weapon in the fight against global warming, more powerful than all humanitarian efforts combined.” “Our strategy is first and foremost a risk management tool for investors,” says Bolton. “It has not been designed to mitigate climate change.” However, if “trillions of dollars are invested in these indexes, there will be considerable pressure on the worst carbon emitters to clean up their act.” Those companies that have been excluded from a major index will have stronger incentives to reduce emissions, while the companies relying on clean energy will gain faster access to that index.

Doom or gloom?

Future developments depend greatly on the geopolitical situation. De Jong takes heart in the fact that China, the world’s largest CO2 producer, is taking steps to clean up its emissions. “Local governments have become aware that the air pollution in certain Chinese cities…scares away foreign residents and, along with that, business activity,” she says.

The outlook is not so sanguine for the U.S., the world’s second largest producer. “The new administration is likely to undo some of the climate policies introduced by the Obama administration and therefore the reduction in carbon emissions…will be slower,” Bolton says.

Fortunately, renewable energy is making great strides. “In some parts of the world, solar energy is now cheaper than natural gas. The acceleration of technological change in renewable energy is bringing forward in time the material risks of fossil fuel,” Bolton says. “Even five years ago, who could have guessed that coal would become a stranded asset by 2017?”