How Investors are Making Better Decisions Amid a Changing Climate

How Investors are Making Better Decisions Amid a Changing Climate
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This insight is part 04 of 12 in this Collection.

January 22, 2024 26 mins

How Investors are Making Better Decisions Amid a Changing Climate

How Investors are Making Better Decisions Amid a Changing Climate

For investors, climate change means navigating uncertainties and understanding a wide range of potential outcomes.

Key Takeaways
  1. While there is widespread acknowledgement that limiting global warming is imperative, views vary on how investors should play a part.
  2. Investors should consider climate change from the perspectives of protecting their portfolios against financial risks, benefiting from growth opportunities in climate solutions and having a positive impact on decarbonizing the real economy.
  3. These objectives may overlap or be implemented differently. No one-size-fits-all approach exists for responsible investing. Investors must assess which strategy best supports their financial goals and values.

The Paris Agreement delivered an international treaty on climate change in 2016. It laid out progressive goals to limit the global average temperature increase to well below 2 degrees Celsius, and preferably to 1.5 degrees Celsius by 2100.1 Projections based on current policies anticipate a temperature rise of 2.7 degrees Celsius by that year.2

Limiting global warming is critical to mitigating the catastrophic effects of climate change on ecosystems and humanity, economies and industries, and investment portfolios. Mitigation efforts will impact investors and their portfolios, in the short and long term, representing both risks and opportunities. 

However, there are distinct global differences in executing these efforts, often based on regulatory, cultural and fiduciary standards. In the UK, for instance, the regulatory and political climate for retirement plans is more attuned to climate issues. A wider range of assessment tools and approaches are used, including climate scenarios. 

“As an investor in the UK, you should be concerned if you hold investments in exposed companies or industries that have insufficiently planned for the transition,” says Tim Manuel, an Aon investment consulting partner based in the UK. “Investors also have an opportunity to benefit from the growth opportunities to invest in climate solutions that have a positive impact on real-world decarbonization.”

Daniel Ingram, North American Head of Responsible Investing and IC Partner, Aon Investments, adds: “For many institutional investors in the U.S., sustainable strategies are permitted if they meet the same thresholds for expected risk and return as any other investment.” 

Five Insights for Investors Considering Climate Change

No one-size-fits-all approach exists for investors considering climate change. Rather, investors should assess which strategies work for them based on their objectives, views and circumstances. These five steps can help pave the way for responsible investing:3 

1. Integrate climate information as part of the investment process. There is an opportunity for skillful investment managers to outperform by integrating climate information as part of the overall investment process. Many investors don’t wait for climate risks and opportunities to happen — they try to anticipate them in their decisions to buy and sell securities, driving market prices to incorporate consensus views. As a result, climate-related risks can be quickly priced into markets and securities as new information becomes known. Investment managers who are skillful at identifying and balancing climate risks with other risks will see positive results.

2. Tread carefully with scenarios. Regulators in some markets are requiring use of climate scenarios to help investors understand the impact of climate-related risks and opportunities. Even with the unprecedented availability of climate information, investors still don’t know the accurate timing or magnitude of climate impacts. Climate scenarios are an important tool for providing a particular perspective on climate risk. However, investors should proceed with caution and clearly understand the limitations.

3. Take a balanced approach to risk. There is no ideal “hedge” to protect a portfolio from multi-faceted climate risks. Though many investors would like resilience to climate risks in their portfolios, it’s not clear how to do this or what the costs are. Simply investing in securities of businesses with low carbon emissions may not be a direct or effective way to protect the portfolio against climate risks. A better approach involves investment managers who are skilled in integrating climate risks and opportunities into their decisions.

4. Seek long-term opportunities. Not all investors seek “impact,” but those who do should prioritize efforts to decarbonize the real economy over the portfolio. Selling carbon-intensive securities in secondary markets doesn’t mean the companies they sold, or stopped lending to, emit less greenhouse gases. It just means someone else will own the securities. Further, the investor may engage and vote proxies differently. As a result, decarbonizing portfolios is not the most direct or effective way for impact investors to use their portfolios to address climate change.

5. Create a positive impact by investing in carbon-intensive businesses. For impact investors who want to mitigate climate change, a viable strategy is to “steward” outsized emitters to reduce their carbon footprints, exercising their ownership rights to drive change in a variety of ways. 

Investors are Considering Short- and Long-Term Factors in their Decisions

Investors face headwinds and opportunities in both the short and long term as they navigate climate risk investing. In the short term, risks are diverse, including:

  • Geopolitical concerns
  • Regulatory and risk pressures
  • Impact of natural catastrophes on physical assets
  • Impact of transition risks

Short-term acute physical risks, including heatwaves, floods, wildfires and windstorms, and chronic physical risks, such as rising temperatures, ocean acidification and rising sea levels, could directly impact company operations and fundamentals. This then causes asset price volatility across portfolios. 

For investors, there will always be a focus on returns. Investors will continue to use data and analytics through climate modeling to make near-term decisions on opportunities for portfolio optimization. The resolution of catastrophe models is high, and investors can gain valuable insights at individual asset levels to make informed investment and divestment decisions. These models continue to grow in accuracy, paving the way for more sustainable long-term decisions.   

In the longer term, investment opportunities will emerge as industries transition from high to lower carbon intensity. Many industries are actively pursuing decarbonization amid growing regulatory and stakeholder pressure. But change requires investment. Exposed sectors, such as oil and gas, commodity traders, utilities, materials and agriculture can accelerate their transition through innovation and investment in new technologies.

These changes could increase exposure to risks, with costly implications if not addressed. This creates indirect impacts across other sectors, including insurers and service providers. Consumer sentiment for greener products may also increase. For investors driving this transition, rapidly changing pressures can make the longer-term financial outlook more difficult to forecast accurately. 

As part of this transition, investors are recognizing their role in moving the needle toward decarbonization through investment decisions. By providing capital to emerging technologies and cleaner operating models, investors can support the transition process, while also accessing potentially attractive future returns. 

A Spotlight on Retirement: In the UK, pension funds  already use climate modeling to build a more robust long-term lens. However, in other regions, like the U.S., the regulations are less specific. Conventions are also more varied in terms of how retirement fund managers consider climate change, though most view it as an economic risk that is yet to materialize.

Climate Scenarios are an Increasingly Critical Tool for Investors 

The range of climate change impacts for investors is vast. Below we share five potential scenarios:

Climate Change Scenarios

The scenarios illustrate varying degrees of impact on the macroeconomic environment, which can also include bond yield movements and equity returns. They underscore the relevance for investors to take climate change into account in their portfolios when trying to preserve financial and economic systems. 

“There are two layers of climate scenarios for investors — the physical scenarios that forecast how the climate is changing, and the transition scenarios that show how the markets may react to policies to prevent or mitigate those changes,” says Tim Manuel. “Both are rapidly evolving as climate change accelerates and more research and a wider range of views become available. In particular, there is ongoing debate about the economic outcomes under the different scenarios, and the complexity of tipping points that may occur.”

Across potential investment and macroeconomic impacts, each of the five scenarios is compared and contrasted against a base case scenario. In the base scenario, world events unfold in a way that is broadly consistent with prices in the current market. 

The Impact of Climate Change on Assets 

Expectations for institutional investors are changing. Maintaining the best possible returns, while also navigating climate-related risks and opportunities, will continue to challenge investors. Boards, trustees and fund managers need data, analytics and advice to help them understand different climate pathways, identify physical and transition risks, and ultimately guide informed decision-making to protect and grow assets. 

This may include investments in new technologies, alongside divestment from investment perceived to have high levels of climate risk, depending on the investor’s objectives and views. For some investors, it may also include using the tools of stewardship (voting and engagement) to encourage investee firms to pay greater attention to emerging climate risks and opportunities in their business planning. 

Except for the largest and most well-resourced investors, it is rare to have the skill or resources to directly lead stewardship for impact in this way. More commonly, institutional investors rely on their asset managers to lead stewardship activities on their behalf. Alignment of views with asset managers can be the key to meaningful impact. 

Find out how climate modeling can help investors make better decisions.

Aon’s Thought Leaders
  • Eric Friedman
    Partner and U.S. Director of Content Development at Aon Investments
  • Daniel Ingram
    Head of Responsible Investing and IC Partner, Aon Investments, North America
  • Tim Manuel
    Investment Consulting Partner, Aon Investments, United Kingdom

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