How Major Investors Are Anticipating the Risks of Climate Change

The highest town in Europe has welcomed the annual smattering of the world's political and business elite to the World Economic Forum's (WEF) yearly conference . Set to build on the Paris climate agreement finalised in December, the participants convening in Davos aim to explore how businesses and governments can work together to reach the below 2C limit of global warming.

The topic of climate change plays a prevalent role during the talks, not least thanks to the latest Global Risks report by WEF labeling it the biggest single threat facing the world economy . This is the first time in more than a decade that the expert respondents ranked climate change as the gravest issue leading the list of menaces - a point that has not escaped the radar of the investor community, who now needs to understand how the effects of climate change will affect financial markets.

The impact of climate change is nothing new to the investor community and the COP21 climate conference only served to bolster its importance, making it the #1 sustainability issue for investors. And rightly so: A recent Mercer study indicated that several investment committees and boards are not yet very acquainted with climate-related risks - suggesting that the investment sector is not fully prepared to address the topic and leaving many investors poorly positioned.

This in turn leads to a series of questions investors need to start asking themselves: Are my portfolios exposed to fossil fuels adequately valued? How quickly can I adapt? The risks faced by investors will also be linked to the timing and scope of new policies . If new changes are well anticipated, investors can prepare for their impact. Getting caught off guard will be certainly accompanied by potential losses.

A typical "progression" has started to develop on this topic among mainstream investors: many have taken first steps to engage in activities that allow them to better understand their climate impact and create transparency within their investment processes. The Swedish asset management firm hman for instance, entrusted with managing assets worth SEK 39bn (approx. USD 4.5bn), conducted a comprehensive portfolio carbon footprint with South Pole Group to better scope out their portfolio's exposure to carbon risk. A signatory of the Montreal Carbon Pledge , hman has been able to engage with internal and external stakeholders on the topic of climate change to a much greater degree, leading to a mutual understanding of problems and contributing to the development of solutions.

While the Montreal Carbon Pledge encourages investors to commit to understanding and publicly disclosing the carbon footprint of their investment portfolios on an annual basis, the next step is taking action in the form of "decarbonising" a portfolio. This is what the Portfolio Decarbonization Coalition is all about: the multi-stakeholder initiative aims to drive GHG emissions reductions on the ground and is currently overseeing the decarbonization of USD 600bn in Assets under Management .

The increasing amount of signatories to such pledges support the growing business case for climate-smart investment. The cost of inaction has recently been given a USD 4.2trn price tag - a sum roughly on par with Japan's entire GDP. Depending on what type of climate scenario unfolds, the average annual returns from, for instance, the coal industry could shrink by anywhere between 18% and 74% over the next 35 years . This poses the risk of assets tied to fossil fuel deposits becoming obsolete - or stranded - when they cannot be extracted and sold.

The action to minimise the possibility of stranded assets has taken the form of divestment and engagement: following the vocal divestment movement, Norway's largest manager of pension funds, KLP , among others, has decided to sell off all its investments in companies that derive 30 per cent or more of their revenues from coal based operations. Nonetheless, outright divestment is only one way to deflate the growing carbon bubble ; it's a single jigsaw piece in a larger puzzle. Another equally important approach is to entice companies to move into the direction of a low-carbon economy by impacting the way they do business. The UK-based Hermes Investment Management , one of the leading engagement firms, uses smart data from South Pole Group to bring up climate strategy topics with their investees. Toronto-based research firm Corporate Knights goes one step further: together with strategic partners, the company recently launched the 'Decarbonizer' platform, enabling anyone to easily determine the impact a divestment from fossil fuels three years ago would have had on fund or index performance. Using this metric, the platform found that the Gates Foundation would have been USD 1.9bn better off if it had divested from fossil fuels . This has been further compounded by new research findings conducted by Waterloo University .

While divesting and stakeholder engagement both work towards reducing climate-related portfolio risk, neither one of them creates a zero net carbon portfolio. In order to create positive impact, additional investments into emissions savings are necessary. This can be done, for example, by using emission reduction certificates to offset emissions. Leaders with a strong zero net carbon agenda are already creating waves in their industries:

The world's first net zero pension fund, Future Super , never invested in coal, oil and gas, and avoided investments into utilities that burn fossil fuels. Adding on to this series of clean investments with premium emission reduction projects from South Pole Group, the Australian superannuation fund is now saving the same amount of annual emissions that are associated with their remaining investments . Following suit, Credit Suisse , now the world's first climate neutral fund, launched the European Real Estate Climate Value fund that both calculates greenhouse gas emissions from all buildings and then offsets them accordingly. In addition to having zero net impact, the actual pricing of externalities lets asset managers see the real costs of their investments.

As the global leaders' conference in Davos reminds us, the global economy is starting to pivot around the urgent necessity to limit global warming well below two degrees Celsius. This new reality will ultimately make climate-smart investment strategies a prerequisite: taking on a "wait-and-see" approach will invite real danger into portfolios as risks grow and become tougher to mitigate.