This article was first published in the March 2016 UK edition of Accounting and Business magazine.

In June last year, the Norwegian parliament authorised the country’s sovereign wealth fund – the largest in the world, with assets of around US$900bn – to sell off US$8bn worth of coal-related investments. The portfolio included holdings in Germany’s E.ON and RWE, and the UK’s Drax and SSE power generators. 

It was the latest development in a trend that had been gathering pace for some months. By 24 November, even before the COP 21 climate summit in Paris, the Portfolio Decarbonisation Coalition (PDC) was able to announce it was ‘overseeing the decarbonisation of $230bn in assets under management, dramatically surpassing its target of $100bn’. The PDC includes some of the world’s largest and most influential investment businesses, formed in conjunction with the United Nations Environment Programme Finance Initiative. PDC’s executive chairman Paul Dickinson said at the time: ‘We have reached a tipping point in the way investors view the impacts of climate change.’

Whether sovereign wealth funds, pension managers, insurance companies and asset managers take an ethical stance on climate change is not the issue. The financial arguments in favour of divesting the equity and debt of polluting companies are compelling enough on their own for them to take action.

Hitting the bottom line

First and foremost, carbon-producing businesses face the risk of taxes or other government impositions. Although the outcomes of COP 21 were vague, governments agreed to limit the effects of climate change. As yet there is no global agreement on how to price carbon emissions, but as more countries impose fees for carbon licences or otherwise tax the cost of pollution, the pain will be felt in companies’ income statements.

Lower profitability and earnings per share will in turn affect the returns earned by portfolio managers and the value of their holdings. Investment managers cannot ignore such effects if they are to fulfil their responsibilities to investors. And there is worse to come.

Even before commodity prices around the world fell to their current levels, businesses involved in commodity extraction were reconsidering the viability of some of their assets. Was it worthwhile to mine or drill? Better perhaps to leave them in the ground and wait for the commodity price cycle to turn. Now, however, with extraction costs higher because of carbon taxes, many more such assets are ‘distressed’. The long-term prospects for profit from their extraction are poor. Investors considering their current holdings and investing in the future face, at best, weaker investee companies and, at worst, considerable uncertainty as to their net worth.

Given the long-term investment objectives of, say, pension funds or sovereign wealth funds, uncertainty of returns is sufficient for them to revisit their asset allocation strategies. Political risk also drives such uncertainty. Investors do not know what strategies and polices governments may follow to meet their avowed climate change targets. A sudden announcement of a policy change could impact asset values significantly. 

In November last year, for example, the UK’s energy secretary announced that Britain’s coal-fired power stations were to be closed down by 2025. The market value of Drax, a large coal-fired power generator, fell by £40m within half an hour. How many other high-carbon businesses around the world could be affected by new government climate change policies? Such political risk is a significant disincentive to investors to stay invested or to make new investments in high-carbon businesses. Conversely, low-carbon businesses are likely to be beneficiaries of the investor exodus from carbon-intensive ones – especially as government policies may tend towards clean sources of power, and incentives may encourage such investment.

How all this will pan out remains to be seen, but a number of decarbonised index products have already been created to attract institutional investors. As long ago as September 2014, MSCI launched its Global Low Carbon Leaders indices. Other such benchmarks have since been introduced based on a methodology that essentially removes from an index those stocks, or even entire sectors, deemed to be polluters. This removes investor exposure to the sorts of carbon risks discussed here and may well bring superior returns compared with those standard indices dragged lower by carbon-intensive constituent stocks whose prices are falling.

Concentration risk

These are relatively early days for the low-carbon investment agenda. However, as Dickinson has suggested, a tipping point may have been reached. If so, this would suggest that we can expect wholesale decarbonisation of asset portfolios around the world. Given the sheep-like nature of the financial services sector, this could bring further risk for investors.

Fleet-of-foot investors who sold their high-carbon stocks first will have been able to conserve value. However, slow adopters of the low-carbon agenda may well have to shoulder losses as asset prices reflect the sales made by faster-moving institutions. At the same time as decarbonised index products and low-carbon stocks benefit from inflows of funds, latecomers – who will inevitably account for the bulk of investment flows – may have to pay higher prices, ending up with lower returns as a result. 

What is clear is that investment funds have to go somewhere. Even if interest rates have begun to rise again in the US, holding large amounts of cash for any length of time is not a remunerative investment strategy in the current low-interest rate environment. Consequently, concentration risk may be an issue in the longer term.

Meanwhile, the reallocation of capital from polluters to low-carbon businesses could have a significant financial and, indeed, social impact. Succinctly explaining the current position from an investors’ viewpoint, Frederic Samama, deputy global head of institutional and sovereign clients at French asset manager Amundi and a pioneer of low-carbon investing, draws the following four conclusions: ‘First, asset owners and managers, wherever they are located, cannot be unaware of the risks involved in investing in polluting businesses. 

‘Second, because low-carbon indices have been developed by major index providers, they are now readily available to investors. 

‘Third, as their peers across the asset management industry are increasingly asked to allocate funds to low-carbon investments, all asset managers will inevitably need to become aware of what low-carbon investment offers, as their clients will insist upon it. 

‘Fourth, while there may be pockets of scepticism regarding climate change, risk management and their fiduciary duty to clients dictate that institutional investors cannot simply ignore the potential climate change risks to their portfolios.’

What comes next may well be determined by what practical steps governments around the world implement following the climate change agreement that was reached in Paris last December and what effects they have on investment portfolios. We do not yet know how this will take shape, so it remains an evolving story.

Richard Willsher, journalist