Climate change raises two challenges for investors: how to include financial costs of global warming into investment decisions; and how to fight climate change.
We assess how global equity investors can fight climate change. They can do so in two ways: by funding cleaner parts of the economy and helping it grow (funding channel); and by convincing management and voting at general meetings (engagement and voting channel). The funding channel can in turn take two forms: selecting “cleaner” sectors or regions (asset allocation); and selecting “cleaner” stocks within sectors or regions (stock selection).
We focus first on the funding channel. We analyse better aligned firms. Perhaps surprisingly, how clean the sectors and regions in which firms operate drive only one-third of their “lower temperature.” Firm-specific efforts (over and above sector/region) account for two-thirds. Hence, selecting firms with best climate practices across many sectors is at least as important in fighting climate change as investing in “green” sectors.
We then focus on the engagement channel. Successful engagement may defeat climate change. Crucially, all firms adopting existing best practices of their sector may bring the world economy on or close to a 2°C trajectory. Therefore, engagement plays a crucial role in fighting climate change.
- Stock selection is at least as important as sector and country allocation when fighting climate change. Namely, firm-specific efforts account for over two thirds of the difference in temperature between below 2°C-aligned firms and the global average. The country and sector mix of firms accounts for the rest.
- Low temperature equity portfolios are only moderately more volatile than global ones. For example, simple 1.5 and 2°C portfolios are only 0.9 and 0.4pp more volatile than global equities, respectively. Tracking errors can be significant, though (4.1% and 2%, respectively).
- Voting and engagement can have a powerful impact. Firms which adopt their sector's best practices could shave on average 1.3°C off their climate footprint.
Our paper in the Journal of Asset Management describes the framework in more detail.
Mercereau, Neveux, Sertã, Marechal and Tonolo “Fighting climate change as a global equity investor”, The Journal of Asset Management, February 2020.