The Importance of Climate Risks for Institutional Investors

The Importance of Climate Risks for Institutional Investors

Philipp Krüger, Zacharias Sautner, Laura Starks

July 12 2019

Climate risks have potentially large effects on investors’ portfolio companies. Some companies face direct costs related to changes in the climate, originating from extreme weather events or a general rise in sea levels. Other companies can be negatively affected from policies and regulations implemented to combat climate change. Technological innovations related to climate change also threaten the business models of some portfolio firms that operate in traditional industries. These risks to portfolio companies, which can broadly be categorized into physical, regulatory, and technological climate risks, have the potential to adversely affect the outcomes for many clients, pension beneficiaries, and shareholders of institutional investors. At the same time, climate change also provides investment opportunities for the portfolio companies and their institutional investors, for instance in the areas of renewable energy or energy storage.

In this study we use a survey instrument to better understand whether and how institutional investors consider climate risks in their investment decisions. As such, we examine the ways in which investors view and manage climate risks and whether systematic cross-sectional variation exists in their opinions about climate risks and their strategies to manage these risks. The 439 survey respondents should be knowledgeable about the role of climate risks for their institutions, as one-third hold executive-level positions in their institutions. Further, our sample includes 48 respondents from institutions with more than $100bn in assets under management. This sizeable representation of very large investors is useful, because such institutions could have particularly strong influences on their portfolio firms’ climate policies. Our survey addresses four key areas: the role of climate risks in investment decisions; climate-risk management; shareholder engagement related to climate risks; and the implications of climate risks for asset pricing.

With regard to the first set of questions, we find that our respondents deem traditional financial risks to be the most important risks they face, followed by operating, governance, and social risks. Climate risks and environmental risks are ranked fifth and sixth, respectively. However, this low relative rank does not imply that climate risks are considered as financially immaterial. The investors believe that climate risks have significant financial implications for portfolio firms. This concern is also reflected in their climate expectations: the vast majority of investors expect a rise in global temperature by the end of this century, and four in ten even predict an increase that exceeds the Paris two-degree target. Our respondents do not view climate risks as a theme of the distant future. Fewer than 10% believe that climate risks will materialize only in ten years or beyond, while 50% state that climate risks related to regulation have already started to materialize.

Our survey demonstrates that no single motivation strongly commands investors’ perspectives on the incorporation of climate risks into their portfolio decisions. Agreement is strongest for three motives: the protection of the investors’ reputations, their moral/ethical considerations, and their legal/fiduciary duties, two of which (protection of reputation and legal/financial duties) have both financial and nonfinancial implications. The next highest-frequency motivations are more purely financial: the ideas that incorporating climate risks into the investment process improves investment returns and reduces portfolio risks.

The second and third areas of the survey focus on implementation aspects, in particular, risk management and shareholder engagement. Our survey shows that investors take a wide variety of approaches to managing climate risks, with only a small percentage (7%) having chosen no approach to manage their climate risks during the five years preceding the survey. Although large variation exists in their approaches, the two major approaches are to conduct analyses of portfolio firms’ carbon footprints and stranded asset risks, which are employed by 38% and 35% of the respondents, respectively. Some of the respondents take these approaches one step further by attempting to reduce the carbon footprints (29%) or stranded asset risks (23%) of their portfolios. Investors also use other forms of climate-risk management such as incorporating climate risks into their valuation models (26%) or hedging against climate risks (25%). From the list of 12 possible approaches, the least frequently used tool is to divest problematic portfolio firms, which is employed by 20% of the investors. The large heterogeneity across investors suggests that the industry is still in the process of finding the most effective ways to manage climate risks.

Institutions more concerned about the financial costs of climate risks use a wider range of tools to manage risks associated with climate change. Additionally, investors with longer horizons, and institutions with a higher fraction of holdings subject to ESG analysis, also engage in more climate-risk management.

The respondents typically use multiple channels to engage over climate risks. Having discussions with management is cited as the most frequently used channel (43% of respondents used this approach, with 32% proposing specific actions to management on climate-risk issues). Close to 30% of the investors submitted shareholder proposals on climate-risk issues, and a similar fraction voted against management on proposals because of climate-risk concerns. Investors that are more concerned about the financial effects of climate risks engage firms along more dimensions. Larger investors also engage firms across a wider range of channels, possibly because they have more resources to engage and they have larger firm holdings.

            Our respondents believe that equity valuations do not fully reflect the risks from climate change, although the overvaluations are not perceived as being very large. Not surprisingly, the oil sector is considered as the most overvalued sector overall, followed by traditional car manufacturers and electric utilities. Yet, the perceived misvaluation of these sectors relative to other sectors seems modest. We observe that the investor types that view more underpricing of climate risks are those with a larger share of their portfolios oriented to ESG standards and those that engage portfolio firms along more dimensions (which may explain their engagement activities).

 

Authors

Real name:
Philipp Krüger