While the pace of climate change is a matter of some debate, most would argue that our path of travel is not.
We are headed toward a hotter, drier world, with more frequent extreme weather events. The impacts will extend to all facets of life, including investment management. The National Climate Assessment, released in late 2018, observes that changes in climate are already being felt and predicts severe damage to the U.S. economy should we not undertake significant mitigation efforts.
As investors, our primary job is to predict the future. This means that we are compelled to develop a deeper understanding of the growing body of research that lies at the intersection of company financial information and climate science if we are to paint a robust picture of companies’ future risks and opportunities.
A key question we need to answer is which companies are likely to successfully adapt to a future physical environment that looks different from that of today. We need to find companies that are best positioned to weather the future storm — a bad pun but a very real investment challenge.
The good news is that many corporations are taking the lead on environmental initiatives, not because they were told to do so but because they believe it is the best way to position their businesses for success. Proactively addressing climate-related challenges can help reduce future costs and gain new customers with the obvious objective of bolstering earnings. Importantly, these organizations are choosing to evolve rather than be backed into a corner by changes in regulations or technology.
Let’s take the example of one of the main themes outlined by the Climate Assessment: water.
Increased risk of water stress, rising water temperatures, saltwater contamination, flooding and drought are just some of the consequences of climate change. Companies producing new technologies aimed at water conservation, filtration, wastewater treatment, desalination and water recovery have every reason to believe that demand for their products will only increase with time.
For companies with business operations that are highly dependent on water, those taking active steps now to reduce their water dependence will be better positioned than slow-moving peers. Moreover, they will drive demand as customers of businesses that make “green” products and services. More efficient use of water should ultimately lead to lower operating costs, giving them an important competitive edge.
A final dimension is the physical risk associated with areas affected by severe water problems. If a supplier is located in a place that increasingly experiences severe flooding, the effects of an interruption to production will be felt down the supply chain. Drought, for example, has the potential to increase the price of soft commodities that are used as inputs to production for other businesses. Here we see physical risk translating directly into increased costs for companies and ultimately consumers.
By viewing companies through a climate lens, such as water stress, we can augment our traditional investment view that is anchored on financial statement analysis and factor in the proactive steps that companies are taking (or not taking) to gain a more nuanced assessment of a company’s fair value and future earnings potential.
Of course, water represents just one climate-change theme, and every industry will be impacted by climate change in some way. This is why it’s more critical than ever that investors think through its impacts and understand where future demand for products will reside, as well as how risks will affect the ecosystem of global companies.
How we collectively choose to combat climate change, as well as the magnitude, timing and unevenness of its effects on the natural world are yet to be seen. One thing we do know is that there will be companies that emerge as winners, while others will lose out. Those who ignore this reality are overlooking one of the key investment questions of our time.
— By Kathryn McDonald, head of sustainable investing, Rosenberg Equities, AXA Investment Managers