How investors can manage the risks of climate change

August, 2022 Print

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Jim Whittington, Head of Responsible Investment and Senior Portfolio Manager, Dimensional Fund Advisors.

Jim Whittington at Dimensional Fund Advisors sets out some basic principles for investors contemplating how their choice of investments should take account of climate change


There are many reasons why investors care about climate risks
Concern for the environment might be the most obvious, but many investors also believe that long-term risk management must incorporate climate risks; be they the physical risks of a warmer planet, or the transitional risks as we adapt to a carbon-neutral economy. Regulators around the world are also demanding better management and disclosure of sustainability risks. When it comes to addressing exposure to climate risks in a portfolio, we think investors should start by applying several basic principles.

Acknowledge market prices incorporate material risks
Ample empirical research supports the belief that market prices are forward-looking and incorporate the collective views of market participants about material risks and opportunities. There is no reason why climate risks and opportunities should be an exception.

Much about climate change is still unknown. But given two otherwise identical businesses, if one is expected to become less competitive as new climate regulations are enacted, or the physical impacts of global warming are expected to pose a greater risk to its operations, market participants will surely apply a lower valuation to that business. And as new information becomes known about expected global warming, the policy response or other material developments, prices will adjust.

Given the uncertainty involved, there is much debate about whether climate change risks are priced correctly by the market. This debate is not unique to climate change risks. After all, the future is uncertain. But this uncertainty doesn’t mean that markets systematically underprice climate risks. Numerous studies show investors have a poor track record of outguessing market prices and the collective wisdom of the market is typically better than any individual investor at pricing risks and opportunities, including those related to climate change.

Diversify
The effects of climate change may be far-reaching and global in scope. For some companies, the risks associated with climate change are material for their businesses. For other companies, changes in technology and consumer preferences represent very real opportunities. Stated simply, the potential risks and opportunities of climate change differ across regions, companies, and industries.

By diversifying across geographies, exposure to company-specific physical risks (such as localised flooding) is reduced. By diversifying across companies and industries, exposure to company-specific transitional risks (such as changes in consumer preference for a company’s products) is also reduced.

Diversification can also bring opportunity. If some assets become stranded, others may become more valuable; if some business models become obsolete, others will become more dominant. A diversified portfolio will hold both winners and losers from the climate transition.

 

 

Exercise active ownership
Boards that truly represent the interests of shareholders should pay attention to material climate-related risks and opportunities. Shareholders can elect board members that have the appropriate skills to oversee and mitigate climate risks and can vote against directors whom they believe are not providing effective oversight.

Sustained, ongoing dialogue with portfolio companies can make a difference. When a portfolio company’s oversight of climate risks, or disclosure of those risks, seems unclear or inadequate, engagement is an effective avenue to start raising concerns.

Consider reducing investments in companies with higher emissions
Investors that follow these steps should be well-equipped to manage material risks in general. When it comes to certain categories of climate risks, however, some investors may have specific concerns.

Some companies generate much of their revenue from extracting or burning fossil fuels. For investors who prefer less exposure to the types of risk these companies bear, reducing or eliminating exposure to them may be appropriate. While we believe these risks are reflected in market prices, our experience suggests it is possible to reduce an investment strategy’s allocation to such companies while maintaining broad diversification and sound investment principles.

We must recognise, however, that divestment alone may not address climate change. In fact, there may be unintended consequences. For example, if investor action were to force fossil fuel assets into the hands of owners with lower environmental standards and less oversight than public companies, climate change and the associated risks may worsen. Governments, consumers and producers all have a critical role to play in curbing emissions.

Risks linked to climate change are significant, but existing tools associated with sound portfolio risk management are a good place to start: using market prices, diversifying, and encouraging strong corporate governance.


 

Dimensional is a leading global investment firm that has been translating academic research into practical investment solutions since 1981. Guided by a strong belief in markets, we help investors pursue higher expected returns through a systematic investment process that integrates research insights with advanced portfolio design, management, and trading while balancing tradeoffs that can impact returns. Dimensional is headquartered in Austin, Texas, and has 14 global offices across North America, Europe, and Asia. As of June 30, 2022, Dimensional manages $575 billion for investors worldwide. For more information, please visit dimensional.com.

Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA) – Firm Reference No. 150100. This document is provided to LAPF Investments for information purposes and intended for your use only. It does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. Any entity responsible for forwarding this document to other parties takes responsibility for ensuring compliance with all financial promotion laws, rules and regulations. Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, but DFAL makes no representation as to their accuracy or completeness. DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document. DFAL accepts no liability for loss arising from the use of this material. DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language. “Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

Risks
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

 

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