Why long-term investors need to think long and hard about climate change risks

The first thing to note is that there is no is disagreement that temperatures are going up. There are disputes about causation, and it’s an emotive issue in some quarters, but the fact remains, the world is getting hotter.

The second thing is that this presents a real risk for financial portfolios. Analysis here is not a choice, if you are looking at the risks of your investments, every investor should be considering the effect of the climate. The effects are both direct and indirect, and they can affect every part of the balance sheet, and future cash flows of a company. In terms of direct risks right now, you need to think about extreme weather events and the chronic effects of rising temperatures. You need to think about the assets around the world with physical capital that could become impaired, and about companies like insurers whose liabilities are related to such physical damage. These are both short and long-term considerations.

Secondly there are the other possible effects of transition risk. There are legal and policy changes that are already underway that will affect whole business models, affect liabilities, and possibly lead to stranded assets. In terms of market changes, if carbon pricing is introduced - where market mechanisms are used to pass the cost of emitting on to emitters - there will be profound consequences for asset prices. Changes are being driven not just by policy makers, but by consumer preference; we are already seeing how this, as well as reputational risk can affect a wide variety of different companies.

Clearly, this is serious issue, and it’s something that every investment manager should be thinking about. Those who are not, will be forced to do so by regulation. If you are a responsible investor there are two sides to explore; there’s the risk management, but there is also the need to think about investing sustainably, and this can be a source of real opportunity to add return. While the main focus at the moment is on risk mitigation, there are definitely opportunities, from resource efficiency to new energy sources. Capital flow is already heading towards areas like these, and that directly affects your cost of capital, so even just considering momentum and capital flows there are impacts for portfolios.

Climate change and sustainability is something that we think about carefully across all of our holdings, and we work closely with our managers to understand their own approaches. But it’s also important to understand that this is one risk among many in portfolio management. All of the typical fundamental valuation risks are still present in markets, some of course are particularly heightened at the moment. Valuation matters. You can look at a company that will do good for the world, but the valuation has to make sense. That’s one danger at the moment across markets, a lot of assets are being priced for perfection, and if perfection doesn’t happen you don’t have that margin of safety built in. For our portfolios the long term risks of climate change definitely need to be managed, but we certainly still have valuation risk at the core of our approach to protect wealth for clients in the long term.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.