What could climate change mean for your investments?

August 10, 2022

The effects of climate change on the environment are well known. Increasingly, though, there's recognition of its potential financial impact on the global economy and, by extension, on corporations and the markets. Without a sharp reduction in carbon emissions, temperatures could rise by over 3 degrees Celsius above preindustrial levels by the end of this century — enough to decrease global GDP by an estimated 25%, according to the Group of Thirty,¹ a nonprofit assembly of experts focused on global economic risks.

Considering the direct threat it poses to global GDP and prosperity, "Climate change will likely become a more central feature of corporate decision-making in the years ahead," says Jonathan Kozy, senior macro strategy analyst in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank. And with conflicts overseas creating ongoing supply chain disruptions and higher costs for fossil fuels, “Geopolitical risk raises the imperative for sustainable, supply chain-resilient energy solutions,” says Sarah Norman, senior investment strategist in the Chief Investment Office for Merrill and Bank of America Private Bank. “It creates an opportunity for green energy to help countries pursue energy independence.”

"For investors, these trends suggest making environmental considerations a part of their long- and short-term portfolio strategies," Norman says. "Companies that embrace climate-friendly business models, operations, products, and services, are likely to experience the potential for sustained growth opportunities over the long term.” One report, for example, finds companies that reduce the costs of resources such as water, carbon and raw materials may improve their operating profits by up to 60%.² Companies that fall behind, meanwhile, could risk greater costs due to regulation. That same study estimates that as much as a third of corporate profits are at risk from state intervention.

Fortunately, “As the scale of the impending environmental crisis has come into clearer focus, the universe of viable climate-related investments has expanded,” Kozy says. Environmental, social and governance (ESG) choices offer opportunities to help investors mitigate the portfolio risks created by the long-term effects of climate change and benefit from the growth potential of cleaner industries, even as they help the planet. Here, Kozy and Norman, two of the co-authors of the CIO report “Sustainable Investing: A focus on the ‘E’ in ESG,” discuss some of the strategies you might consider.

3 approaches: The ABCs of environmental investing

Investors interested in incorporating the "E" in ESG into their investing strategy might consider the "ABC Framework," three distinct approaches to environmental investing as outlined by the Impact Management Project (IMP), an organization that provides a forum for building global consensus on measuring, managing and reporting impacts on sustainability, says Norman.

Avoid. Among the earliest forms of ESG investing, this approach involves screening out certain companies or industries based on practices an investor deems harmful. "This could include reducing or eliminating exposure to carbon-intensive industries, divesting from those that you believe are engaging in harmful deforestation or otherwise harming biodiversity, or reducing your exposure to companies or industries that consume major amounts of natural resources," Kozy says. Such companies and industries could face stiff environment-related costs, especially at a time of heightened regulations. And those risks are only intensifying. “In March of 2022, the U.S. Securities and Exchange Commission formally proposed new rules that would, for the first time, require businesses to report their greenhouse gas emissions, along with details of how climate change is affecting their businesses,” Kozy says.³

Benefit. This involves investing in companies, regardless of industry, that are leading by example, incorporating environmental practices into their governance — and providing visibility into their efforts via ESG metrics and disclosures, Norman notes. For example, companies may demonstrate the ways their practices align with the guidelines such as the United Nations' Sustainable Development Goals (SDGs), the Task Force on Climate-related Financial Disclosures (TCFD) or the Sustainability Accounting Standards Board standards. In 2020, the World Economic Forum's International Business Council, chaired by Bank of America CEO Brian Moynihan, announced a set of "stakeholder capitalism metrics" designed to standardize ESG reporting across industries and regions.

"Doing so can benefit companies by mitigating the potential costs of regulatory and government pressure, as well as risks to their reputations," Norman says. Positive environmental practices could also make such companies more prosperous and hence potentially stronger investments. In one survey, 70% of consumers said they were willing to pay a 5% premium for a "green" product, compared with a similar non- green alternative.⁴ “Companies with a strong environmental strategy may differentiate themselves from the competition and find it easier to attract, retain and motivate talented workers," Kozy says.

Contribute. The final group includes companies and industries whose products or services are dedicated to helping mitigate climate change. "These might include resource-efficient or alternative energy, smart grids, electric vehicles or innovations in food, agriculture, forestry and clean water," Norman says. Renewable energies offer one clear example, she adds. "Between 2009 and 2020, solar energy costs fell by 90%, while utility-scale wind energy costs declined by 71%, making them competitive with conventional power generation.”⁵ “Geopolitical conflicts, if anything, add to the attractiveness of renewables. “Higher fossil fuel prices raise the relative competitiveness of green energy, where costs had already significantly come down,” Norman adds.

Choose the appropriate level of risk for you

The specific investments you choose may depend on your return expectations and your appetite for risk, Kozy says. For example, green bonds, an environmental community loan fund, or municipal bonds focused on sustainable cities or the transition from traditional to renewable energies may offer a modest return in exchange for relatively low risk. Other approaches, such as stocks in companies driving environmental solutions or private equity investments in renewable energy, may offer higher return potential in exchange for greater risk.

As with any investment strategy, it's important to consider any environmental investments in the context of your overall assets and your personal financial goals, Kozy says.