Climate change has become one of the most important financial risks in the context of sustainable investments based on ESG criteria. Many investors focus primarily on emitters of greenhouse gases or companies with large fossil fuel reserves.
In principle, there are two ways for investors to act if they want to reduce the risks of transition to a low-carbon economy. Firstly, investments could be based on ESG indices that substantially exclude emitters of greenhouse gases or companies with extensive fossil fuel reserves. Indeed, ever-increasing numbers of investors are undertaking to disassociate themselves from investments in fossil fuels. This trend toward disinvestment began with the endowed US universities and colleges. In recent years, the total assets of the institutions that have committed to divesting themselves from such investments have significantly increased. However, there are several points to consider. For one thing, universally excluding such companies deprives investors of the opportunity to influence the corporate business policy, with investor meetings and their own voting behaviour at annual general meetings.
Apart from that, excluding companies with high CO2 emissions or reserves of fossil fuels in no way protects an investor from climate risks - in fact a wide variety of companies outside the oil, gas and energy sector are potentially affected. In addition, excluding certain equities may result in a lower risk-adjusted return and less efficient portfolio diversification.
It can therefore make sense to pursue other strategies that are not targeted at exclusion. Instead of completely eliminating all affected companies, the divestiture can be limited to companies that are committed to developing new carbon-rich energy reserves or that do not adequately manage climate risk. Alternatively, companies that are best prepared to
manage the transition to a low-carbon undertaking could be prioritised. Studies have shown that an investment opportunity may exist if an investor becomes committed to companies and in this way drives for orientation towards a low-carbon future. In this way, it is possible for the investor to influence the business strategy, capital structure and numerous ESG issues, even including the risks of climate change. In January 2018, 256 investors, with US$28 trillion of assets under management, launched the Climate Action 100+ initiative. The objective, over five years, is to achieve greater awareness of climate risks in the corporate management of the largest greenhouse gas emitters and to reduce CO2 emissions. Studies have shown that such a commitment can have positive effects on the trend of the share price. The positive effect was particularly clear when the investors‘ commitment was focused on corporate governance and the reduction of climate risks.
Investors can implement this strategy in their portfolios by using various index concepts. For example, the index provider MSCI has combined various components in its ESG Leaders Low Carbon index. The „ESG Leaders“ include the companies with the highest ESG ratings relative to their sector. Companies with activities in areas such as alcohol, gambling and nuclear energy are excluded. The Low Carbon indices are structured so that the companies they include have a carbon „footprint“ that is at least 50% lower than the broad market index. This means that the companies with the highest greenhouse gas emissions and the largest fossil reserves have been excluded.