Many investors prioritize addressing climate change but still aren’t sure how. Portfolio manager Andrew Harmstone discusses strategies to align portfolios with the Paris Agreement.
COVID-19 has commanded investors’ attention over the past year, but long-term global warming remains one of their biggest concerns because of the economic, societal and environmental risks. Indeed, among allocators practicing thematic or impact investing, climate change is the dominant theme, according to a survey of asset owners issued last year by Morgan Stanley Investment Management and the Institute for Sustainable Investing. Despite high levels of interest, however, many investors say they lack strategies for how to address climate change in their portfolios.
To explain how investors—specifically stock market shareholders—can overcome a steep implementation curve to help combat climate change, we asked Andrew Harmstone, Lead Portfolio Manager of the Global Balanced Risk Control Team, who oversees $24.1 billion in multi-asset portfolios at Morgan Stanley Investment Management. He shared how allocators can align their equity investments with the Paris Agreement, part of the United Nations Framework Convention on Climate Change, and its objective to limit the global temperature increase to well below 2 degrees Celsius in this century while pursuing means to limit the increase even further to 1.5 degrees Celsius.
Andrew Harmstone: It’s an all-hands-on deck situation. Effectively addressing climate change requires cooperation from all parts of society. That’s the role in which stock investors and portfolio managers can fit in the big picture of dealing with this critical problem. The Paris Agreement is important because it’s a form of policy that companies and portfolio managers can adopt individually, without necessarily having to coordinate with each other directly; when firms are natural competitors, collaboration even on such important topics may not come easily. In other words, the Paris Agreement provides the impulse for a form of collective action, even before any formal organization between investors.
Q: How can stock market investors and portfolio managers align their investments with the Paris Agreement?
Harmstone: There are different ways of approaching this. The first is reducing or excluding investments in companies that are highly exposed to climate-change risks, or other vulnerabilities associated with social or governance issues. The main goal of this strategy is to mitigate the risk of loss in your portfolio—not necessarily to actively improve the climate-change problem.
Another approach, if you want to contribute to helping solve climate change more actively, is to tilt your portfolio toward companies that do a particularly good job of managing climate-change risks better than their peers. This involves analyzing companies’ carbon emissions, which includes direct exposure—or indirect exposure for those that facilitate the use of other companies that emit carbon—and other metrics, such as carbon intensity, which is a measure of emissions efficiency, using revenue to normalize and compare emissions across companies of different sizes. You can also seek companies that explicitly tackle environmental and social goals, which would be considered a form of thematic or impact investing.
Finally, and more difficult for many investors—because, typically, most don’t own that much of any one company—is to engage directly with company management, which is more appropriate for institutional investors who have larger stakes. In this case, the ideal approach is for an entire asset management firm to engage with corporates, rather than individual portfolio management teams to engage independently. Coordination is likely to have more impact.
Once you develop a view about how much your portfolio companies are exposed to climate-change risk, over time, you can even divest fully from the companies that are fossil-fuel producers or have a certain exposure to carbon emissions.
Harmstone: It’s simply not feasible. Carbon is too ingrained in our entire economy and the exercise would reduce your portfolio to such an extent that there would be little opportunity for investment. But investors can do this gradually to help wean the global economy off fossil fuels. When enough investors divest from companies, they can influence them to change. It’s worth noting, however, that some allocators believe that if you don’t own a company, you can’t have much influence over it and that it’s better to invest in order to press for change.
We’re starting to see different actors within the economy and government align, which signals to corporates and investors that they need to account for regulators trending toward implementing measures that facilitate a transition to a low-carbon economy.
Q: How are central banks or financial supervisors influencing investors’ contributions to the Paris Agreement goals?
Harmstone: Financial regulators are increasingly monitoring government regulations related to climate change. Other types of entities, such as central banks, are also becoming more aware of the vulnerabilities that banks and the financial system face in their exposures to sectors that may be at risk as a result of climate change. We’re starting to see different actors within the economy and government align, which signals to corporates and investors that they need to account for regulators trending toward implementing measures that facilitate a transition to a low-carbon economy. For example, the Network for Greening the Financial System is a group of 89 central banks and supervisors that includes the U.S. Federal Reserve and the European Central Bank (ECB). They have argued that climate-related changes to central banks’ operational frameworks are feasible, although there are clear challenges, for example relating to data gaps. The ECB itself is putting climate at the heart of a broader strategic review of its operations and is due to present results after the summer break.
So the early signs are encouraging, but we await further details before being able to judge the likelihood of central banks or financial supervisors influencing investors’ contributions in achieving the Paris Agreement goals.
ESG Strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.
There is no assurance that the strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks, such as currency, political, economic and market risks. Stocks of small-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes.