Understanding Climate Risks and Opportunities

The world's ecosystem is under threat by climate change, and as an investor, there are multiple risks to keep in mind

Catherine Elliott 12 May, 2022 | 11:15AM
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Earth and its environments

It’s hard to understate the severity of the current climate crisis facing the world. The latest roundup of scientific evidence draws an unequivocal link to human-caused atmospheric greenhouse gas emissions—primarily from the burning of fossil fuels— which is negatively impacting natural climate systems at an alarming rate.

The financial impact of climate change cannot be understated either. The current warming trajectory could wipe out 11% to 14% of global gross domestic product by mid-century, not to mention the myriad of climate-related risks that might affect companies and investors.

Given the urgency to cut greenhouse gas emissions, companies in fossil-fuel-related industries or with carbon-heavy operations are under pressure. Governments, civil society, and the private sector are mobilising—taxing carbon, incentivising renewable energy, even divesting from fossil fuels in a bid to reduce emissions before it’s too late.

The race to net zero emissions is well under way. But as we head towards a low-carbon economy, and with the ever-present threat of irreversible climate change looming, what does this all mean for today’s investors?

Physical and Transition Climate-Related Risks: What Investors Need to Consider

Climate-related risks can be thought about in two ways – physical and transitional. Physical risks are those arising from the increased severity and frequency of extreme weather changes caused by rising temperatures and sea levels - like increased capital costs due to damaged facilities, for example. This is leading to greater scrutiny of the location of companies’ properties, plants, and equipment.

Transition risk is also critical - the shift away from carbon intensive fossil fuels will render many business models obsolete unless they undergo transformational change. Transition risks can include policy and legal regulations, limiting or putting a price on carbon emissions, the costs associated with switching to new technologies, and changing consumer preferences as firms are pressured to align their strategies with the Paris Agreement (which aims to reduce global warming to well below 2°C above pre-industrial levels).

But it’s not all bad news. While climate-related risks are undoubtedly significant, financial markets have a huge role to play in plugging the financial gap in the race to net zero and as such, stand to offer investors great opportunity too. The International Energy Agency estimates that annual investments in clean energy and infrastructure will need to more than triple by 2030 to around USD 4 trillion (EUR 3.8), in order to set the world on a 1.5°C path. They include huge investments in clean energy, energy efficiency, methane emission cuts from fossil fuel production, and clean energy innovation.

Sustainable Investing Continues its Momentum - Especially in Europe

Thankfully, what was once considered as a niche investment area is fast gaining more attention as investors of all sizes incorporate sustainability considerations into their investment decisions. 2021 saw European investors continuing to pour vast amounts of money into sustainable funds — according to Morningstar asset flows data, inflows reached an all-time high of EUR 20 billion and assets surpassed EUR 1.3 trillion.

Regulations and policy also have a role to play in the increased demand for sustainable investments in Europe. The EU’s Sustainable Finance Action Plan targets net zero by 2050, with the aim of making Europe the first climate-neutral continent. The 10-point plan entails cutting emissions by at least 55% by 2030 and reorienting capital flows toward sustainable investment, while managing financial risks stemming from ESG issues.

It also ensures companies and investors are aligned to its long-term sustainability goals, marking a massive shift in the way governments have thought about the need to regulate capital markets. The Action Plan goes beyond traditional investor protection, aiming to harness financial markets as part of a broader policymaking agenda promoting sustainability as core to economic growth and societal benefit.

Evidently, efforts are ramping up across the board. Climate change may have emerged as one of the biggest systemic risks posed to investors, but it also presents a major opportunity and one that will completely reshape financial markets. Investors have a critical role to play, whether driven by a desire to advance the low carbon transition, or purely by risk mitigation goals.

Morningstar Can Support Professional and Individual Investors

Given the urgency around climate change, the shift to a low-carbon economy is both essential and imminent. Businesses must adapt if they want to survive and thrive in the face of physical risks and low-carbon transition risks, and firms must support their investors through both climate-related risk and opportunity.

Morningstar and Sustainalytics have an extensive suite of solutions, research and ratings to help professions during this transition period. To find out more, you can download our free guide - Understanding the Climate Crisis: Supporting Investors Through Climate-Related Risks and Opportunities.

Want to learn more about climate-related risks and opportunities?

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Catherine Elliott  is a content writer at Morningstar