By Thomas Kuh
ESG investors must factor in anti-ESG backlash, the investment impact of climate events and pending SEC climate regulation
As the 2024 U.S. election cycle takes shape, we are starting to see a rise in the volume and intensity around the climate change debate, specifically on three climate-related issues: anti-ESG backlash; the investment impact of climate events and pending SEC climate regulation.
While it can be discouraging to see material investment considerations on ESG risks become partisan talking points, it is important to be aware of the issues. Here’s a closer look at three crucial topics:
1. Anti-ESG backlash
Based on investment researcher Morningstar’s framework, climate-related investing is one dimension of sustainable investing, which also includes ESG and impact funds. These funds have existed since the 1990s, steadily growing in popularity.
Growing popularity also has brought growing political interest, as a series of U.S. state legislatures have introduced legislation to prohibit state entities from doing business with asset managers who have ESG funds and integrate ESG analysis into their investment process. This campaign has been met with mixed results but is probably not going away soon — or at least not before the 2024 election.
It appears ESG investing was politically targeted because it symbolizes how investors have shaped the trajectory of the financial markets over the past two decades. But the growing popularity of sustainable funds also reflects larger transformations taking place in the global economy. So, despite legislative attempts to curtail certain investment practices, ESG analysis and climate-related funds meet the needs of a growing segment of investors. Ultimately, these choices are best left in the hands of investors, who should not be deterred by attempts to limit their investment options for political reasons.
2. Investment impact of climate events
Almost daily, dramatic weather events remind us of the disruptive impact of climate change and keep the topic in the news. More subtle changes like the thawing of the Arctic ice cap and growing scarcity of water to meet the needs of communities and farmers in the Southwest and Western U.S. continue their slow boil.
How can we assess potential investment risks posed by weather? Investment risks related to climate change are typically classified as physical risk and transition risk. Physical risk is damage to property, infrastructure and other real assets from events like flooding, wildfires and hurricanes. Transition risk is the financial impact on companies driven by competitive forces as the economy moves away from fossil fuels toward alternative energy sources.
Regardless of whether a particular industry is directly affected by these risks — as is the case for utilities and automobiles — climate change is impacting every industry to some degree. A company’s financial fortunes may depend on how the energy transition affects the industry it operates in and how well it is prepared for the energy transition relative to its peers.
Investors can choose to play these trends proactively by gaining exposure to companies they believe are positioned to benefit. Or they may want to avoid companies that might be on the wrong side of this trend.
How to make these decisions is not always obvious. For example, some traditionally carbon-intensive companies might actually stand to benefit from the fossil fuel transition due to strategic changes they are making to their business model, like a utility embracing renewable energy sources. Other companies or industries positioning themselves as forward-looking may actually be big carbon offenders.
A range of sustainable investment strategies are available to help investors express their climate-related views. Options include broadly diversified funds: low carbon; ex-fossil fuels, and climate transition funds. There are also green bond funds and thematic alternatives, such as clean energy and climate solutions funds, intended to capitalize on the climate-related opportunities as the economy transitions. It’s up to you how you interpret your investment approach in relation to these developments.
3. Pending SEC climate regulation
The regulatory side of U.S. policy relates to proposed SEC disclosure rules. The SEC’s mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” On the premise that climate risk is investment risk, and therefore financially material, proposed regulations would require companies to publicly report on their current carbon emissions and future plans. The new rules would systematize how companies report this information, providing investors with greater transparency and more decision-useful data to assess climate risk.
Another set of proposed SEC rules is aimed at naming rules for fund managers offering “green” or “sustainable” investment products. These rules are designed to ensure that fund managers accurately name their funds and describe how their processes contribute to the funds’ sustainability investment objectives. In other words, they intend to ensure that investors are getting what fund managers are selling.
Increased transparency about financially material issues is good for investors. These new rules are not without their costs, but the SEC believes the benefits outweigh them. The SEC’s decision on the proposed rules is expected this fall.
Thomas Kuh is head of ESG Strategy at Morningstar Indexes.
More: Oil stocks could outshine clean-energy shares under this climate change scenario
Also read: The next president will have to navigate a tax and debt minefield
-Thomas Kuh
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09-27-23 1511ET
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