What investors can learn from PG&E's latest bankruptcy.
Henry "Hank" Paulson served as the Secretary of the Treasury during the 2008 financial crisis. Now he is warning about another financial crisis. This one, however, won't be caused by subprime mortgages. It will be caused by climate change.
Paulson has been warning that climate change and extreme weather events pose enormous risks to the financial markets. In addition, he sees similarities between now and just before the 2008 financial crisis in terms of a misalignment of incentives and excesses that are bringing us closer to a tipping point in the market.
He is not the only one. Rostin Behnam, a top regulator and member of the Commodity Futures Trading Commission, has stated that “it’s abundantly clear that climate change poses financial risk to the stability of the financial system.” He also cites similarities between climate change and the 2008 financial crisis.
Quantifying climate risk in the financial markets.
Extreme climate and weather events are systematic risks. These are risks that cannot be eliminated through diversification. They also affect the overall market versus a specific company or industry. You have to quantify a risk to be able to manage it. Consider Pacific Gas & Electric (PG&E) in California. They were forced to file for bankruptcy protection due to billions of dollars in liability costs stemming from wildfires. They had insurance, but not enough.
A number of financial firms are racing to improve their understanding of climate risk. Blackrock (the largest asset manager), MSCI (an investment data and analytics firm), and Moody's (a rating agency) have all initiated acquisitions to gain visibility in terms of the shocks we can expect due to climate change. The concern is that companies aren't properly hedging their risks, insurance companies won't be able to keep up with payouts, and investors will end up holding assets that are worthless or severely depreciated in value.
Insulating the financial system from shocks related to climate change.
Our financial and political systems focus on short-term results at the expense of long-term initiatives. Incentives are not aligned. Financially, you expect your investments to last for 30+ years. Most asset managers, however, are rewarded for 1, 3, and 5 year performance.
At the macro-level, central banks are starting to pay attention. Britain, the Netherlands, and France are taking the lead by discussing whether they should be requiring banks to pass stress tests that incorporate climate risks and if they can promote green policies and bonds. There is an argument that central banks are veering outside of their mandate by doing this, but in the absence of a carbon tax, central bank leaders appear to be trying to do everything in their power to shore up the financial system when market disruptions due to climate events become more common.
Economists on both sides of the political spectrum agree that a carbon tax is the most effective and efficient tool in our toolbox, but there is still no nationwide carbon tax in the U.S. Other countries have tried. Over 40 countries have instituted a carbon tax, but most are modest or limited. Voters don't like increases in energy costs even if it is offset by a carbon dividend (when carbon tax revenues pass through the government and go to taxpayers in the form of a check). And even if a carbon tax gets passed with one administration, it can be repealed by the next person to take office.
What investors can do to manage climate risk.
The private sector, including investors, can support green investing and policies. The number of investment assets that are categorized as "sustainable" has grown tremendously, but not by as much as you would expect, given the fact that most would agree the future economy will be low-carbon. Here is how to get started:
Demand better disclosure of climate data from the companies you invest in.
You can do this by engaging with companies or investing in an environmental, social, and governance (ESG) index fund that tilts more weight towards companies that are actively disclosing, engaging, and monitoring climate risks and opportunities.
Insist that the companies you invest in start adapting to climate change.
Paulson cites Colgate-Palmolive as an example. The company "reduced its exposure to climate risk by closing, relocating, or strengthening sites that were increasingly exposed to severe weather conditions as part of a larger restructuring program." Regulation will kick in at some point when the frequency and severity of climate-related events increase. The companies that invest forward and are pro-active in terms of recognizing and mitigating their climate risks will have a quantifiable edge.
Consider adding green bonds to your portfolio.
When companies and governments need money for specific projects, such as a new bridge or for expanding their operations, they can issue a bond. A green bond follows the same structure as a traditional bond, except the proceeds are used for green projects or refinancing eligible green assets. Buying a green bond helps entities transition to a low-carbon economy faster.
Be concerned about "greenwashing", but don't use it as an excuse for not getting started.
Greenwashing is when funds use the "green", "sustainable", or "ESG" label when they are not integrating these principles and factors as promised. Regulation is notoriously slow to the party, but greenwashing concerns are already on the SEC's radar for 2020.
Add an additional layer of due diligence to everything you buy and do, including your investment process.
Ensure that you have considered climate and weather-related risks in your portfolio. Morningstar, ETF.com, and others now have tools for you to understand ESG related factors. You can also choose to work with an advisor that is actively getting educated on our changing economy.
Investors have been given a false choice - you can invest sustainably or you can earn a financial return. The two are not mutually exclusive. You have more options now than ever to invest proactively with a low-carbon economy in mind and to help companies fund their transition to a sustainable future. Only once you understand and manage all of your portfolio’s risks can you capitalize on the opportunities.