- Investors are increasingly adjusting portfolios for climate change, though many haven't yet acted.
- Ignoring climate risks might lead to missed opportunities and affected medium-to-long-term performance.
- Climate-friendly investing includes reducing risks and targeting companies with sustainable strategies.
Several investors are adjusting their portfolios to take climate change into account. However, many others are still waiting around the block for reasons more than one. Unfortunately, we're approaching the days when no one can afford to ignore climate change any longer — whether or not you can see the risks coming down the pike.
Greening your portfolio is about more than shedding fossil fuels or other companies that don't consider climate change. It's also about investing in a socially responsible portfolio or companies you feel good about.
Taking a more climate-friendly view with your investments is about reducing the climate-oriented risks that could affect your investments. Those who continue to ignore this issue may also give up some performance in the medium-to-long term as more and more investors shift to climate-friendly holdings.
Reducing climate risk in your portfolio
One of the more challenging reasons everyone needs a climate-friendly portfolio is the significant risks associated with investments that don't consider climate change. Even companies that seemingly have nothing to do with climate change face potential threats from increased severe weather if they don't take steps to mitigate their own risks.
For example, utility companies are increasingly facing threats from severe weather. Additionally, they may be (and have been) held responsible for wildfires in certain situations, like if they don’t update their equipment. This adds climate-oriented legal risks to the threat of droughts that increase the risk of fires.
On the other hand, some climate risks can be seen a bit more clearly. For example, if electric vehicles are the future, companies that depend too much on legacy automobiles might risk being left behind, at least temporarily. New technologies that are lowering the cost of EVs and renewable energy will also be the future of climate solutions, presenting another corner of the market where investors might look for potential investments.
“The macro trends of electric vehicle and renewable energy adoption create opportunities for technology providers to bring more efficient and lower-cost solutions to market, directly impacting and benefitting from the electrification associated with addressing climate change,
added Dan Brdar, president, and CEO of Ideal Power.
Further, fossil-fuel companies that aren't investing in alternative energy sources or decarbonization also face the risk of being left behind as the transition shifts into high gear.
Other potential climate risks include those from climate-related regulatory changes, technology and consumer behaviors.
Investors may give up some returns
As the world strives toward a net-zero future, investment dollars and returns are shifting toward climate-friendly investments.
According to Morningstar, global demand for climate-oriented funds is surging. Assets under management (AUM) by climate-focused open-ended funds and exchange-traded funds (ETFs) soared 16% to $540 billion at the end of 2023 due to ongoing inflows, market appreciation, and product launches. Climate fund assets have been growing faster than global sustainable funds, now accounting for nearly 20% of the total coverage.
Europe, where climate-related regulations squeeze companies and firms, accounted for the lion's share of global climate-fund assets, at 84%. Morningstar found 875 climate funds in Europe at the end of 2023 versus just 135 in the U.S. Investors may want to consider whether this trend in Europe will eventually forecast what could happen in the U.S. over the coming years.
As a result of this shift, investors who don't factor climate change into their investment portfolios may lose out in the near future.
According to Morningstar, assets in climate-transition funds, which invest in companies that consider climate change in their business strategies, exploded 133% year over year to hit $8.8 billion at the end of 2023. Such funds recorded inflows of $3.7 billion over 2023.
At the very least, climate-oriented exchange-traded funds (ETFs) are currently keeping up with their more broad-based counterparts — for now. For example, the SPDR® S&P 500 Fossil Fuel Reserves Free ETF (NYSE:SPYX) (which measures the performance of fossil fuel-free companies) has gained 40% over the last year, compared to 39% for the SPDR Portfolio S&P 500 Value ETF (NYSE:SPYV).
However, this could change based on the flow data we're seeing and the growing number of climate-related risks descending on companies and industries.
How to green your portfolio
It may seem that the easiest way to combat climate change in your investment portfolio is to divest from assets that aren't climate friendly. However, that's just the first step.
Morgan Stanley offers different ways to approach climate change intentionally in a portfolio. The first is restriction screening, which means divesting positions in or avoiding any companies tied to fossil fuels or that emit high levels of greenhouse gasses.
The second step is to incorporate environmental criteria into your selection process and consider financial metrics. This step also helps reduce climate-related risk in your portfolio.
For a diversified portfolio, you'll want to look at these criteria from multiple angles. For example, you might look at something as simple as a company's carbon footprint or use of natural resources. Other approaches include examining the amount of revenue that comes from products or services that provide climate-related solutions.
The third step involves selecting companies that offer decarbonization solutions and technologies to address the changing climate and position for upcoming opportunities in a net-zero world. Sometimes it pays to get creative about where to look for potential buy-the-dip opportunities.
"Environmental concerns aren't just driving a transition to on-land EVs," said Alexandre Mongeon, CEO of Vision Marine Technologies. "Boat electrification reduces air pollution and the health problems it causes in those living along our world's waterways, an issue that's become particularly prevalent in port-side communities with heavy traffic. As a result, the global electric boat market is expected to grow to $18.9 billion by 2034."
Aside from intentionality, Morgan Stanley also notes the importance of potential activism or shareholder influence over corporate behavior. When investors push for change at a company, it's not unusual for management to enact the called-for changes, which may include climate-related actions.
ETFs and mutual funds versus individual stocks
If all this sounds a bit daunting and you don't have a financial advisor to guide you, there are some easy ways to target climate-friendly holdings on the stock market. A wide array of exchange-traded funds and mutual funds provide easy access to portfolios of companies that address climate change in a variety of ways.
However, diversification among funds is best, so it might not be wise to hold multiple funds that approach this issue from the same angle. For example, many funds provide access to clean energy or electric vehicle stocks, while others, like the one mentioned above, focus on fossil fuel-free companies.
It's generally a good idea to examine each fund's top holdings to see how much overlap there is so that you can avoid investing in the same companies repeatedly through multiple funds.