ESG investing
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Recent wildfires in Canada, the U.S. and Australia, drought in Europe and flooding across Asia have affected investments around the globe. As a result, portfolio managers are adjusting how they approach climate risk.

In particular, they’re assessing physical and transitional risks.

Regarding physical risks, Sarah Neilson, managing director and senior portfolio manager for North American equities with RBC Global Asset Management Inc. in Toronto, said her team looks at companies’ asset concentration, preparedness for extremes, risk assessments done by management and boards, cost allocations, and employee training and safety preparation.

Take insurance companies. Neilson evaluates where they provide coverage in coastal areas or areas with potential for forest fires. “We know insurance companies use large models to think about their risk potential as they underwrite policies, so how are they modelling those risks over the near and long term?”

Transitional risks to climate change, such as regulatory changes, are becoming easier to identify, she said. “For instance, rising carbon costs are getting considered in long-term and discounted cash-flow models,” she said, meaning some companies may have an advantage over others.

Mike Harut, partner and responsible investment manager with Munro Partners in Melbourne, Australia, said the time horizon for both physical and transitional risks has not changed. However, there are risks for investors who recognize long-term issues but adjust portfolios too quickly.

“It’s difficult to predict exactly if and when a severe weather impact will occur,” Harut said. “Markets may also consider some of these issues one-offs and continue to ignore them in valuations. Investors who don’t think they are one-offs might lower their valuations and reduce or sell these positions. So it does suggest that active management has a role to play here.”

Evaluating sectors

Severe weather will affect some sectors more than others.

Neilson noted that drought in Panama would affect companies that ship goods through the canal there. As well, forest fires would impact companies that depend on lumber or rail freight in affected areas.

“Coastal areas have seen impacts on infrastructure, building, engineering and design, and they’ll require adaptation,” she said. “[We’re] understanding how businesses are designed and changing around that, [and] how capital costs will be impacted over the long term.”

Neilson analyzes these impacts by looking at company disclosures and actively engaging with management: “While difficult to forecast, we seek to understand their ability to insure assets where vulnerable, avoid concentrating risk of these exposures, plan for future capital development to address these potential scenarios and address changing regulatory rules,” she said.

Meanwhile, utilities positioned in heat zones face increased fire risk. “Hawaiian Electric is alleged to have contributed to the deadly fires in August 2023 by failing to shut down power lines in Maui, despite hurricane-force winds that could knock them down and start fires,” Harut said.

In some cases, utilities providers are “being asked to improve their systems to avoid being at risk for some of these extreme weather scenarios,” Neilson said. “That can provide utilities with a growth platform. These investments support earnings and reduce risks for customers and investors.”

Harut agreed. Quanta Services Inc., a Texas-based company that develops electricity grid infrastructure, has benefited by building the type of grid “needed for a decarbonized future.”

Companies investing in water infrastructure, such as New York-based Core & Main LP, could see benefits. “They not only see opportunities from the decade-long underinvestment in U.S. water infrastructure, they also see climate resilience as a growing priority for municipalities,” Harut said.

The HVAC industry also has built systems to meet increased demand. This adds a cost to building owners, but also is an opportunity for companies such as Texas-based Comfort Systems USA Inc., which provides and installs energy-efficient HVAC systems. “These companies help increase the energy efficiency of buildings and their climate-change resilience,” Harut said.

Outside of infrastructure, the fine-wine industry has experienced both positive and negative impacts from climate change.

Some historically cooler regions, such as England, have benefited from warmer temperatures, leading to increased demand for English sparkling wine, said Atul Tiwari, CEO, Americas, with Cult Wines Ltd. in Toronto. “We’re seeing big champagne brands, like Taittinger and Pommery, making investments in the region.”

But other regions have experienced wildfires and frost, resulting in reduced wine production and higher prices.

For example, the 2020 wildfires in California resulted in zero production for companies such as Cardinale Winery and La Jota Vineyard Co., resulting in a net loss of about $3 billion for the industry, Tiwari said. In 2021, most production in Burgundy, France, was destroyed due to frost. Both events caused fine wine prices to rise.

“Knowing that the quantities were going to be lower in 2021 in Burgundy, we shifted our buying and trading strategy to focus more on vintages of previous years, like 2016,” Tiwari said. “We ended up buying more of those vintages, knowing they will go up in price because people who are looking to buy 2021 can’t find it or it’s too expensive.”

Harut said the key to positioning investment portfolios to benefit from climate change is to focus on companies that will be “winners from this multi-decade structural change. Investors need to actively [invest] in companies that provide solutions,” he said, and not just reduce holdings in companies that “cause the problem.”

This article appears in the March issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.