Many investors prioritise addressing climate change but still aren’t sure how. Portfolio manager Andrew Harmstone discusses strategies to align portfolios with the Paris Agreement.
COVID-19 has commanded investors’ attention over the past year, but long-term global warming remains one of their biggest concerns because of the economic, societal and environmental risks. Indeed, among allocators practicing thematic or impact investing, climate change is the dominant theme, according to a survey of asset owners issued last year by Morgan Stanley Investment Management and the Institute for Sustainable Investing. Despite high levels of interest, however, many investors say they lack strategies for how to address climate change in their portfolios.
To explain how investors—specifically stock market shareholders—can overcome a steep implementation curve to help combat climate change, we asked Andrew Harmstone, Lead Portfolio Manager of the Global Balanced Risk Control Team, who oversees US$24.1 billion in multi-asset portfolios at Morgan Stanley Investment Management. He shared how allocators can align their equity investments with the Paris Agreement, part of the United Nations Framework Convention on Climate Change, and its objective to limit the global temperature increase to well below 2 degrees Celsius in this century while pursuing means to limit the increase even further to 1.5 degrees Celsius.
Q: Why do you think it’s important for investors to contribute to the Paris Agreement’s goals?
Andrew Harmstone: It’s an all-hands-on deck situation. Effectively addressing climate change requires cooperation from all parts of society. That’s the role in which stock investors and portfolio managers can fit in the big picture of dealing with this critical problem. The Paris Agreement is important because it’s a form of policy that companies and portfolio managers can adopt individually, without necessarily having to coordinate with each other directly; when firms are natural competitors, collaboration even on such important topics may not come easily. In other words, the Paris Agreement provides the impulse for a form of collective action, even before any formal organisation between investors.
Q: How can stock market investors and portfolio managers align their investments with the Paris Agreement?
Harmstone: There are different ways of approaching this. The first is reducing or excluding investments in companies that are highly exposed to climate-change risks, or other vulnerabilities associated with social or governance issues. The main goal of this strategy is to mitigate the risk of loss in your portfolio—not necessarily to actively improve the climate-change problem.
Another approach, if you want to contribute to helping solve climate change more actively, is to tilt your portfolio towards companies that do a particularly good job of managing climate-change risks better than their peers. This involves analysing companies’ carbon emissions, which includes direct exposure—or indirect exposure for those that facilitate the use of other companies that emit carbon—and other metrics, such as carbon intensity, which is a measure of emissions efficiency, using revenue to normalise and compare emissions across companies of different sizes. You can also seek companies that explicitly tackle environmental and social goals, which would be considered a form of thematic or impact investing.
Finally, and more difficult for many investors—because, typically, most don’t own that much of any one company—is to engage directly with company management, which is more appropriate for institutional investors who have larger stakes. In this case, the ideal approach is for an entire asset management firm to engage with corporates, rather than individual portfolio management teams to engage independently. Coordination is likely to have more impact.
Once you develop a view about how much your portfolio companies are exposed to climate-change risk, over time, you can even divest fully from the companies that are fossil-fuel producers or have a certain exposure to carbon emissions.
Q: Can stock market investors aim to immediately eliminate carbon from their portfolios?
Harmstone: It’s simply not feasible. Carbon is too ingrained in our entire economy and the exercise would reduce your portfolio to such an extent that there would be little opportunity for investment. But investors can do this gradually to help wean the global economy off fossil fuels. When enough investors divest from companies, they can influence them to change. It’s worth noting, however, that some allocators believe that if you don’t own a company, you can’t have much influence over it and that it’s better to invest in order to press for change.
Q: How are central banks or financial supervisors influencing investors’ contributions to the Paris Agreement goals?
Harmstone: Financial regulators are increasingly monitoring government regulations related to climate change. Other types of entities, such as central banks, are also becoming more aware of the vulnerabilities that banks and the financial system face in their exposures to sectors that may be at risk as a result of climate change. We’re starting to see different actors within the economy and government align, which signals to corporates and investors that they need to account for regulators trending toward implementing measures that facilitate a transition to a low-carbon economy. For example, the Network for Greening the Financial System is a group of 89 central banks and supervisors that includes the U.S. Federal Reserve and the European Central Bank (ECB). They have argued that climate-related changes to central banks’ operational frameworks are feasible, although there are clear challenges, for example relating to data gaps. The ECB itself is putting climate at the heart of a broader strategic review of its operations and is due to present results after the summer break.
So the early signs are encouraging, but we await further details before being able to judge the likelihood of central banks or financial supervisors influencing investors’ contributions in achieving the Paris Agreement goals.
For more on investing to help combat climate change, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.