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Sustainability Matters

Investing in Our Planet

How to mitigate climate risk and invest in climate solutions.

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The theme of Earth Day 2022 is Invest in Our Planet. If you are fortunate enough to be an investor, I encourage you to take that theme literally. Perhaps the most impactful climate action you can take right now is becoming a climate-conscious investor. Doing so not only has broader impact, it can help protect your portfolio from climate-related risks. Here's how you can align your fund investments with your concerns about the future of our planet.

Greening Your Core Holdings

First, take a look at your core holdings in stock and bond funds or exchange-traded funds. For your existing funds or any fund you may be considering, make sure they are being managed with an awareness of climate risk. This should be your minimum standard. After all, you are paying your portfolio managers to take all material risks into account as they work to provide you a competitive risk-adjusted return.

Climate risk comes at portfolios in two ways, via transition risk and physical risk. Transition risk is about how companies are managing, or planning to manage, the shift away from the use of fossil fuels. The transition is already happening and is sure to gain momentum this decade given the latest Intergovernmental Panel on Climate Change estimate that the world must cut greenhouse gas emissions roughly in half by 2030 to reach net zero by 2050, in order to avoid the worst impacts of climate change. Some companies will be able to manage the transition more easily than others. Some may even benefit from the transition because their products and services may be of greater value in a low-carbon economy. Others, especially the fossil fuel industry, face significant risks to their fundamental business models.

Consulting Morningstar's carbon metrics is a good starting point for assessing a fund's transition risk. (Transition risk is sometimes called carbon risk.) Sustainalytics (a Morningstar company) evaluates carbon risk as the degree to which a firm's activities and products are aligned with the transition to a low-carbon economy. A fund's carbon risk score is an asset-weighted roll-up of these firm-level evaluations. You can also find a fund's average asset-weighted fossil fuel exposure over the trailing 12 months. The Morningstar Low Carbon Designation identifies funds with low levels of transition risk. Many funds get that designation simply because their investment universe is not particularly carbon-intensive, so the designation is not an indicator that the fund's managers are particularly attentive to transition risk.

But there is more to climate risk than transition risk. Physical climate risk is about how much companies are exposed to the direct risks of more-frequent extreme weather events and of the long-term chronic effects of global warming. These physical manifestations of climate change can affect a company's own operations, its entire value chain, the health of its workforce, and the stability of its customer base. As with transition risk, some industries and companies are more vulnerable to physical climate risks than others, depending on the locations of their activities and their customers, as well as how well they manage these risks.

So it's definitely worth asking whether your funds are being managed with climate risk in mind. Check the Principal Investment Strategies and Principal Investment Risks sections of the fund's prospectus. Check the most recent Fund Fact Sheet. Scour its website. If you can't find any reference to climate change, chances are climate risk is not top of mind to your portfolio managers. Spoiler: Don't be surprised to find distressingly few funds that have anything to say about how they're managing climate risk.

That's why you should consider funds that are explicitly climate-aware. They may have fossil-fuel-free; low carbon; or broad environmental, social, and governance investment mandates. Across all sub-asset classes in a typical investor portfolio, you can find climate-aware funds that provide diversified market exposure similar to that of a conventional fund.

Fossil-fuel-free funds completely avoid exposure to oil, natural gas, and coal. SPDR S&P 500 Fossil Fuel Reserves Free ETF, for example, avoids any firm holding fossil fuel reserves but otherwise shares the same holdings and roughly the same weightings as an S&P 500 fund. Low Carbon funds seek to invest in companies with lower carbon footprints. They typically structure their portfolios to have lower carbon footprints than a benchmark. IShares MSCI ACWI Low Carbon Target ETF (CRBN), for example, is a global stock fund that overweights companies with low carbon emissions, resulting in a portfolio with lower carbon exposure than the MSCI All Country World Index.

ESG funds take a broader climate-conscious perspective while also considering other ESG factors, many of which are related to climate change anyway. Brown Advisory Sustainable Growth (BAFWX), for example, invests in companies with competitive advantages in their operations or products that are related to climate or other ESG issues.

Some diversified ESG funds are also explicitly fossil-fuel-free, like Green Century funds, and many others are low carbon, like TIAA-CREF Social Choice Low Carbon Equity (TLWCX).

ESG bond funds are appropriate for your core or core-plus bond exposure. Examples include Pimco ESG Income (PEGIX) and TIAA-CREF Core Impact Bond (TSBIX).

Finally and most importantly for me, whether you are considering fossil-fuel-free, low carbon, or general ESG funds, ask what they are doing as active owners (and as your representative) to engage with companies on climate-related issues, whether they sponsor climate-related shareholder resolutions, and how they vote on these resolutions. Most of these funds or their parent fund companies now issue impact reports that detail their engagement activities and votes. Suffice it to say those that have been active engagers around climate should have a readily accessible, detailed report on their website.

Mitigating climate risk in your portfolio not only helps protect your investments, it also has a broader impact, especially via direct shareholder engagement. As more companies hear investor concerns about climate risk—alongside the concerns of other stakeholders, like employees and customers—it encourages them to take action. According to the Science Based Targets initiative, nearly 3,000 public companies have made Net Zero commitments, and climate-conscious investors will help hold them to it.

Climate Impact in Your Satellite Holdings

Beyond greening the core funds in your portfolio, you have additional opportunities to invest for climate impact. Climate solutions funds focus on companies that are contributing to the transition to a low-carbon economy through their products and services. Examples include GMO Climate Change III (GCCHX), Hartford Cimate Opportunities (HEOIX), and JPMorgan Climate Change Solutions ETF (TEMP). Because of their more-focused mandates, the sector exposures of these funds tend to be more concentrated and they may have overweightings in small- and mid-cap stocks.

Clean energy/tech funds are even more focused on companies facilitating the clean energy transition. These may be renewable energy firms or tech firms enabling energy efficiency, storage, and electrification of end-use products. Examples include iShares Global Clean Energy ETF (ICLN), Pax Global Environmental Markets (PGRNX), and Invesco Solar ETF (TAN).

Green bond funds invest in bonds that finance projects that facilitate the clean energy transition. Examples include Calvert Green Bond (CGAFX), Fidelity Environmental Bond (FFEBX), and Pimco Climate Bond (PCEIX). Many general ESG bond funds also have exposure to green bonds.

How much to allocate to climate solutions, clean energy/tech, and green bond funds depends on how much you want to invest outside of your core portfolio, which should be designed to generate the risk-adjusted return you require to meet your financial goals. It will also depend on how strongly you feel about taking climate action through your investments. When using a core-satellite approach, my rule of thumb is to devote 15%-25% of assets to satellite investments, which may tend to be more volatile because of their concentration around a particular theme or sub-asset class. Another approach is to look at the underlying sector and stylistic weights of your climate impact funds alongside your other funds to make sure you are comfortable with your overall portfolio's exposures.

In sum, to invest in our planet this Earth Day, you can build a climate-conscious portfolio by:

  • Making sure all your funds (including those in your retirement plan) are being managed with an awareness of climate risk (minimum standard).
  • Seeking out diversified funds that place climate and other ESG risks and opportunities in a leading role in their investment process, including in their active ownership activities.
  • Investing in thematic climate solutions funds.

To learn more about the climate funds landscape, check out this piece by ESG analyst Alyssa Stankiewicz.

Jon Hale, Ph.D., CFA, is director of sustainability research for the Americas at Sustainalytics. Follow Jon on Twitter: @Jon_F_Hale

Jon Hale does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.