Why climate change investing is here to stay
Rising global temperatures and efforts to curb carbon emissions have become important inputs to long-term investment decisions. When it comes to climate change investing, a range of approaches is available.
Many of the world’s biggest corporations have acknowledged that failing to address climate change is simply not sustainable. It threatens not only their ability to attract customers, but also the economic and financial systems they collectively rely on. To that end, two-thirds of the revenue of the world’s 2,000 largest companies is now covered by net-zero commitments.
One of the major considerations that has pushed addressing climate change up the corporate agenda is its importance to investors. With 2023 the hottest year on record and 2024 on track to be hotter still, the biggest asset owners and managers have adopted climate change investing as part of their long-term strategy. Indeed, investment professionals continue to factor in the impact of climate change as the real economy moves towards decarbonization.
The evolution of climate change investing
There are three main types of climate change investing:
- Investing in climate solutions, such as renewable energy and emerging technologies to improve energy efficiency and reduce emissions.
- Decarbonizing portfolios by divesting from or reducing exposure to fossil fuel and emissions-intensive assets, which are at risk of becoming “stranded assets” or experiencing steep losses in valuation from changes in regulation or consumer preferences
- Transition investing, which refers either to activities supporting the shift to low-carbon economies, or specifically to investment supporting the decarbonization of hard-to-abate sectors such as steel, chemicals, aviation and shipping.
The WilderHill Clean Energy Index, launched in 2004, is considered the first climate investing index, focused on renewable energy. Although it offered investors targeted upside potential from the anticipated spread of solar and wind energy, such thematic investments can be highly volatile.
With solar and wind power having reached maturity and attained sufficient scale to compete with fossil fuels, the next wave of climate solutions will consist of emerging climate technologies, such as green hydrogen, sustainable fuels and carbon capture, storage and utilization (CCUS), which are a long way from commercial viability.
These emerging technologies will need to deliver around 35% of the emissions reductions necessary to achieve net zero by 2050, according to the latest Net Zero Roadmap from the International Energy Agency (IEA), and are essential to decarbonizing hard-to-abate sectors such as steel, cement, chemicals, aviation and shipping. Though investing in emerging climate technologies is accompanied by considerable risk, these are partially offset by several favorable government policies and private sector initiatives to catalyze and scale-up adoption.
A second stage of climate change investing was prompted by a rush to decarbonize portfolios through divestment of fossil fuel and high-emitting assets. While divestment provides a simple and effective way to reduce exposure to assets that might potentially be stranded during the climate transition, the consensus now is that it is often not the best way to reduce real-world emissions. In fact, it could result in worse climate outcomes, as assets are transferred to owners who are less concerned about decarbonization.
Furthermore, moving to a net-zero world realistically cannot happen overnight: the social and economic costs would be too great. This has given rise to a third stage of climate change investing to support an orderly – but still ambitious – phase-down of emitting assets and switch to low-carbon energy sources and technologies.
For more insights into these topics, please read:
Why climate tech is key to net zero
How investors are approaching the decarbonization of hard-to-abate sectors
Quantifying the potential impact
When it comes to climate change investing, investors and businesses need to consider two key risks:
- Physical risk, including worsening heatwaves, droughts, wildfires and floods, as well as degradation of the natural resources underpinning business activity.
- Transition risk, which can arise when businesses struggle to adapt to changes in policy, regulation and consumer preferences in the shift towards a low-carbon economy.
As the impacts of climate change become more visible and pronounced, governments are likely to respond – perhaps suddenly and unexpectedly – by introducing more stringent climate regulation, including carbon taxes and other measures which will make it more costly to release greenhouse gases such as carbon dioxide and methane into the atmosphere.
Climate scientists argue that current policy falls far short of achieving net zero by 2050, so at some point, there needs to be a significant ratcheting up of policy to avert a climate disaster.
Higher future carbon prices (see Figure 1) pose both a risk and an opportunity. They will incentivize climate action and measures to reduce emissions. And they could upend business models and accelerate the adoption of emerging climate technologies.
To learn more, please read:
How investors are assessing the future cost of climate change risk
Integrating natural capital
Just as investors and businesses are increasingly incorporating climate considerations in every level of decision making, they are facing growing pressure to do the same for nature. Without the ecosystem services provided by nature, economic activity – not to mention life itself – would be impossible (see Figure 2).
The United Nations biodiversity summit, held in December 2022 in Montreal, Canada, resulted in a breakthrough commitment among more than 190 countries to adopt various measures to preserve and restore global biodiversity, including the introduction of mandatory nature-related disclosures by 2030.
Addressing biodiversity is important to the broader mission to mitigate climate change: the two are inextricably linked, and improving one will invariably benefit the other.
Halting and reversing biodiversity loss will require an enormous, concerted and urgent effort. To that end, the lessons learned from incorporating climate change in the investment process could help accelerate progress in nature-related investing.
To delve deeper into this topic, please see:
How integrating natural capital in the investment process can help biodiversity bloom
Allaying greenwashing concerns
While businesses are undoubtedly stepping up their efforts to address climate change and biodiversity loss, there is also widespread evidence that some may be overstating their environmental credentials – a practice known as greenwashing.
This is especially troubling for investment firms, who are held to an especially high standard by regulators. What’s more, in addition to avoiding greenwashing of their own products, they must also identify greenwashing by the companies they invest in, or face potential legal and regulatory consequences.
Greenwashing damages investor trust — contributing to the current backlash against sustainable investing — and results in capital not flowing to the projects and companies that deserve it.
Several technology firms are seeking to solve this problem using artificial intelligence (AI). These solutions can sift through vast troves of unstructured data to gauge and compare companies’ environmental claims against their actual performance.
By helping to shore up confidence in nature-related and climate change investing, AI-powered performance assessments could make an important contribution to narrowing the global climate finance gap.
According to the World Economic Forum, up to USD3.5 trillion of additional investment is needed each year to reach net zero and restore nature. By supporting real-world decarbonization, climate change investing will be a critical part of meeting that target.
For more information about this topic, please see:
A question of trust: how AI is addressing greenwashing concerns
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