Why Investors Can't Ignore Climate Change

As world leaders meet in Paris to discuss climate change, asset managers and consultants are offering guidance on how institutional investors can tackle sustainability—and why it’s so important that they do.

Cambridge Associates and Hermes Investment Management both released reports on how to mitigate climate risk in a portfolio, warning of harm that could come to investments should those risks not be taken seriously.

“Carbon risk cannot and should not be ignored,” said Saker Nusseibeh, Hermes chief executive. “It is time that we in the industry help to address it.”

“Carbon risk cannot and should not be ignored.”

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Cambridge Associates reported climate change could directly hurt long-term portfolios through extreme weather events, which could destroy property, or changing weather patterns, which might disrupt supply chains. Additionally, policy and regulatory responses to climate change could impose higher costs on sectors such as fossil fuels, utilities, transportation, and heavy industry.

In particular, Hermes warned the ongoing COP21 conference in Paris will result in new regulations regarding carbon emissions that impose increasing costs on the heaviest emitters.

“Long term, I think carbon risk is a huge issue,” said Gary Greenberg, head of global emerging markets at Hermes.

To manage these risks, both organizations said managers need to be aware of climate risks in their portfolios, and incorporate those risks into investment decisions. Additionally, Cambridge Associates recommended that investors advocate for more transparency and reporting on climate risk metrics.

Other suggestions included proactive hedging via low-carbon strategies and policy-level exclusion of fossil fuel and other sectors. However, the consulting firm said investors should consider opportunity costs before changing asset allocation strategies to protect against risk.

“While carbon regulation and technological advances in alternative energy may be long-term headwinds for traditional fossil fuels, markets are likely to see many more cycles in which investors can capture returns,” wrote Liqian Ma, senior investment director at Cambridge Associates. “Investors should benefit from the flexibility to take advantage of near- to medium-term valuation opportunities, no matter the sector in which these opportunities may arise.”

Rather than just focusing on risks, Cambridge Associates and Hermes both advised investors to consider the opportunities afforded by sustainability. Renewable infrastructure, clean transportation, energy efficiency, and green technology are sectors that will provide structured and regulation-driven growth in the coming years, they said.

“There is too much focus on the risks and not enough on the opportunities,” said James Rutherford, a Hermes fund manager. “If you look just at the risk, there is a danger that you end up excluding companies. If you look at the opportunities for growth, change, and improvement, it is a much more powerful story.”

One such group already planning to take advantage of these opportunities is the newly formed Breakthrough Energy Coalition. The 28-member coalition, led by Microsoft founder Bill Gates and including the University of California, announced at the Paris summit its intention to bankroll investments in clean energy.

“I hope even more governments and investors will join us,” Gates said.

Hedge fund activism is detrimental to the long-term performance of firms, new research has found.

Firms targeted by activist hedge funds do tend to improve over the long run—but only because those firms are usually performing poorly to begin with, according to a study by finance professors Martin Cremers (University of Notre Dame), Erasmo Giambona (University of Amsterdam), and Simone Sepe (University of Arizona), along with PhD student Ye Wang (Bocconi University).

When compared with similarly underperforming firms—as opposed to the industry as a whole—companies subject to hedge fund activism showed less long-term improvement than peers not targeted by activists.

One reason why targeted firms performed worse, according to the study, is because activist hedge funds are “naturally more empowered than other shareholders to challenge the board of directors to change corporate policies or even corporate strategy, promoting the adoption of decisions to fire the existing management, increase leverage, reduce cash, or sell the firm to a prospective acquirer.” Even the mere threat of these interventions prompts a “detrimental” focus on short-term performance by the incumbents, who fear losing their jobs, and undermines the ability of corporate managers to pursue value-increasing long-term investments.

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Additionally, market mechanisms other than activist hedge funds—such as key employees, top executive management, directors, long-term shareholders, large customers, and suppliers—were found to generally be “more successful than the typical activist hedge fund campaign in turning these relatively poorly performing firms around.”

On average, the value of firms targeted by activist hedge funds was 5.5% lower than that of non-targeted peers at the end of the first fiscal year of an activist campaign, and nearly 10% lower after three years.

“Adversarial” activists—hedge funds employing hostile tactics—were even more harmful, particularly when targeting companies engaged in innovation, which rely more on long-term investments. The value of innovative firms targeted by hostile activists was found to be 50% lower that than of non-targeted firms after the first three years.

While the researchers acknowledged the benefits of activist investing for corporate governance, they found that the costs “seem to outweigh potential benefits.”

The full report, “Hedge Fund Activism and Long-Term Firm Value,” can be downloaded by SSRN.