The world needs to make significant progress to limit global heating. In fact, a recent UN report found “no credible pathway to 1.5°C in place” as stipulated in the Paris Agreement. Volatile macroeconomic conditions have investors, business leaders, governments, and central banks actively managing crises on multiple fronts – and these efforts can also be applied to how family offices invest in impact. In Europe, one of these is the military front of Russia’s war against Ukraine which precipitated the greatest instability in European energy supplies in decades. Fortunately, there is opportunity in these difficult times. According to IEA analysis, “for the first time, global demand for each of the fossil fuels shows a peak or plateau across all WEO scenarios, with Russian exports, in particular, falling significantly as the world energy order is reshaped.” The policy packages shaping this outcome are a combination of long-term planning, forecasting, and short-term reactions.
Public and private sector climate efforts including regulation, new reporting requirements, and financing solutions are all part of the broad-based efforts advancing around the world. Demand for stronger reporting requirements is evidenced by the over ninety per cent of institutional investor respondents to a recent survey who believe that climate risk is not adequately priced into global financial assets. A recent Brookings Institute article argued that
“Our financial system has always relied on publicly traded companies being transparent about the risks their businesses navigate. This open accounting of business prospects is fundamental to the healthy operation of our economy — reliable information is the bedrock of efficient markets.”
The under-reporting of environmental risk reduces market efficiency if you agree with the efficient market hypothesis, but, at minimum, opacity increases uncertainty for investors.
The transition toward a carbon-neutral economy brings significant risks for family offices, especially considering the long-held belief that adaptation to climate change will inflict a net cost on the global economy. However, there is growing consensus that the transition to an environmentally sustainable, low-carbon-emitting economy will both decrease current financial risks and create strong growth opportunities. Analysing environmental risks and the opportunities they present helps frame promising investment strategies in a period of uncertainty and volatility.
Climate risk categories for family offices
Climate risks fall under four primary categories:
- Physical risks
- Litigation risks
- Transition risks
- Reputational risks
Physical risks are the most readily apparent and include drought, floods, storms, wildfires, and heat waves. Litigation risks include liability for past emissions, inadequate action or preparation, and negligence. Transition risks include the destruction of demand for fossil fuels, connected market and price shifts, and impact abatement costs. Reputational risks weigh especially hard upon family offices. They can be difficult to quantify, but a family’s reputation that has taken years to build can be severely damaged through missteps in areas of great importance and public attention such as climate change.
An influential 2015 report by Mercer contributed to new ways of thinking about climate investing by gaming out possibilities through four scenarios that they characterised as transformation, coordination, fragmentation (lower damages), and fragmentation (higher damages). The scenarios spanned a range from strong and successful climate change mitigation efforts (transformation) to limited efforts and high economic harm (fragmentation with higher damages). They also used the concept of “stranded assets” to capture “investments that lose significant economic value well ahead of their anticipated useful life as a result of changes in legislation, regulation, market forces, disruptive innovation, societal norms, or environmental shocks.” A key takeaway from the report is that climate risk is more complex and spread over a longer time horizon than typical investment risks.
More recently, the BlackRock Investment Institute took this line of research much further. They built climate-inclusive economic models that project a “cumulative loss in economic output of nearly 25% over the next two decades due to the level of GDP being 2.3% lower in 20 years’ time if no climate change mitigation measures were taken.” Their work flipped the received wisdom that addressing climate change necessarily will result in a net cost for the global economy in what might be characterised as a realistic and opportunistic way. They argued that the physical damages alone brought through inaction will lower economic growth more than investing in climate resilience:
“Our CMAs [Capital Market Assumptions] reflect our view that the green transition to a low-carbon economy, consistent with the Paris Agreement goals, will deliver an improved outlook for growth and risk assets relative to doing nothing.”
This framing is one of many contributions that are shifting the needle from thinking about risk to opportunity. The evolving consensus is both driving investment and fueling further opportunities:
“The most significant impact is a stronger preference for developed market equities at the expense of high yield and emerging market debt. The composition of developed market equity indices better aligns with the climate transition and equities have more ability to capture the upside opportunities from the climate transition. The higher carbon intensity of companies that typically make up high yield and emerging market debt benchmark indices detracts from their expected returns, diminishing their appeal within our overall preferred strategic allocation.”
We have crossed a tipping point. Staying the course not only increases risk but will increase costs which are creating new pathways forward. In other words, the new normal in investing centres on climate, shifting strategies from “why” to “why not” build climate into investment models.
Facilitating impact investing strategy
But what about strategy? What are the distinct opportunities for investors to align durable growth with sustainability goals? As a start, investors need to filter signal from noise in our current period of economic turbulence:
“For investors looking to mitigate climate risk, and support climate solutions, it’s important not to get distracted by the short-term noise. Instead, as financial markets and the global economy move into an era of climate policy implementation, retaining a solutions-oriented mindset with a focus on long-term climate objectives is key.”
A step further is to identify levers of profitable investment that maximise positive climate outcomes. The BlackRock Investment Institute’s “Managing the net-zero transition” is one influential mapping of this new landscape.
Another step is putting new climate analysis into action through investments. Lombard Odier is one firm with a clear strategy that is helpful for our understanding of investment opportunities. Their vision is to help foster a CLIC® economy that “thrives on efficiency and innovation to boost growth, in synergy with the wider environment.” It includes “new, disruptive business models offer unprecedented opportunities, while critically working to reduce our impact on the environment and deliver prosperity on a broader and more equitable basis.” Lombard Odier’s private credit strategy is aimed at meeting the adaptation finance gap.
The way forward
Family offices have options when it comes to investing in the green transition. They can join with funds focused on impact, the circular economy, and other climate-centric strategies to meet the climate adaptation financing gap. Innovative projects like Klimato, a Swedish start-up measuring, tracking and communicating the carbon footprint of food, are focused on closing the food system loop. New firms renting and leasing electronic and durable goods are focused on maximising product life and the “sharing economy.” Another example is the Kimpa Impact Family Office assisting a family in a leveraged buyout of the international energy transition consulting company Mercados Aries.
In the United States there is a tremendous amount of capital available to meet climate investing needs. The rise of donor-advised funds (DAFs) that allow wealthy donors to delay charitable giving of their foundations have kept an estimated 800 USD from working charities over a six year period studied. One example is the ZOOM Foundation which proclaims on its website to focus “its philanthropic investments on innovative change efforts that have high potential for sustainable impact, particularly in the areas of education, the environment, and democracy.” Recent reporting by Bloomberg found no list of grant recipients, nor would a spokesperson comment for their article. Directing DAFs toward profitable investments financing the climate transition are a way that they can fulfil long term charitable ambitions, grow wealth, and meet favourable tax benefits.
Innovation in multiple sectors underway and macroeconomic conditions are coalescing to create a strong investment thesis that better aligns financial resources with climate solutions. Continued work on economic and financial models to facilitate this alignment offer family offices opportunities to lead the way.