Advance warming: Navigating the risks and opportunities of climate change

The summer of fire and floods has highlighted the compounding effect of global warming. The Northern Hemisphere experienced wildfires in the Pacific Northwest large enough to redden skies in New York, devastating floods in Germany, heat waves in Siberia, unprecedented fires in Turkey, Greece and Italy, and once-in-a-millennium rains in China. We believe that the ever-growing threat of climate changes is currently presenting companies with an array of risks and opportunities. In this wire, I will explain how these ESG factors help shape our Global Quality and Global Sustain portfolios at Morgan Stanley Investment Management.

The global threat is ramping up

After July 2021 produced the hottest global monthly average temperature on record, the heat is still on ahead of the COP26, the United Nations climate summit in Glasgow. The August release of the Intergovernmental Panel on Climate Change report, compiled by more than 200 scientists, suggests that even a moderate emissions scenario with little change in today’s global development patterns will see temperatures rise by 2.1 to 3.5 degrees celsius over the next 20 years. Achieving global warming targets lower than that requires “immediate, rapid and large scale” reductions in greenhouse gases, with a growing focus on methane from natural gas fields and cattle and its significantly higher warming potential than carbon dioxide.

The European Union’s Fit for 55 policy proposals are more likely to be taken seriously against a backdrop where the dangers of climate risk seem more pressing. The European Commission is beginning to plot a road map towards more carbon taxes and new carbon border adjustments for polluting industries (i.e., carbon tariffs), phasing out petrol and diesel car sales by 2035 across the bloc, while encouraging renewable industries and protecting carbon sinks like forests and other ecosystems that are crucial to carbon balance in the atmosphere. The winds of change focused on inequality have also seen the proposal of a Social Climate Fund to support those disproportionately disadvantaged by rising costs. U.S. Democrats are proposing carbon import tariffs in response to this, raising the bar on climate policy, while China has launched its own national emissions trading scheme – now the largest in the world.

How we are thinking about these risks

In our view, climate change presents an array of risks and opportunities for companies, and these are high up on the list of issues which we consider, case by case, including whether and how material they are to the sustainability of any company’s returns on capital. Pathways to reduced emissions may create opportunities for low-carbon solution providers, but regulation including taxation and carbon pricing could reduce profits. Extreme weather may impair physical assets or interrupt business activity. Energy transition may result in stranded assets and wasted investment. Further, companies that are not adapting or that are moving more slowly than the competition could risk their reputation and potentially lose customers.

As part of our integrated approach to ESG factors, we seek to directly engage with our companies to evaluate their position on climate change. Each company has a different starting point, a different exposure and is typically at a different stage in its decarbonisation journey. Our climate and carbon company engagements typically address areas including governance, targets, transparency, implementation, progress, physical risk, product and service opportunities and stakeholder alignment.

Our global portfolios are invested in sectors with high intangibles and low tangible assets relative to other sectors. These businesses enjoy the benefit of a smaller physical footprint and lower physical risk of extreme events relative to other sectors. Key holdings in software typically have a low carbon footprint per unit of revenue, as well as emerging opportunities to sell much-needed tools to help their clients measure and minimise their environmental impact. The direct footprint of staples and health care factories and distribution fleets remains significantly lower than the index, although that doesn’t minimise our focus on their efforts; typically, in these engagements, we focus on areas such as sustainable sourcing, packaging and other indirect (Scope 3) effects.

In the first six months of 2021, we engaged on ESG issues with our companies on 81 occasions, of which 55 engagements focused on environmental issues. We are systematically and intensively engaging with our companies on their decarbonisation strategies. But an improved environment cannot be achieved through decarbonisation alone. Companies (and fund managers) need to be increasingly conscious of – and help find solutions for – excessive natural resource depletion, waste and water intensity and their impact on biodiversity. As such, our systematic engagements with companies focus on a broad spectrum of ESG topics, particularly those material and germane to the company in question. We have our work cut out for us.

Navigating an uncertain environment of climate change, geopolitical posturing, and rising incidence of new COVID-19 variants around the world mean that we continue to steer towards caution, focus on sustainable earnings and cash flows, direct capital towards ESG-aware management and emphasise valuation discipline.

Seek long-term outperformance

At Morgan Stanley Investment Management we strive to deliver distinct, innovative strategies that can mitigate risk during market downturns. To find out more about Morgan Stanley's Global Sustain, watch this Fund in Focus or visit our website.