Beware this rising risk in client portfolios

Environmentalists were recently dealt a blow when President Trump and the Environmental Protection Agency unveiled plans to freeze car emissions standards and allow states to decide how or when to curb coal plant emissions.

Despite the administration’s proposed rollbacks of these antipollution policies, though, many in the financial services industry continue to shift investments in the opposite direction — toward companies that meet higher environmental standards and have lower carbon and fossil fuel footprints.

Nicolo Filippo Rosso/Bloomberg

In a webinar, Morningstar’s Julie Koska, who directs sustainability product management at the research firm, reviewed exactly why wealth managers and RIAs should more carefully assess a portfolio’s carbon risk, a measure of how vulnerable a company is in the transition away from a fossil-fuel intensive economy. She also showcased Morningstar’s new metrics, launched in May, which evaluate such risk for 30,000 funds.

Portfolios that incorporate sustainable investing approaches have grown to include $23 trillion globally in assets under management, an increase of 600% over the past 10 years, according to Morningstar.

And the trend is unlikely to reverse. A fifth of financial planners say they intended to increase their use or recommendation of ESG funds with clients this year, a Financial Planning Association report found. Younger and female clients, in particular, are demanding this type of option: 67% of millennials and 76% of women want to invest in funds and companies that reflect their social and/or environmental values, according to a BlackRock survey.

Morningstar emphasized, however, that it shouldn’t be client demand that pushes advisors to reflect on ESG funds and carbon risk. Rather, it is a part of their fiduciary responsibility. Koska highlighted the findings of a 2015 Mercer study, showing that climate change events, such as an increase in global temperatures, will radically impact investors’ returns. This will necessitate a reallocation of investments to clean-energy sectors like infrastructure, emerging market equity and low-carbon industries, from traditional energy investments like coal, which “could fall by anywhere between 18% and 74% over the next 35 years,” the study says.

Uncertainty surrounding climate change is the reason why pension funds like CalPERS, the New York State Common Retirement Fund, Japan’s Government Pension Investment fund and Sweden’s AP4 pension fund have all adapted low-carbon strategies and are using low-carbon indexes to adjust their risk. It’s a hedge against a likely economic thrashing.

To help advisors do their due diligence by their clients in light of all this, Morningstar’s carbon metrics, based on Sustainalytics data, represent an easy way to evaluate existing funds and how they’ll fare in this transition to a low-carbon economy.

Of the 30,000 funds Morningstar has measured, only 6,500 received its low-carbon designation and earned the little green leaf icon. These funds have both low carbon-risk scores and low levels of fossil-fuel exposure, meaning companies within these portfolios have low-carbon emissions or are actively lowering their emissions to meet the goals of the Paris Agreement.

Morningstar’s analysis states that: “among diversified developed-market equity strategies, Europe ex-UK funds generally have the lowest carbon-risk score, Asia ex-Japan the highest, and the United States lands in the middle while diversified-emerging market equity strategies tend to have higher carbon-risk scores.”

It also adds that low-carbon fund choices exist across all investment styles and regions.

For instance, low carbon funds that provide focus on U.S. large-cap stocks include: TIAA-CREF Social Choice Low Carbon Equity (TNWCX), Calvert US Large-Cap Core Responsible Index (CSXAX) and Vanguard FTSE Social Index (VFTSX), according to a white paper published by Jon Hale, Morningstar’s head of sustainability research.