Climate risk and the markets: 5 key questions answered

Q: How can I evaluate the climate change risk in my portfolio?

'Specific metrics can now assess the carbon footprint of individual companies and the risks for portfolios that invest in them,' says Anna Snider, head of Due Diligence in the Chief Investment Office for Merrill and Bank of America Private Bank. 'One widely used metric, carbon intensity, uses direct and indirect GHG emissions data and corporate revenue to objectively compare companies of different sizes.' While such metrics look at past data, an important and evolving area assesses future risks. 'Many data providers now incorporate a company's stated commitments, renewable energy investments, plans for transitioning away from fossil fuels and other data into their assessments,' she adds.

Q: Can I lower my exposure to climate-related risk through traditional means?

'In our view, renewable investments can now be integrated across many areas of an investment portfolio,' says Joseph Quinlan, head of CIO Market Strategy for the Chief Investment Office of Merrill and Bank of America Private Bank. 'Significant cost declines and technological improvements have made clean energy more competitive over the last two decades,' he adds. These technology gains have in turn led to a host of stock and bond choices.

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If global temperatures continue to rise, global economic growth may decline. Consider these ways to adjust your portfolio and invest in potential solutions.

No matter where you were in July 2023, chances are you felt it: It was the hottest month on record to date,Footnote ¹ prompting a warning from the United Nations that the new reality amounts to "global boiling."Footnote ² The implications are financial as well as environmental. Without a sharp reduction in carbon emissions, temperatures could rise by over 3 degrees Celsius above preindustrial levels by the end of this century, which could in turn decrease gross domestic product (GDP) globally by an estimated 25%.Footnote ³

Below, several Chief Investment Office (CIO) strategists answer 5 key questions related to the impact of climate risk on the markets and your portfolio.

1. Are climate risks already priced into the markets?

Answer: Yes and no, says Sarah Norman, head of Sustainable Investing Thought Leadership for the Chief Investment Office, Merrill and Bank of America Private Bank. "The drop in valuations for domestic coal over the past decade may be the best example of an industry feeling the effects of the move toward renewable energy solutions." Likewise, stocks related to electric vehicles are generally trading at higher multiples than traditional automakers. In fixed income, green bonds have traded at premiums compared with bonds lacking a green focus, Norman adds.

Yet risk assessment methods are still developing, and risks in some market areas, such as municipal debt pricing and real estate in coastal regions prone to extreme weather events, remain hard to quantify. This may create "mispricing" risks for investors positioning their portfolios for the years ahead, she adds.

While the movement to better understand and price climate risk is gaining momentum, it's just one of many types of investment risk investors should consider.

— Sarah Norman,
head of Sustainable Investing Thought Leadership,
Chief Investment Office,
Merrill and Bank of America Private Bank

Question one. What to consider.

"Investors can factor in climate risk by anticipating higher volatility in industries and countries related to fossil fuels or exposed to extreme weather," Norman suggests, "or by considering investments in renewable energies, electric vehicles and green bonds." They may also find opportunities in "transitional infrastructure" such as climate-resilient real estate and financing for low-carbon technologies. But climate shouldn't be the only consideration, she cautions. "While the movement to better understand and price climate risk is gaining momentum, it's just one of many types of investment risk investors should consider."

2. How can I evaluate the climate risk in my portfolio?

Answer: "Specific metrics can now assess the carbon footprint of individual companies and the risks for portfolios that invest in them," says Ekaterina Gradovich, investment due diligence specialist in the Chief Investment Office for Merrill and Bank of America Private Bank. "One widely used metric, carbon intensity, uses direct and indirect greenhouse gas emissions data and corporate revenue to objectively compare companies of different sizes." While such metrics look at past data, an important and evolving area gauges future risks. "Many data providers now incorporate a company's stated commitments, renewable energy investments, plans for transitioning away from fossil fuels and other data into their evaluations," she adds.

Question two. What to consider.

With companies under increasing pressure to report robust carbon metrics and publicly disclose their transition plans, investors can factor climate risk into their portfolios, Gradovich believes. "Combining carbon emission data, transition risk and climate risk metrics can offer a clear picture of the extent to which a portfolio is exposed to climate-related risks and opportunities."

3. Can I lower my exposure to climate-related risk through traditional means?

Answer: "In our view, renewable investments can now be integrated across many areas of an investment portfolio," says Anna Snider, head of Due Diligence in the Chief Investment Office for Merrill and Bank of America Private Bank. "Significant cost declines and technological improvements have made clean energy more competitive over the last two decades,"Footnote ⁴ she adds.

In our view, renewable investments can now be integrated across many areas of an investment portfolio.

— Anna Snider,
head of Due Diligence,
Chief Investment Office,
Merrill and Bank of America Private Bank

Question three. What to consider.

"Investors might explore a range of investment strategies that provide exposure to the energy transition across both asset class and risk and return profiles," says Snider. This includes investing in resource-efficient companies and energy companies that are transitioning their revenue base from fossil fuels to clean energy, alternative energy technology solutions or infrastructure. While U.S. and global policies are creating a tailwind for investments, she adds, "the universe of available options is not dependent on subsidies and has potential for growth as capital is needed to create the energy ecosystem of tomorrow."

4. Which commodities could be attractive in a net zero carbon future?

Answer: "Renewable power requires fossil fuels, metals and minerals," notes Joseph Quinlan, head of CIO Market Strategy for the Chief Investment Office of Merrill and Bank of America Private Bank. Copper, for example, is essential to electric vehicles, charging stations and supporting the electrical grid.Footnote ⁵ Other essential commodities include cobalt, nickel and zinc, as well as water — large quantities of which are needed for mining and mineral processing. And even as society pushes toward that net zero future, climate change will likely also mean higher prices for agricultural commodities.

Renewable power requires fossil fuels, metals and minerals.

— Joseph Quinlan,
head of CIO Market Strategy,
Chief Investment Office,
Merrill and Bank of America Private Bank

Question four. What to consider.

Look into commodities as part of a broader strategy of "FAANG 2.0" investments, Quinlan suggests. That acronym refers to areas likely to benefit during the energy transition, including fuels, aerospace and defense, agriculture, nuclear and renewables, and gold and other metals and minerals. Investment opportunities in agriculture may exist not just in commodities, but in equities along the agribusiness supply chain, including machinery, chemicals and processing.

5. Has the Inflation Reduction Act (IRA) sped up the transition to clean energy — and what investment opportunities does it create?

Answer: Passed in 2022, the IRA represents the most significant government climate investment in U.S. history, earmarking $369 billion for clean energy. "The goal, reducing greenhouse gasses by 40 percent below 2005 levels by 2030, requires major capital expenditures on solar and wind, electrical vehicles and related infrastructure," says Quinlan. The bill also includes a slew of tax credits and other incentives for businesses and consumers to invest in energy-efficient technologies and equipment.

Question five. What to consider.

The law subsidizes and strengthens trends that were already underway, Quinlan notes. "Broadly speaking, we believe it's bullish not just for renewable stocks and electrical vehicles, but a much wider universe of sectors including industrials, materials, utilities and energy," he says. And for business owners and consumers considering purchasing new vehicles or heating and air conditioning systems, the IRA may provide extra incentive.

For a deeper dive into these questions and more, read the CIO's "Portfolio Construction and the Energy Transition: Q&A on What Investors Need to Know" and think about the role that sustainable and impact investing could play in helping you meet your goals.

Next steps

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Footnote ¹ NASA, "NASA Clocks July 2023 as the Hottest Month on Record Ever Since 1880," Aug. 14, 2023.

Footnote ² United Nations, "Hottest July ever signals ‘era of global boiling has arrived,' says UN chief," July 27, 2023.

Footnote ³ Group of Thirty, "Mainstreaming the Transition to a Net-Zero Economy," October 2020.

Footnote ⁴ Lazard, Levelized Cost of Energy Analysis. 2021.

Footnote ⁵ Wood Mackenzie, "Copper: Powering up the Electric Vehicle." August 13, 2019.

Important Disclosures

All investing involves risk. Past performance does not guarantee future results.

Risk management and due diligence processes seek to mitigate, but cannot eliminate risk, nor do they imply low risk.

Sustainable and Impact Investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.

There is no guarantee that investments applying ESG strategies will be successful. There are many factors to take into consideration when choosing an investment portfolio and ESG data is one component to potentially consider.

An investment in Green Bonds involves risks similar to an investment in debt securities of the issuer, including issuer credit risk and risks related to the issuer's business. You should review the relevant offering document carefully before investing.

Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.

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