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Over the past decade, conversations around climate change have often been laden with political overtones, wrapped tightly with competing agendas, opinions and research. However, mounting data and international cooperation has created a significant shift in thinking that is now re-framing the conversation for investors.

As governments and industry make a significant move toward a global low-carbon economy, investors can no longer assume that an energy sector powered predominantly by fossil fuels is where growth lies.

Which poses the question: Should investors position themselves now for this paradigm shift and the range of investment opportunities within it?

An Awareness of the Problem

Many experts agree that human-induced climate change is having a significant impact on the environment and society, representing one of the most pressing challenges of our time.1

Over the last 150 years we have seen a 40-percent increase in atmospheric carbon,2 and global sea levels have risen nearly eight inches since 1880 due to heat absorbed from increased greenhouse gases (GHGs). NASA satellite imaging indicates that this process is accelerating rapidly, with a potential rise between one and four feet by the year 2100, which would threaten 11 of the world’s 15 largest cities.3

Economic growth and global stability depend on vital natural resources. With a rapidly changing climate, we face significant risks to global food, water, and energy supplies.

A signal that global governments, corporations, and investors are taking the threat of climate change seriously is the momentum coming out of the December 2015 United Nations Climate Conference in Paris, also known as COP21. Following two weeks of intense negotiations, a final agreement was reached across both developed and developing countries, signaling an unprecedented diplomatic achievement and further mandate for action.

A Changing Climate for Investors

The U.S. economy is already beginning to feel the effects of climate change. Over the next two decades, the physical and policy implications of a changing climate will increasingly affect the future performance of American businesses and will likely steer investment decisions in areas such as energy, agriculture, coastal property, and infrastructure.4 These effects of climate change will likely affect corporate profitability and government budgets on a global scale, creating long-term ripple effects in the markets.

Fossil Fuel Divestment: Symbolic Act or Sound Investment Strategy?

Divesting from fossil fuels is at one end of a range of strategies open to investors. While not viewed as a practical approach to many investors, it has recently received much media and public attention due to activist advocacy by environmental groups such as 350.org and university groups.

The fossil free movement aims to mobilize institutional and individual investors to divest from stocks, bonds, or investments in fossil fuel companies. Proponents argue that fossil fuel assets are environmentally unsound and a poor economic bet, both risky and losing value. Currently, owners of $3.4 trillion worth of assets have publicly committed to a divestment approach.

Though divestment has a mixed track record as an investment strategy, it often leads to increasing public pressure to take regulatory action on the underlying issues.

In the 1980s and early 1990s, health issues caused by tobacco use led global public health organizations, followed by universities and pension funds, to divest from tobacco companies, which subsequently became highly regulated. Campus protests by American students similarly fueled the growth of the anti-apartheid movement through divestment from South African firms. By 1988, 155 institutions drove a net capital outflow of $23.9 billion, bolstering U.S. sanctions. But perhaps most notable about the divestment movement is that it has sparked a robust debate among investors about how to address fossil fuel risk in their portfolios.

At present, the global economy is so fossil fuel dependent that a wholesale shift away from fossil fuels and the technological infrastructure built around them may not be feasible in the foreseeable future.

That said, there are business, investor and economic trends—highlighted in an Institute for Sustainable Investing Issue Brief—that point to a significant shift toward a lower-carbon energy sector.

Risks and Opportunities

From 2004 to 2014, renewable energy investments increased from $45 billion to over $270 billion. During this same time period, renewable energy accounted for 48 percent of global new generating capacity, increasing the global share of renewable energy for electricity to over nine percent and creating opportunity for investors.5

There are also risks of not addressing a portfolio’s exposure to fossil fuel related assets.

The Institute’s brief notes that environmental risk factors could strand fossil fuel assets in a range of sectors, leaving investors exposed to unanticipated write-downs, devaluations, or conversion to liabilities.

Climate risks and stranded assets

Environmental risk factors could strand assets in a range of sectors, resulting in unanticipated or premature write-downs, devaluations, or conversion to liabilities. According to the Stranded Assets Programme at the University of Oxford, these risk factors include:

  • Environmental challenges related to climate change and natural capital degradation

  • Changing resource landscapes, such as shale gas abundance

  • New government regulations, such as carbon pricing

  • Falling clean technology costs, for example, for solar photovoltaics (PV), onshore wind and electric vehicles

  • Evolving social norms, such as the fossil fuel divestment campaign

  • Litigation, such as carbon liability

The extent to which fossil fuel assets become stranded will depend on policy and regulatory decisions. Scientists estimate the world has a maximum global “carbon emissions budget” of 1000 Gt (gigatonnes) that will limit the increase in global average temperature to 2° C (3.6° F) over preindustrial levels. This carbon budget is needed to help contain the damage from climate change and is the limit that governments have agreed to in the recent Paris negotiations. According to current projections, the world would need to avoid burning up to 80 percent of known fossil fuel reserves in order to live up to those binding commitments. Fossil fuel companies and their investors would face the loss of some or all of these reserves’ economic value.

Developing a Portfolio Strategy

Today, investors who are interested in engaging in climate action and prioritizing both positive environmental impact and financial return have access to a range of options. These options include investment approaches, tools, and reporting that can be used separately or in concert across a total or partial portfolio. Morgan Stanley’s Climate Change and Fossil Fuel Aware Investing Framework includes the following approaches, which begin with reducing exposure to fossil fuel producing investments and extend to shareholder activism.

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Most investors interested in establishing a fossil fuel aware portfolio can follow a four-step roadmap to evaluate and apply this framework:

  1. Assess: In other words, “know what you own” by assessing your portfolio exposure to fossil fuels and companies with large carbon reserves.
  2. Evaluate: Take a close look at the feasibility of investment solutions, including any factors that may limit implementation options—for example, existing exposure to illiquid alternatives or comingled funds.
  3. Define: Consider your overall climate change and fossil fuel aware objectives, then integrate these goals into the overall investment strategy.
  4. Implement: For individual investments this can take the form of an investment plan—or, for institutional clients, an Investment Policy Statement. This step helps to clarify and formalize the investor’s priorities, risk tolerance, return objectives, and time horizon.

Ultimately, the goal is to develop a long-term investment plan which seeks to achieve both the desired climate and fossil fuel aware goals and financial objectives.

With the support of a Morgan Stanley Financial Advisor, Private Wealth Advisor or Institutional Consultant, investors can take actionable steps toward understanding their exposure and the impact of climate change and fossil fuels on their portfolios and shifting their investments toward building a more resource-efficient economy.

This is an edited excerpt from Morgan Stanley Wealth Management’s primer, “Climate Change and Fossil Fuel Aware Investing: Risk, Opportunities and a Roadmap for Investors.” For more information on Investing with Impact, talk with your Morgan Stanley Financial Advisor.

This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Smith Barney LLC recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. This material is not an offer to buy or sell any security or to participate in any trading strategy. Asset allocation does not guarantee a profit or protect against a loss.

This material is based on information from multiple sources and Morgan Stanley makes no representation as to the accuracy or completeness of information from sources outside of Morgan Stanley.

Investing in the market entails the risk of market volatility. The value of all types of investments may increase or decrease over varying time periods.

The returns on a portfolio consisting primarily of climate and fossil fuel aware investments may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria.

Diversification does not assure a profit or protect against loss in a declining market. Past performance is no guarantee of future results.

© 2016 Morgan Stanley Smith Barney LLC. Member SIPC. All rights reserved.

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