In an astonishingly short time, climate change has morphed from a relatively arcane scientific issue into a rapidly intensifying investment concern. This evolution has been propelled by the convergence of several global trends.

• The scientific and social consensus on the extent, potential consequences, and human genesis of climate change is growing.
• Evidence shows that the financial costs of climate change could extend into a wide range of industries. Obviously, oil, gas, mining, and utilities are on the front lines. Less obviously, the effect on financial services, tourism, and agriculture could be every bit as profound.
• Government-led limits on greenhouse gas emissions—most prominently through the 2005 ratification of the Kyoto Protocol and the European Union’s Emissions Trading Scheme—are proliferating.
• Sustainable development has become an accepted responsibility of corporate governance.
• Corporate disclosure requirements are changing, and environmental issues are assuming greater prominence in the rules of pension funds.
• Institutional shareholders are becoming dramatically more active in climate change issues.

These trends are neither ubiquitous nor uniform, but they are real. Combined, they mean that climate change is no longer just an environmental issue; it is also a fiduciary and investment issue.

In the past, when institutional investors dealt with climate change, they typically made two operational assumptions. The first was that sustainability—superior performance on environmental and social issues—implied higher risk, lower returns, or both. It therefore followed that responsible fiduciaries should disdain the pursuit of sustainability.

Both assumptions are wrong. There is a growing, increasingly persuasive, body of evidence suggesting that companies with superior overall environmental management are better-managed companies overall, and thus enjoy above-average profits and stock performance. Consider the findings of research undertaken in 2005 by State Street Global Advisors (SSgA), a division of State Street Corporation, the world’s largest institutional asset manager. SSgA discovered that a hypothetical portfolio of companies with superior sustainability and carbon risk management outperformed the S&P 500 by 5.9 percent a year and had total shareholder returns that were 1.2 percent higher than those of an actively managed SSgA portfolio, which was identical to the environmentally enhanced portfolio, except for the absence of the “tilts” towards environmental factors. One study, led by the head of research for the Dutch pension fund ABP (Europe’s largest) and later published in the peer-reviewed Financial Analysts Journal, reached similar conclusions. Furthermore, a “climate risk adjusted” corporate-bond index jointly constructed by Innovest Strategic Value Advisors and JPMorgan Chase has outperformed its benchmark by over 90 basis points (0.9 percent) annually—a significant margin for bonds—since its creation two years ago. Perhaps even more important, we have every reason to believe that companies with superior environmental strategies will command an even larger premium in the future as climate regulation and tax regimens become even more pervasive and onerous.

If so, fiduciaries can potentially be derelict with regard to their responsibilities if they fail to consider a company’s environmental and social risks. Nonetheless, most financial analysts continue to ignore or understate them as improbable or immaterial. Moreover, these analysts haven’t a clue about the relative risks within industries (exhibit). Among electric utilities, for example, Innovest estimates that the environmental risks facing the highest-risk companies are 30 times greater than those facing the lowest-risk ones. We define “climate risk” here as net risk, taking into account not only companies’ carbon footprints but also their ability to manage that risk exposure effectively, and indeed to seize new competitive and profit opportunities on the upside as well. Yet few if any investment analysts, including people whose firms have publicly expressed great consternation over climate change, can currently identify—on an extremely wide continuum of risk—which companies are which.

That will change as the risks and opportunities associated with climate change become more apparent. Climate change is the latest and most pervasive manifestation of an “eco-industrial revolution”—a global industrial restructuring of competitive advantage. As with previous economic transformations, the post-Kyoto one will create whole new classes of corporate winners and losers. Depending on which sectors companies compete in and what specific risk exposures they confront, climate change could require major (and expensive) strategic shifts. We are already witnessing some of the early and painful shifts and “creative destruction” in the automobile industry, as climate, energy, and other environmental concerns curb demand for the sorts of large, gas-guzzling vehicles Detroit has specialized in for so long. Recent research by Innovest has found that even under highly conservative scenarios, more than 50 percent of all earnings and 35 percent of total market capitalization in sectors such as electric utilities and metals, mining, and construction materials could be threatened by the financial consequences of climate change.

The losers will be the companies that don’t adapt to the reality of a carbon-constrained world; their poor climate performance will directly affect their cost and availability of capital, putting them at a severe disadvantage. The winners will be the companies that understand that climate change need not be a black hole of financial risk. Indeed, those that do will also have huge business and investment opportunities in energy efficiency, clean technology, and emissions trading. The bottom line is that climate change is as much a financial, management, and performance issue as it is an environmental one. Let’s hope that businesses recognize this truth before the last vestiges of the polar ice cap disappear.

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