22/04/2016 9:11 AM AEST | Updated 15/07/2016 12:52 PM AEST

Investors Should Look to the Low Carbon Economy

Close up picture to photovoltaic array panels in a raw

By Kevin Rudd and Audrey Choi

World leaders are gathering in New York today to sign the Paris Agreement on climate change, committing to keep average global temperature within 2°C above pre-industrial levels. We think investors everywhere should pay attention. Country commitments (if kept) will reshape economies in ways not seen since the Industrial Revolution. With big business also embracing a low carbon economy, here are three reasons investors should think about climate risk and opportunity in their portfolios:

Opportunity knocks

We believe a low carbon world will support, not hinder, economic growth. According to Bloomberg New Energy Finance (BNEF), meeting the 2°C target will require $12.1 trillion in low carbon energy investments by 2040. That huge sum will create long-term ripple effects in the markets and uncover new investment opportunity as companies and governments shift toward low carbon solutions.

Emerging economies will likely be among the biggest markets, with many primed to leapfrog or scale back fossil fuel infrastructure. China and India - two of the top three greenhouse gas emitters - are looking to capitalize on effective, affordable energy technologies now widely available. Plagued with urban air pollution, China is turning to renewables and clean coal technologies, building efficiency and electric vehicle incentives. It is likewise building the world's largest carbon market, providing incentives to businesses across sectors to lower emissions and drive a cleaner energy future.

In the U.S., too, the physical and policy implications of climate change will increasingly shape investment decisions. Sectors ranging from energy and agriculture to real estate are already feeling the impact.

All of this has potential implications for how investors assemble their portfolios to maximize returns and minimize risk. Looking to get ahead of these market movements, some investors are already reducing exposure to high emitters and fossil fuel producers. Strategic long term investors are taking a more proactive route. Recognizing the potential to mitigate risk and reap reward, they are investing in countries and firms that have clear visions for a low carbon future.

Ignorance is risk

There's a growing consensus, endorsed by the Governor of the Bank of England and the regulator of the largest US insurance market, that pension and investment fund managers should incorporate climate risk into valuation as part of their fiduciary duty. The Insurance Commissioner of the world's eighth largest economy, California, has gone so far as to ask all insurance companies that conduct business in the state to divest from thermal coal. And 36 stock exchanges, including the New York Stock Exchange, Nasdaq and the London Stock Exchange have advocated for environmental, social and governance data disclosure.

Meanwhile climate change impacts loom large. The Sustainable Accounting Standards Board found that 93% of market capitalization, or $38 trillion, is affected by climate change. U.S. losses from extreme weather have ballooned to $50 billion annually from $10 billion in the 1980s. Fund managers who fail to understand these risks could face material losses if and when climate risk manifests as falling stock values.

The Future is here

The question for investors is not whether to act; the low carbon economy paradigm shift is here. For the first time, 2015 saw global investment in clean energy ($329 billion) overtake investment in oil and gas ($253 billion), according to BNEF. Coal prices have suffered as the industry has been hit by lower-cost alternatives (including natural gas, wind and solar), tightening environmental regulations, bankruptcies and divestment campaigns. In many regions, renewables are outperforming fossil fuels in the stock market.

These trends were well underway before 195 nations agreed to the unexpectedly strong commitment at the Paris climate conference. Staying below 2°C - even coming close - will necessitate a shift away from fossil fuel combustion, the single largest generator of greenhouse gas emissions. Given policy pressure to reduce carbon emissions, large emitters face a regulatory squeeze, lessening their long-term appeal.

We are not suggesting a low carbon world will materialize overnight. It will take time to reduce dependence on coal and oil as well as update the technological infrastructure built around them. While energy sources diversify over the next 10-15 years, and renewables grow market share, there will still be some short term upward movements in fossil fuel markets.

But the trajectory looks clear and, unlike previous ups and downs in clean energy markets, there is no going back. Responsible investors are already analyzing and adjusting portfolios for the risk and reward opportunities in the low carbon economy ahead.

Kevin Rudd is President of the Asia Society Policy Institute and the former Prime Minister of Australia. He is an Advisory Board Member of the Morgan Stanley Institute for Sustainable Investing.

Audrey Choi is CEO of the Morgan Stanley Institute for Sustainable Investing. She is a former correspondent and bureau chief at The Wall Street Journal and former Chief of Staff to the Council of Economic Advisors.