Sustainalytics founder discusses how climate puts sustainability on the agenda, as well as the rise of retail investors.
I moved to a 72-acre farm in rural Ontario a couple of years ago. This experience provided me with a long list of “handyman to do’s” and an ever-expanding file of lessons learned. I’ve come to learn that people require the right tools to achieve their objectives. And that no matter how good the toolbox is, successful outcomes remain highly dependent upon a person’s skills and seriousness. These lessons apply equally to sustainable investing and finance. They are especially critical as the climate crisis increases the complexity of investing and the themes related to sustainability continue to proliferate.
As we enter 2022, it struck me that VUCA--a concept that originated in the mid-1980s at the U.S. Army War College to describe the volatility, uncertainty, complexity, and ambiguity of the world after the Cold War—is still a useful framework to think of where we are now. Greed and fear, as Warren Buffett has quipped, are "two super-contagious diseases [that] will forever occur in the investment community." From my perspective, the dominant feeling today is fear. New strains of the coronavirus continue to emerge. Geopolitical tensions are rising, with the re-emergence of historical tensions in Europe between long-time foes and an increasingly assertive China cracking down on religious minorities in Xinjiang and flexing its military muscle.
Clients and capital market colleagues often talk about how climate change is leading to systemic risks, thereby contributing to VUCA and an underlying sense of fear. Hence, the increased interest in what now falls under the rubric of sustainability – environmental, social and governance practices. For example, heavy rains and flooding have devastated British Columbia in the past few months, the third natural disaster to hit western Canada in the last year after a heatwave caused uncontrolled forest fires. Without trees and other vegetation, the barren landscape was vulnerable to flash floods and mudslides. Insurance and rebuilding costs are expected to top the C$12.7 billion (US$10 billion) of Canada’s most expensive natural disaster in Fort McMurray in 2016. That’s just one example of the knock-on effects of climate change. You can see how sustainability challenges can lead to disproportionate negative outcomes for disadvantaged countries and people who don’t have the same financial resiliency. Drought and flooding worsen their hardship and make it more difficult to supply basic needs. And that deepens inequality. Those issues were laid bare by some of the political divisions at the recently concluded climate summit, COP26. Developed nations, which arguably have contributed more to climate change, historically have failed to adequately support the financing of the energy transition for developing countries.
So, what do I expect from 2022? A few themes will help shape the discussion around sustainability.
Theme One: Climate has put sustainability in general on the agenda. We will now see a continuing proliferation of social issues intertwined with climate, such as the just transition. The Just Transition Declaration, signed by more than 30 countries at COP 26, reflects International Labour Organization guidelines and commits them to find strategies that support communities through the shift to a more sustainable economy. You will see more national initiatives, such as the EU’s €17.5billion (US$19.8 billion) Just Transition Fund, as well as global ones such as the UK’s CDC Group collaboration with India and South Africa. Then there are investor initiatives such as the World Benchmarking Alliance, which assess how well 180 companies are managing the just transition.
The climate crisis also encompasses a range of other issues—deforestation, the destruction of biodiversity, pollution, and human rights, among others. Ultimately, these are about the health and resiliency of the planet, which underpins the well-being of those that inhabit it. Humans are a part of, not separate from, nature. While climate change and weather-related events will dominate the coverage, discussions will be much broader. For example, they will encompass human health: In October, the medical journal The Lancet, predicted that climate change would be the “defining narrative of human health.” There is evidence that air pollution worsens the severity of Covid-19. All these discussions will pick up momentum. If climate motivates people to think about these problems in a meaningful way and turn that thinking into action, that can be very positive. The risk is that addressing climate change loses focus because people use it to promote their varied agendas.
Theme Two: Net Zero will focus the discussion for the foreseeable future. The Net Zero transition isn’t simply about reducing carbon. It’s a business model transformation akin to the Industrial Revolution. As will result through a long transition, there will be winners, survivors, and casualties. If you’re on a board of directors, in the C-suite, or allocating capital as an investor, you are trying to figure out what you need to do to be in the winner’s circle, or at the very least to avoid being a casualty. Much is unknown: Defining net zero is challenging, as is finding the best path to achieving net zero emissions. More daunting is contemplating a new business model while the market is evolving at lightning speed in unpredictable ways. As a critical pillar of the capital markets, the investor community must absolutely be focused on driving meaningful outcomes through their investments. I read a humorous article that poked fun at the net zero movement. It was about an Australian man who set an ambitious target to quit drinking by 2050 when he turns 101. He didn’t see that he needed to stop drinking in the short or medium term. That won’t work for Net Zero. We need meaningful progress now, or we’re not going to make it.
Theme Three: Divestment and engagement both have a place in the conversation. One of the most critical questions of our time is how we can de-carbonize investment portfolios. Thus, an old and much-trodden debate has again emerged on the front page– divest from high-carbon emitters, or engage with them? Divestment decisions look very different from the past. Consider Dutch pension fund ABP, which announced in October that it would divest from fossil-fuel producers, citing “insufficient opportunity for us as a shareholder to push for the necessary, significant acceleration of the energy transition at these companies." Similarly, YK Park, head of responsible investment and governance for APAC at APG, another Dutch pension scheme, described APG’s decision to divest from South Korea’s state-owned utility Korea Electricity Power Company (KEPCO) by saying “engagement wasn’t going anywhere, and we could no longer call ourselves a responsible investor by continuing to hold shares in the company.” Critics of divestment argue that the assets simply end up in the hands of private equity or state-owned enterprises, neither of which has cared much about sustainability in the past. The state-owned enterprises will surely require political will to change. But even private equity and venture capital are increasingly paying attention to sustainability issues. More and more, owners of capital will demand that their private assets are also engaged in ESG. As banks face more scrutiny from global regulators about climate risk, you can expect to see nudging from the capital markets on the debt side too.
As I shared off-the-top, that long list of to-do tasks at my farm has taught me that you need an array of tools, and the outcome depends on how seriously you wield those tools. Instead of simple letter-writing, those who engage with companies need to fundamentally challenge them on their underlying business models and call for significant change. That requires commitment and resources. Engine No. 1, the activist that elected three candidates to Exxon’s board this year is a very different model of engagement. Can it be done at scale?
It is certainly true that net zero represents a fundamental transition of the global economy, and grappling with it is part of fiduciary duty. Clients I speak with increasingly are undertaking stress testing and scenario analysis to ascertain how to position their portfolios. According to one model, by FutureZero in collaboration with Credit Suisse HOLT™, pricing carbon at US $75/ton CO2 equivalent for scope 1 and 2 emissions results in an erosion of more than $20 trillion to Enterprise Value globally, 83% of it from just five sectors: Materials, utilities, energy, industrials and consumer staples. I’m not arguing that this analysis can’t be challenged – I’m simply suggesting that the decision to divest from energy can be underpinned by an informed investment thesis guided by fiduciary duty.
Theme Four: Sustainability shifts from “nice to have” to “need to have.” As more investors in both public and private assets insist on greater sustainability, a screaming need for consistent, shared disclosure and reporting standards has arisen. Imagine a world without generally accepted accounting principles or international financial reporting standards. It would be chaos. That’s essentially where we are now. Today, the infrastructure for sustainable finance is falling into place. Recently, the IFRS Foundation announced the formation of the International Sustainability Standards Board (ISSB), which merges two important standards-setting entities. Meanwhile, efforts by Morningstar and others to clarify the terms used for sustainable investing can also help new investors who worry about greenwashing and other potential problems.
In 2022, as the pace of embedding sustainability considerations into longstanding financial reporting, oversight, risk, and regulatory frameworks quickens, I expect that our habit of speaking about sustainable and responsible investing, ESG and sustainable finance will begin to fall by the wayside. Increasingly, we will refer to the work we do as investment or finance--one’s prefix of choice no longer being necessary as sustainability becomes the norm.
Theme Five: Here come the retail investors. As Morningstar CEO Kunal Kapoor has noted, the number of ESG ETFs has exploded more than six-fold even as active ESG fund assets keep growing. That alongside record-breaking asset flows into sustainable funds may speak to the interest of retail investors, who are traditionally last to the party – and whose arrival, to cynical investors, heralds the top of the market. This might be true if sustainable investing were simply a fad, but investors are adopting ESG as part of the transition to a Net Zero world. Individuals in North America are a powerful client base for large institutional investors. Today, when Morningstar asks investors about sustainable investing, 77% say they don't really understand it. But when you take away the industry jargon, almost 90% of them say they want to engage more. More growth may come, in fact, as individual investors start investing in sustainable funds through their retirement plans.
I’d argue that retail investors have dual expectations: They care about a secure retirement, financial goals and risk, but they also care about whether air pollution is giving their children asthma or whether the increased incidence of wildfires means their home insurers are curtailing coverage. How ironic it might be that the final people to join this party may be the catalyst for moving the conversation towards the impact of portfolios to address these issues. In doing so, they could be the force that sparks change.
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