ESG: Not achieving enough to address climate change

Financial markets are sleepwalking into imminent – and abrupt – government policy action in response to climate change, and ordinary savers could end up paying the price, the UN-backed Principles for Responsible Investment (PRI) warns.  

“Given the Paris Agreement’s commitment to limiting the increase in global average temperature to 1.5 degrees above pre-industrial levels is looking to be an ever more elusive target, and the time left to be able to do anything near that is going to be shorter and shorter, significant policy change will be needed to have an impact,” explains Fiona Reynolds, PRI CEO.

‘Inevitable financial fallout’

Reynolds suggests that by the time governments really get their act together to address the climate emergency, the policies that will be introduced to address the climate risks will be forceful, disruptive and disorderly because of the delay.  

The PRI predicts that up to US$2.3 trillion could be permanently wiped off the world’s largest companies by 2025 as a result of abrupt and forceful government climate action, with the most carbon-intensive firms losing more than 40% of their value.

The analysis is a core component of a major initiative the PRI is working on with partners Vivid Economics and Energy Transition Advisors. 

The PRI’s Inevitable Policy Response (IPR) is a considered and detailed programme, designed to help investors prepare for what they forecast as the “inevitable” financial fallout in a transitioning and complex policy and regulatory landscape.

“The pressures on governments from the increase in extreme weather events, shocking climate research findings, civil society on the march, demanding change, and security concerns around the increase of climate refugees in the future are all going to have a major impact on how investment policy is shaped in future,” Reynolds warns. 

She points out that central banks have even started to talk about the risk of not considering climate change and climate policy developments on financial markets. Pension funds are now demanding to understand how investment managers are dealing with climate transition risk and how the companies in their portfolios are making the transition to a low-carbon economy.

The PRI expects uncoordinated, localised policy action across a number of critical levers that will have a dramatic impact on global financial markets.

These include the phasing out of coal, a ban on internal combustion engines and widespread carbon pricing.

Industry decarbonisation, a significant ramp-up of renewable energy and energy efficiency initiatives, widescale reforestation programmes and major investment in agricultural technology and infrastructure will also create major losers – as well as winners – in the financial markets, Reynolds argues.

The PRI report predicts that oil use will peak between 2026 and 2028 with solar and wind generating about half of all electricity by 2030. It says deforestation will be virtually eliminated in the same timescale. 

“Even with major policy change we will still struggle to limit warming to 1.5 degrees. Developments in technology including those generating negative emissions are going to have to play a huge role in our future,” she adds, calling for investors to not only mitigate the risks to their portfolio but also seek out the opportunities surfaced by the transition to the world of the future.  

Jeremy Grantham, one of the pioneers of quantitative investing and co-founder of US-based investment firm Grantham Mayo Van Otterloo (GMO) makes the case for increasing regulation quickly to address the climate emergency.

A well-respected voice in the global investment community whose quarterly letters to clients make media headlines, Grantham set up the Grantham Foundation for the Protection of the Environment in 1997. He has famously committed 98% of his net worth to fighting climate change, but is not optimistic we are currently winning.    

“The market forces of capitalism are unequipped to tackle the current climate issues facing the planet,” he says, but cautiously suggests that “as conditions deteriorate we will be forced to behave more responsibly”.

This certainly seems to be the case already as investment data shows billions of dollars pouring into ESG strategies and no abatement in enthusiasm. 

One of the world’s most influential investors, the Norwegian Sovereign Wealth Fund, worth US$1.4 trillion (£1.1 trillion) is invested in more than 9000 companies – the equivalent of owning 1.4% of every listed company in the world. 

Cultural shift

Norges Bank Investment Management’s Chief Corporate Governance Officer Carine Smith Ihenacho talks about the enormous importance they put on ESG investing as long-term investors on behalf of the Norwegian population. 

She describes how last year they had more than 3,200 meetings with companies in their portfolio and about half of those meetings involved discussion of ESG factors.

“We are particularly pushing for better reporting on ESG from our investee companies with a focus on data and outcome-based metrics,” she says.

Meanwhile, Dutch pension fund manager APG has doubled its assets under management related to the UN’s Sustainable Development Goals over the past five years.

“This has required an enormous cultural shift to include responsible investing as one of the main pillars of our investment process across all asset classes,” says Gerben de Zwart, Head of Quantitative Equities, APG Asset Management. 

Questions from APG’s clients on the associated impact on risk and return has forced the firm to focus on clear communication and effective data and research, de Zwart reveals.    

Lasse Pedersen, Professor of Finance, Copenhagen Business School and NYU Stern and Principal at AQR Capital Management says his ESG-efficient frontier theory is one way that investors can assess the costs and benefits of socially responsible investing without always putting profit as the sole investment objective. 

But changing the pure-profit motive and shareholder-led approach to investing is not proving palatable for everyone. 

While 181 US CEOs signed a Business Roundtable letter in August of 2019 dropping the shareholder-first approach long-held as the purpose of a listed company to include a much wider stakeholder group, others take a different view.

This includes Nobel Laureate Oliver Hart, Andrew E. Furer Professor of Economics, Harvard University. 

“The stakeholder approach flies in the face of freedom of contract,” he argues. “Where the pure-profit motive is not working in the interests of ESG concerns, those issues can be resolved through consultation with shareholders.”   

On the march

Meanwhile, the Impact Investing Institute was set up last year in the UK with government support to grow a sustainable ESG investment market and catalyse change in the capital markets.

Dame Elizabeth Corley, Senior Adviser, Allianz Global Investors and Chair of the Impact Investing Institute emphasises the importance of inclusionary approaches to ESG investing, which are more effective in driving more positive business behaviour and solutions to the planet’s problems. 

She says simply excluding certain businesses from a portfolio has limited overall benefit to the planet as someone else will be prepared to hold the so-called “sin stocks”.

From an academic perspective, Henri Servaes, Richard Brealey Professor of Corporate Governance; Professor of Finance of London Business School, warns that ESG strategies will not always be the best-performing, particularly in the short-term. He calls for calm and rational analysis in the wake of growing media attention and excitement about the sector. (See box below.)

As the ESG investment market continues to grow, so too does the potential for greenwashing – false claims from investment firms as to the extent of their ESG credentials – and the potential for scandal, but there can be no doubt that ESG investing is on the march and is an ever-evolving phenomenon.

Within the next five years, it could just become known as investing and if the investment community can lead the innovation and find opportunity in the challenges that are facing the world, policy intervention need not be as punitive.

But that remains to be seen.

Prof Alex Edmans
Corporate Governance: Why Investors should care

Prof Henri Servaes
ESG Investing: The Academic Perspective

Prof Lasse Pedersen
The ESG-efficient frontier

All comments in the above article were made at London Business School’s 2019 Insight Summit on the future of investing: ESG and New Frontiers hosted by the School’s AQR Asset Management Institute.