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ESG Focus: Investing For The Fourth Industrial Revolution

ESG Focus | Feb 24 2020

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG focus: Investing For The 4th Industrial Revolution

-ESG investing and reporting standards continue to develop
-Fourth Industrial Revolution is carried by both ESG and new technologies
-Global manufacturing will be transformed in the decade ahead

By Sarah Mills

The Fourth Industrial Revolution (4IR) is set to transform the manufacturing industry, which in turn is squarely in the sustainability sights of the world’s leaders.

Manufacturing’s early and pivotal position in the supply chain, and in the 4IR, means it will drive sustainability reforms across the globe, and will subject to greater-than-average scrutiny on many fronts.

In fact, many aspects of ESG appear to have been developed specifically to ensure that the Fourth Industrial Revolution occurs in a sustainable, orderly fashion; and particularly to ensure the social unrest witnessed in former industrial revolutions is not repeated.

A quick history 

Industrial revolutions tend to occur around transformative communications, energy and mobility convergences.

The First Industrial Revolution started in England in the 1760s and quickly spread to France, coinciding with the French Revolution (and being considered one of several causative factors). 

It started in Russia more than a century later in roughly 1880, and coincided there with the Second Industrial Revolution, a phase of rapid standardisation and industrialisation  (think centralised electricity and telephones) from the late 1800s to early 1900s. The Russian Revolution began in 1917.

Neither the French nor the Russian revolutions stopped the industrialisation process but they did wreak substantial disruption upon the world order. 

The Third industrial Revolution started in the 1950s with the advent of semiconductors, mainframe computing, personal computing, and the internet – yielding the first digital revolution. Thirty years later, the Berlin Wall fell and a new order began.

ESG provides a framework for the rollout of Industry 4.0

Many consider ESG as an important organising principle to ensure world peace and prosperity in what promises to be a period of intense upheaval. 

The World Economic Forum’s Global Risks Report rated unemployment and underemployment as one of its top five risks, noting its potential to create profound social instability. 

Interestingly, previous revolutions all generated economic growth and jobs and there is no reason not to assume the same will happen this time.

According to a Deloitte survey of industry CEOs, 87% of respondents believe Industry 4.0 will lead to greater social and economic equality and stability. The problem with most industrial revolutions is not jobs, but conditions, pay, stability and the pace of change.

But there is one major variable this time – the introduction of advanced robots and artificial intelligence, that will replace many low-to-medium skilled jobs.

Governments globally are canvassing options for a universal basic income, just in case, and the addition of a sustainability platform is expected to expand the breadth and scope of industry investment into a circular economy, which is being touted as a massive investment opportunity in its own right. 

Together, 4IR and the circular economy are expected to work hand in fist, in a ratcheting fashion, to accelerate productivity.

So the UN Sustainability Development Goals (SDGs), which sets the tenor for ESG standards, is expected to operate as an enabler of job generation, a securing of the world’s largest global asset – nature, as well as a brake on corporate excess.

World leaders set the sustainability agenda – it begins in 2020

Technological advances in manufacturing, combined with regulation aimed at improving economic efficiency and sustainability, will enable companies to support the UN’s SDGs and support a shift to a circular economy.

Regulation is expected to guide investment, but it is hoped the cost of transition will be largely offset by productivity gains from new technology.

“With 2020 being seen as the “super year”, kick-starting a decade of action for people and planet, there is also an opportunity to bring sustainable markets into focus in each of this year’s major global meetings,” declared Prince Charles at the World Economic Forum in January.

In order to secure our future and to prosper, we need to evolve our economic model. … I have come to realise that it is not a lack of capital that is holding us back, but rather the way in which we deploy it. Therefore, to move forward, we need nothing short of a paradigm shift, one that inspires action at revolutionary levels and pace.

Changes are already under way in manufacturing. According to a 2019 survey by PWC and The Manufacturing Institute of 100 US manufacturers, titled Navigating 4IR to the bottom line, nearly half reported they are in the early stages of a smart-factory transition (the awareness, experimental and early adoption phase). More than half planned to increase investments by up to 25% this year – a significant pool of money, which has to go somewhere.

Citi’s Factory of the Future report estimates growth rates for several manufacturing industries and service providers, and expects some could record compound average growth rates of up to 60% a year over the first half of the decade.

A McKinsey Global Institute simulation suggests that the front runners in adoption of artificial intelligence, a key 4IR technology, will increase their cash flow by 122%, while followers will see only a 10% cash-flow increase.

“The key driver is that higher transition costs and capital expenditures of the front runners is overcompensated for by output gains,” says McKinsey.

Massive growth opportunity for ESG investors in 4IR circular economy

The shift to circular manufacturing will create growth opportunities for ESG manufacturing investors.

The transition to a circular economy is estimated to represent a US$4.5trn increase in global growth and productivity gains by 2030, according to Reiter, and a major investment opportunity.

Using a sustainable markets framework, we have an incredible opportunity to create entirely new sustainable industries, products, services and supply chains, based on a circular bioeconomy, while in parallel helping to transition our existing systems,” said Prince Charles in his address. “To do this we must look at our markets using a business model approach to revenue generation and system operations.”

Prince Charles continued: “Sustainable markets can also inspire the technology, innovation and scale that we so urgently need … Looking forward, new employment opportunities, entire new industries and markets rooted in sustainability are within our grasp, with the potential for unprecedented economic growth.”

Think circular economy meets 4IR: think zero waste, recycling, smart design, inter-changeability, R&D, and multi-tasking of equipment and additive manufacturing.

Regulation – the sustainability stick

Most major economies have issued at least an in-principle agreement to a circular economy. For example, in 2018, China and the European Union signed a landmark agreement to align policies supporting the transition to a more sustainable economy. 

Countries to introduce ESG disclosure laws include the European Union, Germany, the United Kingdom, Norway, Sweden, South Korea, Japan, Kazakhstan, India, Singapore, South Africa, Brazil and Canada.

The United States has implemented the Sustainability Accounting Standards, in which companies must report on sustainability metrics in their 10K filing forms, and even laggard Australia has legislated on the issue of modern slavery.

A Deloitte survey of more than 2,000 C-suite executives across 19 countries on 4IR readiness found executives believed the changing regulatory environment will have the greatest impact on their operations – over and above the emergence of new businesses or delivery models, smart technologies, digitisation and an evolving economy. 

New regulation will likely be a response to how well – or not – governments perceive business is managing the impact of Industry 4.0 on the workforce, the public sphere and the environment. 

Prince Charles in his WEF address called for the: “reversing (of) perverse subsidies and improving incentives for sustainable alternatives. “

To achieve scale within sustainable markets we must not be afraid to adapt our long-standing incentive structures if we are to reap the benefits afforded by a more sustainable world,” he said.

Re-orientating economic subsidies, financial incentives and regulations can have a dramatic and transformative effect on our market systems

It is time to level the playing field and to think about how we properly deploy taxes, policies and regulation in a way that catalyses sustainable markets.

This reflects a sharp departure from the 20th century credos of letting the market decide. The market, it seems, can still decide, but only within a sustainable framework, as set by the UN SDGs.

The Deloitte survey suggests that it is with this departure in ethos that manufacturers struggle most. The majority of executives surveyed acknowledge they may not be ready to harness the changes of the 4IR with only one third of executives confident of capably acting as stewards.

“We have governing structures, legal systems, rules and institutions that were appropriate for the last industrial revolution, not this new one,” says John Flint, chief executive, retail banking and wealth management, and CEO-elect, HSBC, in the Deloitte survey. 

Regulations extend to the stock exchange with the Sustainable Stock Exchange Initiative (SSEI) – a UN Partnership Program. “The Sustainable Stock Exchanges initiative is a peer-to-peer learning platform for exploring how exchanges, in collaboration with investors, regulators, and companies, can enhance corporate transparency – and ultimately performance – on ESG issues and encourage sustainable investment,” says the website.

The SSEs meet each year to explore how they can work together with investors, regulators and companies to create more sustainable capital markets. They are designed to analyse, promote and foster communication on stock exchanges’ sustainability-related activities and they are increasingly likely to set ESG-based listing standards.

The SSEI has 84 international exchanges as members, including the ASX and Sydney Stock Exchange, and heavy hitters such as the New York Stock Exchange and London Stock Exchange.

ESG – the sustainability carrot 

If regulation is the sustainability stick, then ESG is the carrot.

Prince Charles forecast an increased focus on standardising ESG metrics and platforms: “… it is time to move to unified metrics and global standards … connecting investments to investables using platforms that can rapidly scale solutions,” he told the World Economic Forum.”

The Deloitte survey executives’ view on regulation reflects a generally held awareness that government taxes, subsidies and ESG investment choices will be one of the major sources of capital and drivers of financial success for the manufacturing industry.

Hundreds of trillions of ESG investment and tax dollars will be channelled into establishing a 4IR-enhanced circular economy over the next two decades.

This very much reflects the “Who Cares Win” spirit of the ESG founders – the title of the 2005 paper in which the term ESG was coined.

ESG frameworks set 4IR parameters – greater clarity to come

ESG frameworks have been rolled out over the past five years in preparation for 4IR and the circular economy, ranging from the UN SDGs, to the Sustainability Accounting Standards, and to Trucost (polluter pays) initiatives.

But both manufacturers and investors struggle with the lack of clarity in ESG reporting standards and rating requirements. This will change as 4IR kicks in, aided in part by 4IR technology. Reporting will become increasingly standardised, simplified and streamlined, making it easier for ESG investors in the manufacturing sector.

The 4IR will mark the advent of AI-driven sustainability data, which also aims to remove analyst bias – a small example of the ratcheting power of 4IR and the circular economy, which ESG architects hope will be mirrored across all industry sectors.

According to the World Economic Forum (WEF)’s website: “The Future of Sustainable and Impact Investing project aims to build industry coherence and collaboration to accelerate the evolution from the short-term investment mindset to one that focuses on long-term investments and sustainable impact.”

WEF has developed an ESG Ecosystem Map, which provides a momentary snapshot of the key players of the rapidly changing ESG system. It also refers to many principles such as Trucost and is a good starting point for would-be ESG investors.

“Complexity and non-transparency of the ESG ecosystem impedes investors in their ability to freely allocate capital to companies that score well on ESG criteria,” says WEF, which produced a white paper, Seeking return on ESG.

… By first shining a spotlight on exactly what is happening in this space, stakeholders can take an important step towards clarifying where any potential combination or convergence of efforts could be most beneficial. Therefore, this map aims to decipher the “who is who” and the dynamics of ESG reporting.”

In essence, the above will make ESG investing more transparent and based less on proprietary information, to open investment to a broader pool of investors. 

ESG tools and infrastructure specifically for the manufacturing sector

As mentioned above, at the big-picture level, the UN SDGs, set the pace, supported by legislation such as the US Sustainability Standards. And we have written previously about a range of broad ESG indices. The ESG Ecosystem Map lists the main players.

But exchanges and indices specific to the manufacturing sector are also being developed.

For example, the S&P Kensho New Economies Composite Index is designed to measure the performance of companies involved in the New Economies 21st Century Sectors.

It is a broad market index within the S&P Kensho New Economy Index Series and aims to represent companies that are “focused on propelling the Fourth Industrial Revolution and fostering new industries that will be transformative”. 

According to the website: “It strikes a unique balance between mainstream and cutting-edge companies as they shift their strategic focus to the 21st Century Sector technologies driving the rise of the New Economy.”

Meanwhile, The Paris Aligned Climate index will list companies with publicly disclosed science-based targets, to try and eliminate greenwashing. For example, companies must show a 7% annualised decarbonisation over the previous three years, using the Trucost physical risk concept.

For ESG manufacturing boffins, we list the SDGs that most directly relate to manufacturing (soon to be published on the FNArena website).

ESG funds will rebalance into manufacturing

Morgan Stanley says that, at present, Industrials only represent about 9% of the top-200 holding of ESG-focused funds, which is less than the MSCI average of 11%, but it expects this to change.

We see potential for ESG funds to rebalance their portfolios to be more in line with market weighting. Of these industrial holdings, about 60% are capital goods, with Siemens, Vestas and Schneider Electric the three European names most held by ESG-focused funds,” says the analyst.

Given some sectors and services are tipped to record compound average growth rates of up to 60% a year over the first half of the decade, and 122% increases in cash flow, it should be informative to observe the direction of managed funds with an ESG consideration over the next five years, which are tracking towards $50trn.

Timeline – already behind schedule

It is clear than many of the SDG’s 2020 targets will not be met, and Prince Charles WEF rhetoric suggests more meetings than actions for 2020 at least. 

For example, SDG target 12: “By 2020, achieve the environmentally sound management of chemicals and all wastes throughout their life cycle in accordance with agreed international frameworks, and significantly reduce their release to air, water and soil”, are well behind schedule. Several countries recently committed to coal-fired power stations.

In addition, much of 4IR will depend on the rollout of 5G technology, which is already meeting opposition from health advocates. The Belgian government has already ceased its pilot 5G rollout on the grounds cellular emissions exceed radiation limits. This may be an argument in favour of shifting to robots in 5G enabled manufacturing environments.

But if Citi’s Factory of the Future report and the McKinsey Global Institute simulation are anything to go by, the 4IR is starting to proceed apace, offering strong compound average growth rates in certain sectors over the next five years, and cash flow leverage for early adopters. 

It will be interesting to see to what extent 4IR and the circular economy coalesce between now and then.

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