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ESG Focus: The Megatrend Is Your Best Friend

ESG Focus | Jul 23 2020

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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: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

This is the first article in a series covering the ESG and ESG-related megatrends that are framing investment flows in the 21st century. It sets the scene and the major parameters and metrics guiding investment flows for the near, medium and long term

ESG Focus: The Megatrend Is Your Best Friend

-Megatrends are transforming institutional investment approaches
-Creative-destruction concepts spawn ESG megatrends

-Naming the megatrends, sustainable themes and metrics

By Sarah Mills

The old saying “the trend is your friend” has proved the investor’s rallying cry through the ages, and this remains the case with ESG.

Megatrends have always set the stage for investment, be they population demographics, technological revolutions, or government driven regulation.

ESG has, in a very short period of time, emerged as a new global megatrend, muscling out its own space, sometimes in competition with other megatrends.

This is demonstrative of the power of vast swathes of capital at play. More than US$3trn in funds are being funnelled globally through direct ESG filters every year, and growing.

The most recent US SIF (Sustainable Investment Framework) Trends Report notes that funds channelled into general sustainable investment strategies is even larger, hitting US$12trn in the United States alone – or 25% of professional assets under management – as investors seek superior risk-adjusted returns or greater protection in uncertain times.

It’s the vibe

This megatrend has proved something of a quandary for many analytical investors given the lack of transparency and often anti-intuitive nature of ESG scoring through these filters. 

ESG is also elbowing its way into the traditional megatrend territory and skewing long-standing investment practices, adding to confusion.

But it is a good match for trend investors.

The Economist posts this cracker of a quote on the subject of the scoring factors that claim to assess corporate performance based on ESG factors from United States Securities Exchange Commissioner, Hester Peirce: 

Labelling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric”.

This is a fair comment. Investors are being asked to put their capital in the hands of those with sophisticated, opaque scoring systems, the only people it seems, with the wherewithal to process the vast amounts of information required to assess the rate of global corporate progress towards the 17 United Nations sustainable development goals (SDGs) 

This is a development, a bit like high frequency trading, which has the power to disadvantage smaller individual investors – at least until technology becomes cheap enough to increase accessibility. 

But small investors can still jump on the ESG bandwagon and prosper. Because ESG is a major trend that is continuing to build momentum, for the next few years at least, investors reweighting their portfolios intuitively to major ESG themes, using core sustainability metrics, are likely to be swept along with the tide.

This series of articles aims to simplify some of the guiding principles and unravel some of the mystery to at least lay down some broad themes for the avid trend investor.

What is a megatrend

The United Nations Principles for Responsible Investment (PRI) lists five megatrends: environmental challenges; society and demographics; globalisation and connectivity; emerging economy growth and dynamism; and technological advances. 

PRI defines megatrends as global macro forces that transform business, marketplaces and society. They affect the financial system, capital allocation and environmental and social conditions, including the ability to deliver the United Nations Sustainable Development Goals (SDGs).

“Megatrends are omnipresent but growing in importance,” says PRI in its Responding to Megatrends report. “Increasingly, it is apparent that these should form part of all institutions, investment processes.

“Most institutions share a common belief that megatrend dynamics will result in multidimensional transformations across society, technology, economics, environment and politics (STEEP) … to be framed within the context of an integrated system of real-world powerful forces altering the structure of economies, industries and global capital markets.”

PRI ranks the megatrends in order of impact and difficulty of management. Technological Advances top the list, followed by Society and Demographics, Environmental Challenges, Globalisation and Connectivity and Emerging Economy Growth and Dynamism.

Marx and Schumpeter’s creative destruction

Megatrends have their conceptual roots in the economic theory of creative destruction, as first outlined by Marx and popularised by Schumpeter.

In his Theories of Surplus Value, Marx pointed out that capitalism carries its own seeds of destruction as a result of surpluses, that trigger crises, which then prevent companies from renewing their reproduction process at the same scale (such as the extreme example of war). This is a big simplification for the purposes of brevity.

Schumpeter and other proponents elaborated on this theory, noting that the destruction inherent to capitalism triggered transformative changes (for our purpose megatrends), propelling capitalism further. Markets have since used the term more loosely to describe any number of trends.

The differences between Marx and Schumpeter in regard to creative destruction, is summarised by social geographer David Harvey as follows:

Both Karl Marx and Joseph Schumpeter wrote at length on the “creative-destructive” tendencies inherent in capitalism. While Marx clearly admired capitalism’s creativity, he … strongly emphasised its self-destructiveness. The Schumpeterians have all along gloried in capitalism’s endless creativity while treating the destructiveness as mostly a matter of the normal costs of doing business.”

Add concepts of creative-destruction to modern monetary theory, which holds that, in the absence of inflation, the creation of money should absorb/unleash spare capacity in the economy (helping smooth out those destructive tendencies of those capitalism-induced surpluses), and it brings us pretty much to today’s economic environment. 

More than ever, the megatrend is the investor’s best friend; and only time will tell if Marx or Schumpeter’s view will prove correct.

What is an ESG megatrend

Both 4IR and ESG have been mooted as megatrends of the decade but in reality, ESG is something of a vehicle or concept into which several relatively new global megatrends have been bundled.

ESG megatrends are sub-trends of the above five megatrends, but are large enough to be transformative in their own right.

Their definition is related to both the reach/influence of the ESG thematic and its risk profile in relation to economic and social stability.

Climate change for example, represents a systemic risk; as would inequality, and food security.

These ESG megatrends have emerged in part in relation to PRI’s five megatrends, and creative destruction:

“A systems view of megatrends reveals the interrelation of several sustainability issues which broadens the set and complexity of second-order risks and opportunities for investors,” says PRI.

“Greater interconnectivity between economies and financial markets has shifted perspectives from considering how a single company competes compared with the system as a whole, allowing a better assessment and management of risks faced by individual companies as well as systemic risks.”

For example, PRI notes that the main impact of climate change is through transition-driven "creative destruction" in the global power sector and secondary effects along supply chain chains, which affects about 25% of all listed global equities.

PRI notes that, from a capital allocation perspective, the implications over 10 years are moderate but scale rapidly over time.

Studying the investment ecosystem, not just the markets, is critical to anticipate some transformational changes, especially given the accelerating pace of change.”

The main ESG megatrends

A few years ago, asset manager Robeco published a report: Three megatrends shaping the world, in which it pegged climate change; inequality; and cybersecurity as the three main ESG global megatrends.

The report examined themes dominating the short to medium-term ESG landscape, but it would be fair to add other megatrends or related megatrends to this list for the medium to long-term.

A “sustainable” fourth industrial revolution would be one. The 4IR is a megatrend, posing systemic risk in its own right, but the decision by the powers that be to link it to sustainability has created a hybrid megatrend that will guide huge flows of money – most likely within the next five to 10 years.

The 4IR sustainable hybrid is really a sub-trend of the larger sustainable investing megatrend, which has grown in currency given greater understanding of the risks entailed in investing in companies and industries with poor sustainability.

For example, a company that is inefficient with water and energy will have a higher cost base than its competitors. Also, poor management of resources can trigger conflict, and rapid collapse of any number of social, economic and natural systems.

I am also adding water to the list. Water, a sub-trend of sustainability, has yet to make its presence felt, but legislation in this area has been carefully and quietly laid down for the past several decades and water is likely to emerge within the decade as another megatrend. Already, “water barons” have emerged in drought prone regions such as Australia, China and California.

Another likely ESG-related megatrend is rapid urbanisation. It carries a level of systemic risk and is likely to result in a large flow of funds over the next few decades. It has been noted that rapid urbanisation is one way to absorb economic surpluses (remember Marx's pesky crisis-causing surpluses). China is a classic example of this.

So not surprisingly, the development of cities plays a key role in the United Nations Sustainable Development Goals.

So where do the United Nations SDGs fit in? It would be tempting to suggest the SDGs are megatrends. But rather, several of the goals are bundled into an overarching trend, and sometimes cross over. 

For example, gender equality, ending poverty, slavery and hunger, for example, would fall under the Robeco megatrend definition of inequality. But ending poverty and hunger also have dramatic implications for food systems, and the development of cities, for example.

Sustainable development

As mentioned above, sustainability is a broad-based mega trend, into which many other ESG megatrends are bundled.

Sustainable development as defined in the 1987 Brundtland Report general protection targets involves:

  • Protection and restoration of the natural environment/ecosystem
  • Protection of natural resources
  • Protection of human health and, wherever possible, improvement of well-being
  • Protection and promotion of social value and of public goods
  • Protection of capital and material goods.

Others:

  • Non-renewable resource consumption (materials)
  • Non-renewable resource consumption (energy)
  • Freshwater consumption
  • Lifecycle cost
  • Safety

One of the key findings of the report was that poverty increases environmental destruction, threatening human civilisation and the natural world, hence, ending poverty is a key driver of SDGs.

Collision of megatrends

As ESG thematics collide with old systems and new technological developments, new investment themes appear, generating opportunities and risks for investors.

For example, inequality could generate new developments in human capital management – a shift from the system that has dominated for the past 200 years and been refined in the past 30 – and companies that excel in this arena may gain an edge.

Another theme, related to the 4IR megatrend is data. As Microsoft’s former head of research and strategy Craig Mundie said data is “becoming the new raw material of business almost on par with capital and labour.”

Sustainalytics in its 10 for 2020: creating impact through thematic investing report nominates 10 such themes around the following trends and assesses them against SDGs:

  • Scaling big tech (relating to SDGs 8 and 9)
  • Health and Society (SDGs 3 and 12)
  • Ecosystem Stewardship (SDGs 14 and 15
  • Mitigating climate change (SDGs 7, 11 and 13)

These themes are:

  • 5G
  • Digitilisation of mining
  • Industrial automation
  • Connected medical devices
  • Slow fashion
  • Cleaner shipping
  • Banking on biodiversity
  • Energy storage
  • Big oil transition
  • Reinsuring climate change

There are many other such thematics emerging and these are likely to have knock-on impacts across the board, offering new investment opportunities.

Megatrend investing: a broad-brush approach backed by metrics

Adopting the “trend is my friend” approach, large swathes of passive investors are advising their fund managers to jump on the ESG train.

However, this is little help to active traders that prefer to manage their own funds, or those managing funds for others, who would like to supplement their trend investing with facts and figures.

The major problem all investors face is the lack of standardisation of information, and lack of transparency of data.

Steps are in place to rectify this. The United States Sustainability Accounting Standards Board, for example, has developed 77 industry specific sustainability metrics.

The US government ruled last year that companies must report on these metrics annually as part of their 10K filing form, but it will take some time before many corporations develop the reporting systems to meet these regulations. 

Those that do, are likely to be favoured initially, and this will be something to keep an eye out for if investing in individual companies, as will any large pledge to improve sustainability.

BHP Group ((BHP)), for example, recently pledged $400m to improve its sustainability, and was rewarded with an immediate share price gain.

No such legislation is in place in Australia, although corporations are being asked to report on slavery in supply chains. 

The Australian Council of Superannuation Investors has developed an ESG reporting guide for Australian companies, and those companies that choose to follow the guidelines are likely to cover the sustainability metrics in their reports.

Assuming you do not have the money to invest in your own ESG software, and do not wish to hand your investment dollars to an adviser, the megatrends, backed by sustainability metrics in annual reports, do at least offer a general guide.

Greenbiz and Trucost in their annual State of Green Business report update their list of sustainability metrics annually to include any new metrics, and track the progress of the 1200 world’s largest companies globally against them. 

Many more national based platforms and registries are developing on specific megatrends. Many governments for example, are developing registers to police modern slavery.

In the traditional stock markets, using a traditional company-based approach, investors are likely to gravitate to those that demonstrate the best performances against ESG megatrends and metrics as published in annual reports: the “best-in-class” stocks.

Investors are being advised to seek out transparent scorers, not partial scorers or those offering incomplete information; and keep a keen eye out for greenwashing.

In the impact investment market, investors are likely to seek out ventures in service of the UN SDGs that also intersect with at least one other megatrend simultaneously, such as 4IR.

The impact investment market is harder to track from a standardised information viewpoint because investors tend to demonstrate preferences for different causes and this is likely to be refined at a slower rate than best-in-class investments. 

Guiding sustainability metrics

Some investors are opting to use sustainability metrics as an adjunct to megatrends, or in isolation, based on their own merit.

MSCI, for example, has 80 exposure metrics, six social themes, and five environmental themes, three dimensions: and more than 120 environmental social and governance indicators keyed to the Global Reporting Initiative’s list of performance indicators, and more than 70 key performance indicators in three categories. 

This is rather complex, and your average investor is more likely to opt to examine the annual report sustainability metrics and assess them against their individual investment viewpoints and ESG preferences, the main metrics being:

  • Greenhouse gas emissions
  • Energy-generation mix
  • Water use
  • Water pollution
  • Waste generation
  • Supply chain slavery
  • Economic
  • Gender representation on boards and management and in the workforce

ESG returns

ESG investments, depending on the choice, are offering outsized risk-adjusted returns because of the sharp rush of funds and growing volatility in markets.

However, Robeco points out the advantage to be gained from this megatrend when applied to traditional stocks is likely to slow within the next few years as these companies progressively and continuously invest in improving their sustainability. 

To an extent, this is already happening with many stocks being downgraded in advance. For example, value investors have taken a hammering with covid-19 and value-stocks are proving slow to recover, partly as investors direct funds to growth stocks to jump on megatrends, but there is also a level of caution on display.

Investors will need to be on the hop to keep on the crest of this wave.

During this downgrading process, risk-adjusted growth is most likely to be gained from new industries serving traditional sectors, supporting their transitions to new technology and sustainability. 

Examining the megatrends

In the meantime, we hope you enjoy the coming series of articles that will examine each of the abovementioned megatrends in isolation, starting with climate change (which will also include a series of articles on oil, gas and renewables).

In the meantime, funds continue to flow and, in the spirit of the trend is your friend, investors are being advised to keep their noses turned in the right direction and head for home – and don’t forget the umbrella.

As Dennis Denuto says in the Australian film classic The Castle: It's the vibe!

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: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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