ESG Focus | Aug 05 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:
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/
-Climate change is a 10-pronged attack on markets; systemic and unhedgable risk
-Most significant effects of climate change will be felt in the second half of the century
-Successful transitioning delivers superior longer-term returns
-Climate change and inequality are intertwined
The Climate Change/Inequality Nexus
By Sarah Mills
Climate change is the megatrend king
Climate change is one of three ESG megatrends that are transforming the investment landscape, according to a 2017 Robeco report Three megatrends shaping the world.
Of these, climate change is the dominant ESG thematic. It supersedes all environmental, social and governance themes and is driving massive flows of capital through equity and fixed-income markets.
This article is not about the science of climate change. It accepts that the concept alone is driving capital flows; provides an ABC of climate-related ESG concepts; and examines the way in which climate-related ESG investment themes are likely to play out over the decade.
A 10-pronged attack on markets
Climate change and sustainability are driving the green investment movement, which includes green equities, green bonds, and green real estate, and shuns their flipside, dirty equities, dirty bonds and dirty real estate.
Climate change is expected to affect markets in eight main ways:
- Imposts as regulators move to make polluters pay (part of the broader sustainability push);
- Imposts on non-taxpaying multinationals such as Apple, Amazon, etc, to fund society through the transition;
- Stranded assets as the old economic model for fossil fuels founders;
- ESG flows out of carbon-intensive assets and into renewables;
- Compressed margins as a massive spend on decarbonising and improved efficiency increases costs;
- Volatility across all sectors: Investors are already flocking to companies and sectors with almost zero-carbon risk, rather than taking a more measured approach to those that are decarbonising, forcing up price-earnings multiples in some stocks and industries, creating bubbles, while destroying value in others, and laying the stage for massive corrections;
- Capital destruction arising from growing climate volatility and more frequent extreme weather events; and
- The potential of extreme weather events to heighten inequality (another ESG megatrend), and threaten global social and economic stability, resulting in further capital destruction.
It also may have two related affects that dovetail with the inequality megatrend:
- The possible break-up of corporations and a rise in anti-trust legislation as the powers that be seek to shore up inequality in a bid to avoid social instability as a result of the transition (and the sustainable 4IR transition).
- Shifts in employment legislation to ensure a greater distribution of wealth (for the same reason as above), both of which will threaten margins.
Institutions flex their muscles
Institutions are determined to manage their exposures to these risks and have proven more than willing to flex their muscles.
Fossil fuel companies and major downstream carbon users are being dragged kicking and screaming to the climate change table, and are being forced to reveal their carbon dioxide emissions, and other sustainability metrics.
Many of the world’s largest hedge funds are excluding companies that refuse.
This has been one of the first steps in gaining transparency on climate change exposure; revealing fossil fuel and downstream user risks.
“Short term shifts in market sentiment induced by awareness of future, as yet unrealised, climate risks could lead to economic shocks, causing substantial losses in financial portfolio value within timescales that are relevant to all investors,” says the Cambridge Centre for Risk Studies, in its 2015 benchmark report on stress-testing financial portfolios for climate risk: Unhedgable Risk: How climate change sentiment impacts investment.
“Factors including climate change policy, technological change, asset stranding, weather events and longer term physical impacts may lead to financial tipping points for which investors are not presently prepared.”
It says the most significant effects of climate change will be felt in the second half of the century but that markets are likely to experience significant volatility in the next two decades as investors pivot to protect capital.
Carbon lending slashed
The above is a concerning assessment given the massive steps that are already being taken to reduce these risks.
Goldman Sachs shows that new lending to the upstream fossil fuel space in Europe fell from more than $14bn in 2014 to less than $2bn in 2018 and predicts the lack of investment and credit availability will result in sharply lower global production by 2025.
This is likely to result in intermittent sharp short-term spikes in prices as a result of supply shortages, but every exaggerated spike in prices will drive consumers increasingly into the more predictable renewables camp and away from fossil fuels.
Nevertheless, renewables rely on fossil fuels for production so it is likely to be a rocky ride.
“The current down-cycle is set against a backdrop where major institutional investors and lenders are increasingly withholding capital from upstream companies … and the implications are profound,” says the investment bank.
“The capital that is leaving the industry today, through organic means (a price downturn) may never return due to the adoption of (inorganic) policies driven not by returns but by social activism on the part of investors.”
It is interesting to note that those less aligned with ESG investment describe such activities as social activism, whereas the institutional investors are framing their decisions through the lens of risk.
Systemic unhedgeable risk
The definition of an ESG megatrend appears to be related to the reach, or influence, of an ESG theme as well as its risk profile, and this is why climate change trumps Robeco’s second and third megatrends: inequality and cybersecurity.
Climate change is billed as the unhedgable risk, and the Cambridge University report shows that less than 50% of all portfolios can be hedged against the impacts of climate change. Not good odds for investors.
All economic sectors are exposed to this risk. Although fossil-fuel-related industries are the most directly affected, any company that uses energy will suffer consequences. Hence the corporate drive for greater efficiency and lower carbon reliance is set to intensify as companies in all industries attempt to stay ahead of the pack.
Regulators will not be ignored
It is in recognition of this systemic risk that central banks have stamped climate change as their territory and right, claiming climate change is “a source of financial risk” that falls well within the mandate of regulators.
Basically, the central bankers seek a systematic approach across all countries to mitigate risk. They seek a new rating system for public and private sector investments – something organisations such as S&P are already working on, and a global standard for financial markets and public procurement.
It is expected that a full rollout should occur in 2021. It will significantly affect global equities, real-estate and fixed-income markets, but should at least give ESG investors more specific guidance.
The inverse relationship
The market affects listed above can be broken into two large financial risks:
- The physical effects of extreme weather and climate conditions on human food sources, health; assets and the environment; and
- The impact of the transition to a lower-carbon economy
There is a relationship between the two: the faster the transition to a lower carbon economy (increased transition risk), the lower the physical risks, and vice versa. The idea is that investment in transitioning should be more than offset by the costs associated with unchecked carbon growth.
Three risk scenarios
Robeco‘s report outlines three potential scenarios for climate change, which correlate closely to Cambridge University’s 2.0C, Baseline and No mitigation scenarios:
- A benign scenario in which temperatures rise 1.5C to 2.0C;
- A midling scenario under which temperatures rise 2.0C-2.5C; and
- A third scenario, of higher temperatures
ESG policy has and is being developed around these scenarios.
A United Nations Environment Programme report estimates that to meet the 1.5C target, emissions from all sources must fall by -7.6% a year between now and 2030, and keep falling after that.
To meet Robeco’s midling scenario would require annual reductions of -2.7% a year.
Scenario 1
The benign scenario is based on a speedy shift from fossil fuels to low-carbon alternatives. This would require massive investment in new infrastructure and this bill is expected to be footed by investors in traditional stocks.
On the flip side it represents opportunities for new infrastructure investment, technologies and industries.
Robeco notes that it would also generate greater market volatility as the impacts of climate change become deeper and more regular, so investors can expect more and larger ructions over the decade.
There has been some talk of regulations to reduce short-term trading in some of its manifestations to help manage this volatility.
The Cambridge University report warns that markets will demonstrate orderly behaviour in the near term before becoming increasingly disorderly as investors rush to shed at-risk assets.
The Robeco report predicts that, under the first scenario, the distribution of funds into new industries will provide employment and reduce social unrest and lay a runway to long-term sustainable growth, feeding positively into the second ESG megatrend of inequality.
The Conversation notes this scenario would save the economy trillions of dollars in the long term, despite the massive transitioning costs.
From an environmental standpoint, The Conversation says that beyond 1.5C, dangerous tipping points could be triggered resulting in rainforest die-back, deadly heatwaves; sharp rises in sea level; the extinction of half the world’s insect and plant species. The worst-case scenario would be ecosystem collapse and a threat to human civilisation.
This contrasts sharply with the more measured tones of the Cambridge report, which says a No Mitigation approach would definitely result in recession, lower productivity and investor returns in the next five years. Something of a moot point in the wake of the coronavirus.
Scenario 1 would offer the strongest long-term returns for aggressive equities portfolios, according to the Cambridge report, and the lowest returns for High Fixed Income (although equity preservation in the latter would be respectable).
Scenario 3
Skipping the 1.5C-plus midling scenario and going straight to the third scenario of greater than 2.5C (or the Cambridge University No Mitigation scenario) yields catastrophe.
This scenario envisages a world in which growth is prioritised over the environment and the resulting slump in confidence as environmental degradation, water stress and resource constraints bite would result in conflict, lower sovereign credit quality, subdued economic prospects, and sharp falls in long-term returns.
The consensus is that it would be particularly painful for high-growth equities portfolios and High Fixed Income would be the outperformer.
Scenario 2 (Midling)
Robeco’s midling scenario forecasts a slower reduction in fossil-fuel useage; and one assumes the impact on markets would be somewhere in between the first and third scenarios.
The Cambridge report predicts this “Baseline” outcome would outperform the first scenario in the short term, but underperform in the long term.
The Cambridge study
The Cambridge report has proved something of a benchmark for climate change commentators. It models the impact of the three climate change scenarios on four types of portfolios: conservative, balanced, aggressive and fixed income only.
It stress tests each portfolio against the macroeconomic effects of carbon taxation, energy investment, green investment, energy and food prices, energy demand, market confidence, bond market stress and housing prices.
“Some of the economic losses incurred in this transition can be avoided or hedged through mere reallocation strategies, while others will require system-level intervention in the form of policy or regulatory action,” the report says.
The results show that on a No Mitigation basis, 47% of the negative impacts of climate change across industry sectors can be hedged through industrial sector diversification and investment in industries that exhibit few climate-related risks.
Shifting from an aggressive equity portfolio to higher fixed-income assets makes it possible to hedge 49% of equity risk. But no strategy will offer more than 50% coverage.
“This gives rise to the conjecture that, even in the short run, climate change will constitute an aggregate risk requiring system-wide action in order to mitigate its economy-wide effects,” says the Cambridge report.
Emerging markets are forecast to suffer more than developed markets; and some of the equities risk can be offset by re-allocating into stocks with low climate-change exposures, but again, only about 50%.
In terms of transitioning risk, the report has this to say:
“Although the physical effects of climate change will have limited impacts on the economy over the next five to 10 years, the effects of climate policy and market sentiment may cause significant economic disruption.”
The short-term economic impact of both No mitigation and 2.0C result in negative consequences for the economy. 2.0 degrees cuts economic growth in half compared with the baseline scenario. It performs worse than the baseline in the short term but recovers and grows much faster in the longer term, outperforming the baseline by 4.5%. No mitigation underperforms by 16%.
Best and worst performing sectors
Not surprisingly, heavy users of fossil fuels are likely to bear the brunt of transitioning losses.
The Cambridge report expects that, under the first and second scenarios, the three worst performing sectors in the developed world will be real estate, followed by basic materials, construction and industrial manufacturing.
The best performers would be transport and agriculture, followed by consumer retail, health care, industrial manufacturing and technologies (think 4IR).
In emerging economies, the worst performers are tipped to be energy/oil and gas, consumer services and agriculture.
When it comes to individual stocks, Robeco has this to say:
“Investment candidates are those companies that are building a strategy which will be implemented in a safe, responsible and carbon-efficient manner, through technology innovation, digitalisation and strategic partnerships … this will improve the quality of the company’s asset base; and boost the sustainability of cash generation over the long term.”
Cash generation appears to be a primary theme for fossil fuel companies seeking inclusion in fixed income portfolios in a post-ESG world, as does investment in low-carbon energy systems.
A few upshots from the report:
- Fixed income and quality green bonds should prove something of a safe harbour under all scenarios;
- Investors will need to keep a keen eye peeled to global temperature and weather events as guidance to Scenario progress;
- Investors will also need to keep a keen eye peeled to systemic regulatory action. Strong intervention being suggestive of a Scenario 1;
- The pace of transition. Transition implies continuous movement and innovation from one point to the next, with both points at the moment appearing largely undefined. It suggests investors seeking to ride ESG investment flows will need to be nimble and focus on technologies that have the best chance of survival over the longer term, or which offer a strong return as an interim “transition technology”.
Slicing and dicing economic impact
Meanwhile, other analysts have been busy integrating climate change into their traditional economic frameworks.
Amundi points to three major risks: physical risks arising from climate and weather events (capital destruction); liability risks arising from climate change compensation; and transition risk arising from a sudden shift to a low-carbon economy.
It then models the global economy under a range of assumptions.
“In assessing organisations, analysts ask if a company or individuals/countries can subsist physically and economically if the average temperature rises. What would they have to pay if the optimal tax was implemented and would its business still be profitable,” says Amundi.
Morgan Stanley meanwhile has published a report titled Climate Change: Physical Risks and Opportunities Emerging.
It proposes a framework for assessing the physical impacts of climate change – short-term disruption versus long-term structural change. It is quite long and examines several industries and sectors and rates them according to their vulnerability. It notes that individual businesses even within the same sector can have different experiences.
Risk assessment products growing
Just to further confuse investors, a myriad of climate data risk assessment products are hitting the market.
MSCI, for example, has launched a product to assess climate data for private real estate assets: the MSCI Real Estate Climate Value-At-Risk provides a forward looking return-based valuation assessment to measure climate-related risks for real estate assets in an investment portfolio. It looks at transition risk and models the way in which a building may need to change over time to comply with jurisdiction-specific legislation.
Climate change and inequality nexus
It is tempting to assume that the climate change megatrend is being prioritised over social investing (the inequality megatrend), but rather, the two are considered to be closely related and are likely to ratchet up together to some degree, with climate change leading the charge.
In a strongly worded article in Forbes, Wal van Lierop of Chrysalix Venture Capital argues that to truly fight climate change, inequality must come first.
He notes that given inequality is now at its highest since before Nazi Germany, the wealthy cannot expect the poor to fund climate change or it will risk class warfare; and urges ESG investors to become GSE investors, prioritising governance and society ahead of climate change.
“To push primarily the E in ESG without more accounting for social impacts will undermine support for solving our massive environmental problems,” says van Lierop.
“The financially insecure working class will place its lot with populist strong men who promise yesteryear’s jobs in exchange for autocratic powers.”
Lierop notes that much of the onus to transforming climate change is being placed on corporations, and while not quite the fox guarding the henhouse, it is a flawed strategy and he expects greater regulation will be necessary.
“No matter how well corporations score on ESG frameworks, they are ill-equipped to solve complex, systemic problems that offer no short-term profits.”
Elsevier elaborates on this, citing economy theory from the likes of Knapp, Elking, Luzzati, and Miclas Luhmann’s theory of social systems.
It points out the difficulty corporations have in this respect given the open system character of the economy.
“The understanding of the present-day sustainability challenges, as well as the understanding of sustainability accounting rest on specific assumption about the relationship of the economy to its outer environment …”
It notes that because corporations exist within the system, and the fact that they affect the environment and vice-versa, it makes it difficult for them to gain a more global perspective given they are always prone to favour certain outcomes over others.
In summary, investors are standing on the crest of a tidal wave. Flocking to low-carbon companies may not be the safe haven imagined. Careful thought, with consideration to both the Climate Change and the Inequality megatrend will be essential to riding the barrel in a world awash with wipeouts. Our next article, Climate Change 2 – takes a peak at the fossil fuel industry.
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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