ESG Focus: Climate Change Megatrend – Part 1

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:

-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.

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