The December 2018/January 2019 edition of our member journal, Financial World, featured a series of articles looking at some of the issues around sustainable investing and its impact on both the planet and on financial services.
Ben Caldecott explains how more detailed information on climate change is helping develop sustainable investment strategies and alter financial practice.
Financial institutions decide where capital flows, generally based on risk-adjusted returns. In principle, then, they could be expected to factor the risks of climate change and environmental damage into their analyses. That would not only give them more insight into potential developments, but also boost the resilience of the financial system as a whole.
At the end of October, the US Forum for Sustainable and Responsible Investment announced that US sustainable investment holdings in 2017 had increased to $12tn, a 38 per cent increase over 2016 (US GDP in 2017 was $19.3tn, according to the World Bank). Since the group began tracking the data in 1995, sustainable and responsible investment assets have had a compound annual growth rate of 13.6 per cent, an impressive record.
This story is replicated globally, with claims that signatories to the UN Principles for Responsible Investment (PRI) now account for more than $80tn of assets under management. PRI signatories agree to incorporate environmental, social and governance (ESG) issues into their investment analysis and decision-making processes, as well as to seek appropriate ESG disclosures from investee companies and to report on their own ESG activities and progress.
If you take these huge numbers at face value, you could be forgiven for thinking that the investment industry is close to integrating full consideration of climate change and the environment into financial institution decision-making. But the reality is much less comforting. The definitions being used to generate these numbers are incredibly broad. The actual proportion of funds managed anywhere close to best practice and/or having any real impact on sustainability challenges is a tiny fraction – probably closer to the tens of billions than the tens of trillions. We still have a long way to go.
In terms of what best practice looks like and what investment managers need to be able to do, I think there are seven dimensions that should be considered. The extent that each matters depends on the asset class (for example, engagement with management is more important for equities than it is for debt) and what is considered best practice is a rapidly moving target.
The dimensions are:
- Being able accurately to identify, measure and assess risks and opportunities related to sustainability, many of which are non-linear, complex and poorly understood.
- Understanding and measuring the impacts, both positive and negative, that investments have on sustainability.
- Having governance processes and incentives in place that support manager decision-making aligned with economic, financial and environmental sustainability.
- Reporting results and impacts accurately and in a way that is meaningful to clients.
- Integrating client preferences to create appropriately aligned and bespoke investment strategies and products.
- Engaging with companies and investments in a way that supports the realisation of sustainable outcomes.
- Proactively shaping policy, regulation and societal norms to promote sustainable outcomes through investing and other corporate activities.
In each area, progress is being made, albeit at varying speeds and from very different starting points depending on where you are in the world. Northern Europe is the undisputed leader and has driven the development of sustainable finance. There are other significant pockets of innovation, particularly on the west coast of the US and in China.
What is particularly interesting about these developments is not just the positive change they promise for the planet, but also the improvements they could bring to financial analysis and financial services.
Risk and impact measurement
Let us just take the first and second dimensions – risk and impact measurement. To realise sustainable investment strategies, you need better data. In particular, you need data that give an understanding of i) the effects that investments will have on the local and global environment, as well as on sustainable development; and ii) insight into the potential for stranded assets. The latter is important because climate change poses a range of hard-to-assess transition risks as investors shift their focus.
How do we get sufficient data to understand these risks and impacts? Traditional approaches used company disclosures at the parent level, particularly disclosures on carbon emissions.
Technology can now start to enrich and expand those data sets vastly. We have never been in a better position to carry out empirical and real-time observation of many of the factors that can affect financial assets. We can also gather much information about what is going on in listed and non-listed companies at low cost, even if companies do not want to make such fine-grained disclosure. These capabilities, enabled by earth observation systems, sensors and machine learning, will allow us to upend the current information asymmetries between companies and their investors – and between financial institutions and their regulators.
This has big implications for the integration of data on climate change and the environment into financial institution decision-making. It is also important for financial analysts assessing company risk and performance where ESG is not being considered. Over time, detailed data will make financial analysis increasingly “spatial”. Parsing geospatial data will become a core competency for many financial analysts.
Similarly, as investors become more able to question companies closely about their response to climate change, active ownership will have more teeth. Companies and their investor relations professionals should keep a close eye on those developments.
How long it will take to embed the cutting edge of today’s sustainable finance practices properly into day-to-day investment management is hard to say, but I bet it will happen quite quickly.
What is certain is that the demand and interest in sustainable finance is not a passing fad. First, environmental challenges are increasing, not diminishing. Second, even if we make significant progress in tackling climate change, there will always be material risks related to the environment. Third, societal concern for the environment is likely to grow. People are aware that threats are increasing, at the same time as population growth and higher overall standards of living are detrimental to the environment, at least in the short to medium term. Fourth, those same population and wealth increases mean there will be both more financial assets and also more concern about sustainability. If nothing else, as countries and people become richer they tend to value the quality of the environment more.
All these longer-term structural drivers mean that mainstream financial practice will start to include sustainability in its assessment of risk-adjusted returns. Whether this happens quickly enough to tackle climate change and deliver the investment required to meet the UN Sustainable Development Goals is another question.
Ben Caldecott is a founding director of the Oxford Sustainable Finance Programme at the University of Oxford and co-chair of the Global Research Alliance for Sustainable Finance and Investment
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