sustainable investment
Transition opposition: 3 ways to challenge sustainability sceptics
As the financially material risks and opportunities of the climate and nature crises become clearer, many investors seek new analytical approaches to understand which companies are adapting to a more sustainable economic model. But some pensions trustees resist this change.
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Financial materiality
Two of the chief counterarguments are that sustainability risks are financially immaterial or the impacts of climate change and nature’s decline on assets are too difficult to price. This can be frustrating for the investment consultants and asset managers they have appointed who believe there is merit in understanding how efforts to green the economy could influence long-term returns.
What can cut through scepticism about sustainability? At Race to net zero, an event convened by LOIM for UK investment consultants, we discussed three approaches to clarifying the financial materiality of climate and nature risks.
Good ESG integration is arguably an extension of strong fundamental analysis. Intensive research of a company will assess the quality of its corporate governance and standing with regulators; how it treats employees, suppliers and community stakeholders; and the environmental impact of its operations.
But sustainability risk is different, in our view. Where ESG focuses on business practices, sustainability analysis looks forward. It focuses on how the business is adapting its business model to be successful in a future shaped by the regulation, technologies and consumer appetite driving an economic transformation in response to the unavoidable challenges of climate change, biodiversity loss and other transgressions of Earth’s scientifically proven planetary boundaries.
Understanding this difference expands the scope of investment analysis performed on companies. It requires portfolio managers and analysts to go beyond traditional valuation metrics and seek new, forward-looking data points to understand how these transformations can change the drivers of demand for products and services, and the operating environment for businesses. Investment teams can then assess how well companies are adapting to these shifts.
The investment industry is in a phase of knowledge-building regarding the financial materiality of sustainability risk, making expertise beyond traditional valuation metrics essential – especially since forward-thinking investors are more likely to be positioned favourably.
By allocating capital to assets and businesses that should benefit from the sustainability transition – and avoiding those likely to be stranded – the investment industry can help drive the transition forward. Still, it isn’t the only element in play.
Regulatory, technological, consumer and market forces across the global economy are driving the transition to a sustainable economy. These powerful forces will impact pension portfolios, making them a material investment concern for trustees. Consider the following:
- Policy: regulation will make CO2 emissions increasingly expensive as governments aim for net-zero targets, creating transitional and liability risks for businesses in all industries. Policymakers are also focused on waste reduction and circularity.
- Consumer demand: people are demanding greater sustainability – and disclosures – from the companies they buy from and the employers they work for.
- Market forces: As innovative, clean technologies are adopted more widely and gain scale, sustainable solutions become the logical economic choice. The cost of solar power has declined 99% since 1977 and is now often cheaper than fossil-fuel energy. Electric vehicles are projected to be cheaper to produce than internal-combustion-engine cars by 2026, bringing forward the date on which they will usurp the long-standing incumbent.
- Investors: Seeking the best risk-adjusted returns, investors globally will aim to integrate sustainability factors in asset valuations. Capital is likely to flow to businesses aligning with the transition at the expense of those failing to adapt, as laggards will be exposed to intensifying physical, liability and transitional risks.
Each of these forces are mutually reinforcing and will shape markets in the coming years, in our view. Given their long-term horizons, pension schemes will be exposed to the full force of these changes. It would be prudent for trustees to consider how to adapt scheme portfolios to the rise of these financially material factors.
About 250 years ago, the Industrial Revolution built the foundation of the modern economy. In the last two decades, digital technologies have massively disrupted it. The transition to a net-zero, nature-positive economy that values decarbonisation and natural capital will be as impactful as the advent of industry but will move with the speed of digital innovation.
Having seen handwritten or typed letters on paper give way to digital communications and cloud computing during their careers, many trustees will be familiar with how quickly and comprehensively the status quo can be upended in the business world.
Disruptions on a similar scale are underway today, across the economy. The energy industry’s long-running generation of fossil-fuel power will progressively shift to green electricity from renewable sources augmented by battery storage. A momentous change that’s at an earlier stage is the transformation of food systems to become more sustainable – both to support policy goals for climate and nature and to restore the natural Earth systems they depend on.
The world of 2040 will be strikingly different to today’s. Since markets always move before the real economy – investors need a forward-looking perspective to anticipate these changes.
Make it happen
New metrics are being developed to gauge climate risk and the dimensions of natural capital, from deforestation and water intensity to materials extraction. Externalities are being priced. As some companies pursue new growth opportunities, others risk becoming stranded.
Scepticism among trustees could result in schemes being exposed to intensifying risks while forgoing opportunities generated by the sustainability transition. Part of the job for their investment consultants and asset managers is to make the conversation happen.
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