Back in 2001, concepts such as ESG integration, impact investing and stewardship were at the fringes of financial vernacular. Now they dominate investment conversations as much as net inflows.
The 2021 survey from the Global Sustainable Investment Alliance shows that they account for $35.3tn of assets, equivalent to 35.9 per cent of global professionally managed capital. The dollar amount was up 33.4 per cent on the 2018 level. The Paris Agreement is seen as a key driver.
But, the rhetoric of the sustainability revolution is running ahead of reality. Despite all that money in motion, there are widespread concerns that capital markets are not pricing in climate risks. Many are as yet unsure as to whether the good financial returns they have notched up so far simply reflect a bandwagon premium fuelled by a huge wall of capital in this era of super-easy monetary policies.
Such concerns are confirmed by our latest survey, ‘Can capital markets help save the planet?’, published on the eve of COP26. It is based on structured interviews with 90 top leaders among large pension plans, wealth managers and asset managers who collectively manage $34.5tn of assets.
The survey shows that a green investment portfolio has not equated to a green planet. This is because capital markets cannot easily detect risks and opportunities associated with climate change.
Governments globally have not taken action to incorporate costs of carbon pollution into corporate balance sheets, nor to reform prevailing accounting standards to reflect evolving forward trends. Arguably, measures so far have yet to go from virtue signalling to value signalling. As such, markets have had mixed signals on risk or alpha. Greenwashing has been the outcome, as hopes run ahead of expectations.
The survey concludes capital markets could help save the planet. But left to their own devices, it will not happen. The invisible hand of markets needs to be matched by the visible boot of governments.
Looking ahead, net zero pledges made at COP26 imply all major economies have finally aligned themselves to the Paris goals. In that context, the role of the Glasgow Financial Alliance for Net Zero, commanding $130tn of capital, is likely to be critical in lobbying governments to introduce rules that properly internalise environmental and social costs of pollution into companies’ financial reporting – in ways that assist the price discovery of climate risks.
Not enough
Important though they are, these pledges will not be enough to deliver net zero goals. They need to be backed with more active stewardship that underpins the rise of a new investment belief after the 2015 Paris Agreement.
The belief has five tenets. First, stewardship is about the long-term mindset of ownership and advocacy, in line with the concept of ‘universal owners’, which the majority of our respondents see themselves as. They believe they ‘own’ the negative externalities caused by their portfolio companies due to the sheer depth and breadth of holdings in all asset classes and regions. Such ‘paper’ holdings do not negate their fiduciary responsibility to wider society. They have to act as agents of change.
Second, it is essential to look beyond blind spots from short-termism and detect new risks unfamiliar to the conventional risk models based on past price behaviour. That has been a key lesson from history. Megatrends, such as globalisation and rise of emerging markets, came disguised as continuity. They were hard to spot at the time, but have been hugely consequential in hindsight. So too will be climate investing.
Third, a singular focus on financial returns when investing in a company is no longer enough, if its business practices both negatively affect the environment and are affected by it. Today’s investing is overly influenced by Modern Portfolio Theory, which ignores negative externalities. Under societal pressures, these are now being taxed – via carbon pricing, sugar taxes, tobacco duties – to ensure the costs they inflict on societies are being borne by their perpetrators as well.
Fourth, more than ever, long-term economic value creation now also rests on natural and human capital – as shown all too vividly by Covid-19. Investing can no longer be indifferent to the generosity of Mother Nature. After all, stuff made by companies depends on land, water, trees, metals, food, seas, oceans, clean air, biodiversity and many more. Not only do they have intrinsic value in their own right, but they also constitute inputs into the production of tangible goods and services.
Finally, moving early to anticipate far-off risks to existing business models could turn them into opportunities. Investing by looking in the rear-view mirror means missing all the future upsides. Global warming necessarily means the past is an imperfect guide to the future. This is duly reflected in the goals that our survey respondents are targeting in their climate investing: 70 per cent of our respondents now target good risk-adjusted long-term returns, 54 per cent target a ‘double bottom line’ – doing well financially and doing good environmentally – and 66 per cent target a more defensive portfolio that minimises fat-tail/far-off risks.
Direct engagement
To back up these goals, 81 per cent of respondents regard stewardship as the main criteria when selecting external asset and wealth managers (see Fig 1). It means managing assets prudently by engaging directly with investee companies by exercising voting rights, filing or co-filing shareholder resolutions, having a say on lobbying activities and fostering year-round dialogue on impact issues and value creation.
Under the new belief, this form of shareholder activism is the linchpin: as consequential as asset allocation decisions, if not more so. The latter could easily reshuffle asset ownership between investors without tackling environmental damage from corporate action. Specifically, the divestment of fossil fuel producers from pension portfolios does not starve them of capital. Most feel that engagement and advocacy is the only approach for true change. This in the belief that those who are part of the problem can also be part of the solution.
In economic terms, however, stewardship is also a non-excludable public good. That means the benefits of engagement are enjoyed by all investors, irrespective of whether or not they behave as responsible long-term owners by investing in stewardship. The familiar ‘free rider’ problem is ever present.
In order to counter that, many of our respondents belong to various asset manager/asset owner networks that work collaboratively when engaging with their target list of companies. Indeed, 63 per cent factor membership of international networks – like the UN Principles of Responsible Investment, Climate Action 100+ and the Net Zero Asset Managers Initiative – into the manager selection process (see Fig 1).
They typically vote against resolutions and directors, not companies. They also have year-round behind-the-scenes dialogue to ensure that not only are their views on adaptation and mitigation heard and acted upon, they also deliver results.
To ensure meaningful engagement, their climate risk teams draw people from multiple disciplines such as technology, law, architecture and portfolio management. Their ultimate goal is to promote a better, more stable global economy and improve quality of alpha and beta returns alike by driving positive change.
Simple yet powerful
To conclude, therefore, net zero is a simple yet powerful concept. It underlines the climate challenge and its urgency, setting out the complementary roles of governments, financial institutions and investors in unleashing stronger price signals to capital markets.
To gain early mover advantage, some of the world’s largest asset managers and pension plans in our survey are making ever bigger allocations to climate investing. Thanks to active ownership, they expect traditional investing and green investing to converge over time, as the negative externalities companies create are increasingly being passed back to them in the form of higher costs.
Amin Rajan is CEO of Create-Research and Anthony Cowell is partner at KPMG Islands Group
