Living in the developed world over the past 50 years, life has been stable, even idyllic, for most people. That is certainly compared with their grandparents and previous generations who lived through two world wars and the Spanish flu. But, as COVID-19 has shown so cruelly, there are existential dangers that can lie hidden. These can rip the established world order asunder if not tackled beforehand.
The world is waking up from its complacency. Perhaps one positive outcome of COVID-19 has been a better appreciation of the dangers of critical long-term trends that need to be tackled before the next crisis they create overwhelmes. These pose questions not only for politicians, but also investors for whom the Chinese word for crisis, weiji, is often translated as danger plus opportunity.
Chris Varco and his colleagues Annachiara Marcandalli and Lydia Guett at Cambridge Associates published a note earlier this year highlighting five key sustainability trends they believe will help shape investment portfolios over the long term. Sustainability, they argue, is increasingly material to investment returns. Climate change, a move towards multi-stakeholder-driven societies, resource degradation, demographic challenges and technological revolution are trends they argue, that are “disruptive, will not mean revert, and will take the investment landscape to somewhere new”.
The UN Sustainable Development Goals (SDGs) cover the same ground and the EU has been a key proponent of them. The problem – and perhaps the opportunity – lies in the fact that prices may still not reflect long-term sustainability concerns. One reason may be that while official statistics suggest Europe is making progress on the SDGs the truth is it is falling seriously behind. That is what Patrizia Heidegger, a director of global policies and sustainability at the European Environmental Bureau, a network of environmental organisations, argues in the October 2020 issue of the Ecologist magazine.
One of the key challenges that needs to be addressed is the ability to create accurate measurements of sustainability. Heidegger says the EU’s current system to monitor and report on its sustainability policies and the progress towards the SDGs is not fit for purpose. That is despite the fact that the EU SDG and spillover indices, measuring unintended negative effects of environmental measures, show that impact on global shared natural resources and negative spillover effects can be calculated.
The only monitoring tool for now, she points out, is the annual Eurostat SDG report for the EU. She describes it as “a report that provides an overly positive picture of our level of sustainability”. The reason for this, she says is that the Eurostat indicator set does not contain any indicators on global commons and spill-over effects. That means the EU’s negative impacts on third countries’ sustainable development are unaccounted.
“Obvious as it may sound, indicators must also measure what they actually set out to measure,” says Heidegger. This applies not only to countries but also to corporations. As Cambridge Associates points out, standard accounting metrics do not incorporate the negative environmental and social impacts created by some business activities. That is whether they are degrading the environment or causing social harm. The potential liabilities are off-balance-sheet, that is ‘externalities’ which have allowed many companies to ‘over earn’ in their financial statements. As a result, private profits may have been obtained at the expense of public losses.
Today, the increasing emphasis on socio-economic accountability is forcing the internalisation of negative externalities created by corporate activities. But charging companies for the monetary value of negative externalities caused by their actions will, as Cambridge Associates points out, change the competitive dynamics and turn winners into losers.
The problem in the financial markets, says Cambridge Associates, is that sustainability is not properly priced. That is because investors tend to have short time horizons, behavioural biases, and an over-reliance on history that is less relevant in the face of new problems such as climate change.
Sustainability challenges are not “black swans”, or unpredictable material events, but are “white swans kept in the dark” by the short time horizon of typical financial analysis, says the Generation Foundation, a UK-based advocacy initiative, in a 2017 paper. White swans, it says, are highly predictable, and analysts can determine a probability. The failure to integrate into models traces back to a defect in the analysis. White swans might appear black if financial analysis leaves them in the dark. The problem it finds is that risk and valuation models typically have a three to five-year forecast horizon, after which short-term trends are just extrapolated. As a result, risks and trends with material impacts beyond five years are unlikely to be captured.
It is certainly true that over the past few years, ESG-related matters have come to the fore amongst investors and fund managers are alert to this. Cambridge Associates says it finds evidence that focusing on sustainability boosts returns for public equities managers. A notable array of managers are building strong track records from genuinely integrating sustainability in an economic way.
During the COVID-19 crisis, Cambridge Associates says that “this willingness to be different and embrace sustainability trends is resulting in material outperformance by public equity managers that we consider to be sustainability thought leaders”. The problem, however, as the Generation Foundation argues, is that the output of ESG analysis is usually not translated into quantitative metrics that can be easily factored into analysis and hence equity-risk premiums or risk factors in credit rating. As Cambridge, adds, mere ESG box ticking, obscures best practices and makes thoughtful investors sceptical.
Yet the future should not be gloomy for investors. The world is facing dangers, but these also present investment opportunities. Sustainability trends are clearly material but as Cambridge Associates points out, sustainability is not properly priced. This is because investors tend to have short time horizons, behavioural biases and an over-reliance on history that is less relevant in the face of challenges such as climate change.
Cambridge Associates sees technology as a sustainability trend because it sees it as the glue that binds nearly all solutions to achieve a more sustainable future. Solving global challenges at the interface of technology and sustainability, it says, is a huge investment opportunity. “The impact of this may have the magnitude of the industrial revolution at the speed of the digital revolution and spans finance, health, food and agriculture, industry, real estate, transportation, and energy.” But for this to happen, society at both the government and the corporate level, needs to be prepared to put values on externalities and charge companies those true costs. Only in this way can resources be properly directed towards creating sustainable economies.
In the short term, it will make losers out of previously thought of winners, but in the long term we will all be winners.
Joseph Mariathasan is a contributing editor to IPE and a director of GIST Advisory