Five key themes within ESG and the case for focusing on them
Sustainability is increasingly material to investment. We see five trends that are likely to have implications for investment portfolios over the long term. The five trends all warrant attention from investors, even if they overlap.
Climate change: Climate change is now economically material and actionable for all investors, as is the related ongoing energy revolution that offers the potential to shift to a global low-carbon economy and will have clear winners and losers. It also exacerbates inequality, since it disproportionately affects people of colour, lower-income communities and developing countries. Science strongly suggests that climate change is directional and will not mean revert on any timescale relevant to investors. Understanding this can help simplify strategic asset allocation and manager-selection decisions and give investors an advantage. This is one area where the past is a poor guide to the future for investors.
Impacts for investors to consider include transition risks to high-carbon businesses if we move to a lower-carbon economy, and direct physical risks to assets – such as real estate that will be affected by rising sea levels or a warming climate – if we do not. Some combination of the two is inevitable. Carbon and location are now two key dimensions to add to any discussion of risk.
Multi-stakeholder-driven society: The expectations that society places on companies around social and environmental issues appear to be increasing, even as some populist political figures back away from climate accords, support coal mining, or boost rainforest logging. Rising inequality cannot be a stable equilibrium. Recent material events in the US have highlighted the critical importance of, and growing expectations around, diversity and racial justice, issues that were already of increasing importance for investors. Standard accounting metrics do not incorporate the negative environmental and social impacts created by some companies’ business activities – whether degrading the environment or causing social harm. The potential liabilities are off-balance-sheet, and this is why they are called ‘externalities’. This has allowed many companies to ‘over earn’.
Greater socio-economic accountability is forcing the internalisation of these costs, changing the competitive dynamics and turning former winners into losers. This pressure from stakeholders can come from regulators, governments, legal claims, non-governmental organisations (NGOs), and consumers employing social media. A holistic investment approach can help identify mispriced contingent liabilities, and identify winners. For example, multiple studies have highlighted how more-diverse companies perform better.
Other externalities that might be mispriced today include plastics pollution, carbon emissions, irresponsible marketing of tobacco products in emerging markets, selling unhealthy food, unsustainable agriculture, and the environmental footprint and social cost of the fast-fashion business model.
Resource degradation: Our stable climate is not the only natural resource experiencing degradation. Companies whose core activities use resources unsustainably are facing material risks; this presents opportunities for competitors promoting efficient growth. Resource-efficiency opportunities extend beyond the energy and power sectors, encompassing industrials, transportation, manufacturing, agriculture, and real estate. Investors can fund technology supporting the transition from today’s linear economy (make, use, dispose) to an asset-light ‘circular economy’ that minimises waste and recycles resources.
Resource degradation can seem academic and removed from investment decisions, but this is increasingly not the case. A UN-backed study predicted, for example, that exploitable fish stocks in the Asia-Pacific region could disappear within 30 years. Land degradation is harming agricultural productivity on 23% of the world’s land area. In all, the world loses about 1% of its soil each year, 0.5% of arable land, and some studies show there are perhaps 30 to 70 good harvest years left, depending on location.
Water stress is also a growing issue globally, with a quarter of the world’s population living in countries with high-water stress and at risk of ‘day zeroes’ (in 2018 Cape Town, South Africa, nearly ran out of water).
Demographic challenges: As emerging markets (which are a majority and rising proportion of the world’s growing population) consume resources at levels previously associated with developed economies, all three of the previous trends will become more material. Businesses that can provide goods and services more sustainably will benefit, and those that stick to resource-intensive processes face increasing risks.
For example, consider just the production of basic materials needed for eight billion people. Aside from energy and transportation, carbon emissions from the production of steel, cement, plastics, and aluminium alone may prevent countries from meeting global emissions-reduction targets in the coming decades. More generally, our current model of economic growth is unsustainable. If everyone on earth produced as much carbon as the average person in the US, global emissions would increase more than threefold, and we would likely face a catastrophic impact on asset prices and society from uncontrolled and irreversible global heating.
New models for financial services and for provision of affordable healthcare provide investment opportunities that would help solve demographic challenges. Investors have clear options to more sustainably meet the demands of younger populations in emerging markets by bypassing certain capital-intensive or high-carbon business models.
Technological revolution: How technology is reshaping investment opportunities needs no explanation. Some may question why we are even claiming it as a sustainability trend; technology is the glue that binds nearly all solutions to achieve a more sustainable future. Solving global challenges at the interface of technology and sustainability 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.
Outlook: Sustainability trends are disruptive, will not mean revert, and will take the investment landscape to somewhere new. They are material and can be mispriced and overlooked. By drawing on all the strengths of a diversified long-term investment framework, while looking at the widest range of material financial and sustainability inputs, investors can exploit this investment opportunity, avoid risks, and build resilient portfolios that meet their long-term objectives.
Chris Varco is managing director in Cambridge Associates’ sustainable and impact investing group
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