A panel of investment specialists discusses the rapidly expanding world of environment, social and governance (ESG) investing, with a particular focus on climate. They discuss best practice for achieving impact investing, their expectations on climate risk disclosure and the latest advances in data and analytics to be applied when assessing climate and ESG risk
- Eric Lonergan, Macro fund manager, M&G Investments, and author, Supercharge me: net zero faster
- Peter Mennie, Chief sustainable investment officer, Manulife Investment Management
- Krista Tukiainen, Head of market intelligence, Climate Bonds Initiative
- A portfolio manager specialising in sovereigns at an asset management firm
Which has the biggest ESG impact: investor divestment or engagement?
Eric Lonergan, M&G Investments: Both excluding and engaging can be effective. In the case of some bad agents, divestment – which drives up the cost of capital and creates a sort of market stigma – makes a lot of sense. There is already evidence, when it comes to carbon emissions, that exclusions, or a higher risk premium, have materialised. In the bond market, for example, there appears to be a higher interest rate effectively charged on businesses that are heavy emitters. The cost of equity also seems to have been affected by emissions risk.
Equally, there are businesses having a positive impact that should trade at a premium. Then there is the group of businesses that are mission-critical to the transition that we need to be engaging with very heavily. For example, no credible net-zero plan can avoid the transition of our electricity systems to renewables.
Many utilities have high carbon footprints because they are currently reliant on gas and potentially coal. It is very important that we are not simply divesting those assets and raising their cost of capital. The aim must be to achieve over 80% of electricity generation from renewables. The global average is currently closer to 25%.
Peter Mennie, Manulife Investment Management: There are certainly some assets that don’t belong in a sustainable portfolio, but there are other companies that can be engaged with.
For Manulife, stewardship is a strong lever to achieving impact. Whether through engagement or shareholder voting, we find that working with companies directly and collaboratively to encourage change can be effective. As active investors owning a position, we have credibility with company management when we suggest changes because they understand that we have an interest in their business being successful. That gives them the confidence to consider our ideas. Divestment certainly has its place, but engagement has a really strong role to play and can achieve real-world impact.
Portfolio manager, asset management firm: Portfolio selection should go beyond getting rid of the worst performers in your portfolio: those assets do not disappear, but are actually bought by others, so it is relevant to push those issuers to change to the extent that is possible.
Engagement should happen first. However, at a certain point, divestment may seem appropriate. This could be when transition risks are too high, there is no proper response to engagement or the net contribution of an issuer to society is never expected to be positive.
Sometimes divestment can also be a communication exercise, announcing that certain practices or approaches are not tolerable in an ESG portfolio.
Krista Tukiainen, Climate Bonds Initiative: There needs to be a combination of the two. For something being sold as pure green, the focus should be solely on things that are already net-zero aligned. However, that limits the investable universe substantially, and doesn’t allow for engagement with heavy polluters. Divestment doesn’t get rid of the emissions, it just offloads them elsewhere.
There is a lot of evidence to suggest that engagement, especially for large shareholders, can be really powerful if you know what you require of the issuer and demand them to demonstrate that. There are also initiatives – such as Climate Action 100+ – that bring together the collective power of large shareholders to collectively submit requests. This brings clarity to the issuers on what shareholders want in terms of decarbonisation action.
A prevalent misconception is that this is all going to be orderly and nobody will need to take a financial hit. That’s not going to be true. Winding down assets and creating new operations is capital-intensive and is something else to bear in mind when constructing portfolios. What is the risk of stranded assets, and how confident is an investor when engaging with polluting sectors that its transition plans will happen?
Can the energy transition be achieved solely by capital markets or is it down to policy-makers to drive the change and set out the pathways?
Peter Mennie: Climate change is a systemic problem, and systemic change needs the involvement of multiple stakeholders. Therefore, decisions from policy‑makers are absolutely crucial – capital markets can’t solve the problems alone.
There is now overwhelming scientific consensus on climate change, which is driving enormous worldwide political support for action. So, as investors, we know policy-makers are likely to continue to act to make pollution more expensive and therefore financially unattractive, and that really creates the impetus for capital markets action.
The fact there are incentives that point to the likely direction of travel by policy-makers helps us as investors talk with companies and highlight why this is not just a societal issue, but a financial issue too.
Eric Lonergan: Policy-makers can make a huge difference by affecting the cost of capital through the regulatory regime, but also by helping to de-risk certain strategic sectors.
Ideally, we want to lower the cost of capital for renewables to accelerate investment. Most of the cost of renewable energy is in the upfront capital expenditure and has much lower marginal costs than fossil fuel. Lowering the cost of capital for renewables production significantly reduces the overall cost of those investments.
A very successful example is the contract-for-difference market in the UK, where auction prices for offshore wind have fallen 70% since 2015. This is a very smart intervention that costs pretty much nothing. De-risking is very powerful and should be replicated globally.
Policy also affects behaviour. For example, in Norway, the list price of electric vehicles is cheaper than fossil fuel vehicles, and Norway has the highest penetration of electric vehicles in the developed world. This is much more effective than taxing petrol.
We also need clearer policy. Most people are confused as to what they need to do. However, it should be quite straightforward. The answer is to make electricity renewable and run everything off of electricity – electrify transport, homes and manufacturing. That would create a 75% drop in emissions without people really needing to change their lifestyles.
Krista Tukiainen: It would be great if there was an overall agreed plan by governments globally, but obviously each government needs to have the interests of its own people first. From a science perspective, the nearest we have is the Intergovernmental Panel on Climate Change in terms of setting out what needs to happen.
I would love to see more clarity around preferential policies to the extent possible from individual governments. For example, it is unlikely we can completely decarbonise heavy manufacturing, such as steel and cement, just via electrification; it’s likely to require hydrogen as well. But hydrogen producers today are unable to make the investments needed to build the industry to the size required as they don’t have the necessary demand guarantees.
This is where governments can play a huge role by setting policies that will drive capital to where it is needed. Fiduciary duty dictates that firms focus on achieving returns in the short term and that cycles can’t be broken without government commitments.
What advances do you anticipate in data gathering that could further climate and ESG risk analysis?
Portfolio manager: Data is improving in availability, quantity and quality, and is slowly ceasing to be an issue. But two main problems remain. The first is the lack of model homogeneity. Science is advancing towards understanding the relationship between human action and climate, but climate has always been difficult to predict. Models should be created by scientists and endorsed by global entities.
The second problem is the wider lack of standards. This is likely easier to fix as data on emissions is becoming better. However, the alignment to certain standards at the investment level can only help address climate issues from the most efficient point of view possible.
Krista Tukiainen: It’s really important to be able to track the impacts of an issuance or an issuer. Investors need to understand whether funds raised through the capital markets are being allocated appropriately, whether they continue to be aligned with the right things and what impact the investment is having.
The work of the Spatial Finance Initiative in the UK, for example, is an interesting development. I think we’re going to see more of this mass analysis of different types of data from different sources. Most of this is either model data from the ESG data providers or data collected manually from annual reports and similar disclosures from individual issuers. It’s now much easier to bring this data together en masse to be analysed with machine learning, alongside other datasets derived from satellite imagery and remote sensing, for example. Increases in computer power will change everything and make it possible to solve the puzzle going forward.
Eric Lonergan: There’s huge progress occurring in the form of, for example, the Science Based Targets initiative (SBTi) and auditing that takes emissions into account. At the same time, there is a tendency in the financial sector to prioritise complexity. There are a lot of very confused metrics. It’s not at all clear to me that a single metric can capture all ESG factors. One needs to have a much more nuanced and intelligent approach.
It’s certainly worth measuring environmental and social factors independently. You have to think very carefully if you’re making single investments or if you’re combining them, whether that actually works in terms of what you’re trying to achieve. Our strongest power is in influencing the cost of capital. If you take too many factors into account, there is a risk of creating indexes that have no meaning.
Peter Mennie: When it comes to historical data – for example, the level of greenhouse gases that companies have emitted – I expect this to become increasingly detailed as companies report in line with guidelines such as those published by the Task Force on Climate-related Financial Disclosures. It should also be expanded to cover not just scopes one and two carbon emissions, but also the range of scope three greenhouse gas emissions.
What is also important is the future pathway of emissions. We want to have confidence that emissions will reduce. The more companies disclose about the future trajectory of their emissions and their expectations for how they’ll achieve reductions, the more confident we can become in those forecasts.
There are, of course, mechanisms already – such as committing to net zero or to a target under SBTi – through which companies can signal their intention to reduce emissions. What I would love to see in terms of how data evolves is increasing data and structures around that data in which companies explain how they foresee getting there, giving greater confidence to investors that it’s likely to happen. That way, investors could focus on a firm’s future pathway as well as their historic emissions.
A key part of this is companies getting used to reporting and the need to report. As they do, their reporting will evolve and improve as they think about and reflect on issues, and are then able to provide more and more detail. Firms conducting their own analysis of the impact of climate risk on their business, in addition to third-party assessments, would be really helpful for investors.
What advances in analytics do you see being applied to climate and ESG risk analysis in the coming years?
Portfolio manager: I expect our understanding of climate dynamics and how these feed back into economies will improve. This is not about assigning a score, but about understanding how to fight climate change most effectively, leveraging this understanding.
In the case of sovereigns, there needs to be a better understanding of the role that externalities play, for example the carbon dioxide that is produced outside a country’s border in the manufacture of goods the country imports. The sphere of responsibility for climate – and sustainability issues in general – needs to be better defined.
Also, more investors recognising and aligning ESG risks in their portfolios will cause them to become a more relevant part of securities’ pricing. This is extremely important because it will result in prices deteriorating slowly when ESG risks arise, and that trend will allow action to be taken sooner. In contrast, if ESG risks are not properly priced in, we may see some risks suddenly materialise, creating winners and losers, with no time to act.
Where are the biggest data gaps when it comes to measuring a firm’s future climate risk? What is not being measured now that needs to be?
Krista Tukiainen: Companies are pretty close to measuring what they need to, except for scope three emissions. That’s also something that leveraging technology and software applications is going to help a lot. We have most of the solutions, they just need to be brought together. The hard part is agreeing on the right metrics because that involves politics and differences of view and debate.
To what extent is ESG risk management contributing to decarbonisation and to what extent is it more about firms managing reputational risk?
Peter Mennie: The two are not mutually exclusive. Clearly, reputational risk is part of the reason companies will act on something such as climate change. However, many companies recognise both the societal need and the future direction of policy driving the need to decarbonise their businesses. They know they need to protect those businesses in the future. Companies that are forward-looking and thinking about the impact of climate change on their business wouldn’t see decarbonisation, for example, as merely a reputational issue. They would see it as something they need to do for the future success of their business.
Krista Tukiainen: It seems more the latter, and that is fair enough because it’s really the de facto starting point for a lot of investors who are beginning to engage on these topics. Typically, they will start with the ESG ratings, so companies have to prioritise those.
While there is a climate component in ESG, there are other unrelated issues. For example, the governance piece isn’t related to how well set-up a company is to execute on decarbonisation. It’s general governance. So, focusing on ESG is the starting point, not the end-point, and it’s certainly not enough on its own to drive emissions down.
Eric Lonergan: I don’t think we can separate the two. People are going to start very quickly asking what the effects of this ESG wave have been and, if people are engaging in cosmetic changes to funds and activities, it will be seen through very quickly and translate into reputational damage.
A review by the European Central Bank found that many European banks are failing to meet basic supervisory expectations for climate risk disclosures. Does the problem lie with the disclosure process, or is it that many portfolios are not that green yet?
Krista Tukiainen: The cynic in me thinks it’s probably more that the portfolios are lagging behind because these banks continue to underwrite, provide capital for and invest in fossil fuels. However, there is also a lack of standardisation around disclosure.
Not many central banks have set standards for stress-testing or set out clearly what should be taken into account and covered in climate disclosures. There’s a lot more to be done on that front, by the supervisory bodies as well as by the central banks themselves.
Eric Lonergan: I don’t know, but central banks have a huge role to play and could be incredibly powerful. The banking system needs to be repurposed so it is starving the fossil fuel industry of finance and providing hugely attractive finance to renewables and transition sectors. That will dramatically accelerate the transition and reduce the cost of electricity. The idea that central banks can’t impact electricity prices is a bit of a myth.
How are asset managers addressing other ESG elements such as diversity and human rights? What metrics can asset managers use to track the trajectory of these elements in their portfolios?
Portfolio manager: From the point of view of sovereigns, human rights is a major focus. The Sustainability Development Challenge framework is a good place to start, where many key performance indicators can be studied corresponding to different challenges.
Many indicators can be used to trace diversity and inclusion, and human rights. The question is how to balance these in the context of a wider portfolio where these issues come into play together with a different set of priorities.
In the end, we find these metrics useful from two angles: as a way to capture capital growth, and also to align with basic principles that need to be sustained and rewarded. For example, we believe diversity and human rights play a role in long-term growth since these have a big impact at a micro level on issues such as social meritocracy and providing equality of opportunities. Countries with higher basic human rights should have a higher ceiling on their economic growth than those with poor human rights records.
Krista Tukiainen: The Climate Bonds Initiative would like to see human rights being framed from a climate perspective. We need to think about the disproportionate impacts – whether transition risk or physical impacts – on the poorest segments of the global population. There will also be very localised effects – for example, if employment was decimated in Alberta, Canada – it would be helpful to consider how to engage on those issues from an investment perspective.
Eric Lonergan: This will be a moving target. We have to be alert to unintended consequences and make sure it is being done in a very intelligent and thoughtful way. What I have seen so far gives me encouragement.
However, there is a serious methodological problem caused by the fact that you can’t measure utility as a quantity. You can’t provide a number. I am not convinced by the scores that I’ve seen and the attempts to measure ESG that these very subtle and that difficult problems are actually being effectively worked out.
Peter Mennie: It is really important to engage with companies across a range of ESG issues. There are many crucially important issues that pose just as much of a systemic risk as climate change – a loss of biodiversity, for example. We try to monitor the range of engagements that we’re undertaking to keep a balance and make progress on a number of fronts.
For example, we think diversity in the workplace is an important issue, not just from a social justice perspective, but also from a good management perspective. We believe a company that doesn’t have a diverse board or diverse management team may not be as likely to perceive important shifts in societal expectations in the medium to long term and perhaps may not adapt well as they should as society evolves and changes.
What mechanisms could be used to speed up the transition to a low-carbon energy sector, giving us a fighting chance to keep temperature rises capped at 1.5º Celsius?
Peter Mennie: It’s really important to maintain support for a transition by ensuring people understand the benefits it brings. Equally, we need to think carefully about issues of justice around the transition. For example, there will be job losses and we need to effectively replace employment in more polluting industries with new jobs in renewable sectors. We need to incentivise investment in sustainable practices while fairly penalising pollution. In some cases, there will be short-run costs, but we need to make sure we understand who should be paying those costs and who’s gaining. That’s how we build and maintain public support for this change and it’s a really crucial part of making sure it happens.
Krista Tukiainen: One really practical mechanism is to issue green bonds. These provide the quantifiable benefits of potentially getting slightly cheaper funding and a broader and more diversified investor base. Also, just going through the process results in a lot of organisational learning that comes from having to build a sustainable investment framework and figure out things such as how you are going to report on key metrics on an ongoing basis.
The more people do it, the deeper the liquidity will become. We’re potentially at a watershed moment for this market segment, but it really needs that extra push, and that’s where policy can also help.
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