For a majority of institutional investors, the environmental, social and governance (ESG) agenda has been a strictly minority pursuit. Many fear that investing sustainably will hurt performance. Their reluctance to integrate ESG criteria into portfolio management practice is further exacerbated by conflicts of interest. Some of the biggest fund management groups have been unwilling to support dissident shareholder resolutions calling on energy groups to spell out the financial implications of global warming because they hope to win pension fund mandates from these companies. They claim that academic research has been inconclusive on the correlation between ESG and financial performance.
Yet the mood among professional investors has changed over the past year or so, not least because of the agreement by 195 countries in Paris in December 2015 to reduce greenhouse gas emissions and accelerate the transition to a lower carbon economy. This legally binding action plan has a goal of keeping the increase in global average temperature to below two degrees celsius above pre-industrial levels. Adherence to the Paris targets implies new risks and opportunities for companies and investors as a result of climate change, climate policy and new technologies.
by The Economist Intelligence Unit has estimated the value at risk from climate change to the global stock of manageable assets as ranging from US$4.2tn to US$43tn between now and the end of the century. Many assets will be ‘stranded’ – that is, they will lose value or turn into liabilities before the end of their expected economic lives. Much fossil fuel will not be burned and will remain stranded in the ground because its use would result in breaches of globally agreed and country-based temperature goals. Stranding will also be increased by advances in battery storage, renewables and enhanced oil recovery.
That said, there are extraordinary opportunities, too. According to the Basel-based Task Force on Climate-related Financial Disclosures, the expected transition to a lower carbon economy could require around US$1tn of investments a year for the foreseeable future. In short, the risk-return profile of companies exposed to the impact of climate change could see a dramatic metamorphosis. And as Mark Carney, governor of the Bank of England, has emphasised, the risks include potential shocks to the financial system.
All of this makes any discussion of historical correlations between ESG and financial performance irrelevant. For institutional investors, the new imperative is to identify those assets that are most at risk from stranding and the opportunities that will be thrown up during the transition. A growing number are working out how to integrate ESG into their investment process. And some of the biggest funds have already conducted extensive exercises to identify their carbon footprint by examining every company in their portfolio. The question then is whether to divest fossil fuel stocks, at the cost of some loss of dividend yield, or to hold on to encourage best practice. In many carbon-sensitive industries outside the energy area, engagement will be the natural avenue.
Increasingly, large global institutional investors are combining forces to address the environmental challenge. In 2017, 225 funds controlling assets worth US$26.3tn launched Climate Action 100+, a campaign to put pressure on 100 of the world’s more carbon intensive companies to step up their actions on climate change. This shareholder action plan is the biggest ever attempted. To meet the Paris commitments these companies will have to cut emissions by 80% by 2050.
Are those investors who have, until now, been ambivalent in their response to climate change turning? In May 2017, BlackRock and Vanguard helped secure a 62% majority at the ExxonMobil annual meeting in calling for a yearly assessment of the long-term portfolio impact of climate change policies. Both supported a similar motion against the board at Occidental. ESG activism is not confined to the energy sector. Activist investor Jana Partners recently joined US pension fund giant CalSTRS in calling on Apple to recognise the potential dangers to children of excessive use of its iPhones.
A conundrum in all this is how far the market is already discounting the transformation of risk and return profiles across the corporate sector. As yet, carbon-related disclosure is patchy. There remains a risk that, in the transition to a lower carbon economy, capital will be seriously misallocated.
John Plender is a Financial Times columnist.
This article was published in the Q2 2018 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.