The "E" in ESG stands for "environmental", and refers to the impact that a company has on the natural world
Environmentally responsible investing
The environment factor in ESG investing reflects the impact of a company’s operations on the natural world. This includes any resources it uses, such as water and land, and anything it produces, such as pollution and waste, as well as its effects on oceans and wilderness areas.
- Investors cannot afford to ignore environmental damage from an ethical or financial perspective
- The most critical risks we face include rising global temperatures, extreme weather events, water shortages, degradation of soil, and loss of biodiversity on land and in the oceans
- Repairing the damage is a vast challenge, but one that will present huge opportunities
- The green economy included 3,000 companies with a combined market capitalisation of $4 trillion in 2020
Why must investors care about the environment?
There was a time when environmental damage was tolerated as a side-effect of economic growth. Today, that is no longer true. Almost everybody recognises that long-term damage to our planet poses an immense danger to the human race.
Natural assets stemming from ecosystems have enormous and irreplaceable value. Out of these natural assets (such as air, soil and water) and actions (such as purification of water through the water cycle or the pollination of crops by insects), humans derive ecosystem services that deliver regenerative returns and make human life possible. Regenerative returns are estimated to be worth around $125 trillion to $140 trillion a year – more than 1.5 times conventionally-measured global GDP.
Consequently, it is more important than ever to focus on natural capital and the ecosystems attached to it. The impact of human activities on this directly drive the triple crisis that our planet faces: pollution, biodiversity loss and climate change.
The knowledge that there is a trade-off beyond rampant growth and sustainability predates the industrial age. However, the scale of the problems created by the modern economy began to enter public consciousness in the 1960s, helped by books such as Rachel Carson’s Silent Spring (1968), which documented the impact of synthetic pesticides on wildlife in the US.
In the same year, the Club of Rome – a gathering of politicians, officials, scientists, business people and economists – was launched to raise awareness of the challenges of economic and population growth in a world of finite resources. Its first report, "The Limits to Growth" (1972), attracted global attention. In the same year, the United Nations (UN) conference in Stockholm was the first time that the gathering of world leaders discussed the trade-offs and challenges of making economic growth sustainable.
The cost of the climate crisis
Awareness that carbon dioxide emissions, caused by more than a century of global industrialisation, were starting to raise the temperature of the planet led to the Earth Summit in Rio De Janeiro in 1993, where leaders discussed plans to protect the environment. This was followed by the Kyoto Protocol on greenhouse gas emissions in 1997 and the Paris Agreement on climate change mitigation in 2015.
Needless to say, while awareness of our growing environmental crisis has increased enormously, none of the actions that have been taken so far are sufficient to head off many of the crises we are facing. Indeed, the scale of the problems is growing.
A decade ago, Deutsche Bank’s assessment of the greatest risks the world faced were mostly economic or financial: asset price collapses, a retreat from globalisation, surging oil prices, and fiscal crises. Today, most are related one way or another to the environment: the failure to act on climate change, the loss of biodiversity, extreme weather events and water shortages. The growing importance of these issues is also reflected in their prominence in other research, such as the World Economic Forum’s Global Risk Report 2021, which notes that environmental degradation represents an “existential threat to humanity”.
Environmentally responsible investing
The only cause for optimism is that the investment community unambiguously understands the perils that we face and is embracing the need for environmentally responsible investment to address it.
In 2018, a group of 420 investors representing $32 trillion in assets issued the “Global Investor Statement to Governments on Climate Change”. This called for world governments to take more action to meet goals for greenhouse gas reductions under the Paris Agreement and to accelerate private-sector investment into the transition to a low-carbon economy.
Investors have also called for improved standards on climate-related financial reporting, following the recommendation of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TFCD). But while climate change is the greatest single threat we face, it would be a mistake to assume that the challenge of environmentally responsible investing begins and ends there.
The launch of the Taskforce on Nature-related Financial Disclosures in 2021 is intended to encourage a broader view of nature-related risks. This reflects the fact that biodiversity loss is interconnected with climate change, but focusing on it solely through the lens of climate ignores other very large and immediate risks.
The TNFD proposes to provide a framework to "report and act on evolving nature-related risks, to support a shift in global financial flows away from nature-negative outcomes and toward nature-positive outcomes". The final framework, which is planned for 2023, aims to complement the TCFD framework and should enable companies and financial institutions to report a fuller picture of their environmental risks.
Land and water degradation
The range of problems that ESG investors must consider is vast. These include water pollution from industry and degradation of agricultural land due to unsustainable farming practices. Both increase the massive challenge of feeding a growing global population.
Without biodiversity, cumulative welfare losses could amount to 7% of annual consumption in 2050 while accelerating the decline of crucial ecosystem services even further according to conservative estimates by the World Wide Fund for Nature. The impacts of nature’s decline would result in a $129 billion loss in global GDP per year by 2050. The impact is expected to be unevenly distributed across the world, with some regions being far more severely affected than others.
Pollution and encroachment of humans into wilderness areas poses a huge threat to biodiversity. Ocean acidity is forecast to rise by 100% or more over the next century, potentially affecting half or all marine life, while more than 10 million hectares of land are destroyed each year. More than 31,000 species are now threatened with extinction.
These are huge challenges, but also represent opportunities for environmentally responsible investment in measures intended to address them. There are around 3,000 companies listed globally that have direct exposure to the green economy, according to analysis by index compiler FTSE Russell, representing a market capitalisation of around $4 trillion or 5% of the total market.
While energy efficiency is the most high profile sector, it is amounts to only a third of the total green economy. Other sectors such as transport, waste & pollution and water are vitally important. Combined, the green economy has been growing at around 8% per year over the past decade, faster than the wider market.
Dedicated eco-friendly investments (also known as green investments) are a fast-growing part of the investment industry. This is shown by the rapid growth of the market for green bonds – debt issued to finance climate-related investments.
The first green bond was issued in 2007 by the European Investment Bank, under the name "Climate Awareness Bond". The World Bank issued its first green bond a year later. Multilateral institutions such as these remained the only issuers until 2012 and the total market size remained under $10 billion at that time.
However, the market began to expand rapidly from 2013. A total of $1 trillion green bonds had been issued by 2020 and that is expected to rise by almost 50% in 2021 as more investors embrace sustainable investing approaches in the wake of the coronavirus crisis.
Mutual funds and exchange-traded funds (ETFs) that market themselves as eco-friendly investments are also growing in popularity rapidly. In 2020, seven of the top 10 funds in Europe in terms of inflows were environmental funds, according to data from Morningstar. Six attracted inflows of more than $1 billion each.
Environmentally-friendly mutual funds and ETFs
Investors frequently expect environmentally responsible mutual funds and ETFs to follow one of two strategies.
1) Exclusionary or negative screening: which means that they avoid investing certain types of stock – typically oil and gas and coal mining and sometimes other mining sectors as well.
This is in line with the “divestment movement” emphasised by many environmental pressure groups, which argues that refusing to invest in these industries affects their ability to raise capital and helps to maintain pressure to move away from fossil fuels.
Institutions such as pension funds with around $14.5 trillion assets have committed to divesting fossil-fuel investments.
2) Sustainable investing: The second is to actively invest in companies that are helping tackle environmental problems, from renewable energy to recycling to water management. These funds go under various names including impact funds, green funds and sustainable funds.
However, simply avoiding fossil fuels does not mean that investors are reducing their environmental impact as much as you might hope. A technology company may sound green compared with an oil firm or a miner, but if its data centres consume vast amounts of energy or the raw materials for its products are highly polluting to extract, then its environmental impact may still be substantial.
Funds that actively invest in clean technologies may avoid these indirect impacts and help to drive environmental gains, but focusing solely on these may pose risks to investment performance. The relatively limited number of sectors that they invest in will make it more difficult to hold a balanced, diversified portfolio.
The alternative approach to building an environmentally responsible portfolio is ESG integration, where the full ESG performance of a company’s operations is considered as part of the analysis process alongside its financial performance. Pursuing an ESG-based strategy allows investors to take responsibility for the decision that their investments have on the real world without compromising on returns
Investors should however be aware of the potential for “greenwashing” – the practice of companies rebranding existing investment vehicles as ESG, sustainable or green to meet rising demand for these products. Consequently, it is important for investors to make sure that their investment managers have made a fundamental commitment to ESG practices.
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