Long-term benefits of ESG investment

March 28, 2023 09:41
Photo: Reuters

Looking into the decades that lie ahead, asset owners and managers have a great opportunity to think sustainably and act responsibly; it will bring enormous risks if we do not.

Since no economic system will be immune to the impacts of severe climate change, their presents risks that cannot be easily diversified or hedged. As universal owners, we are exposed to a representative slice of the economy and all of its sectors. Some might argue that incorporating ESG factors into decision-making falls outside our fiduciary responsibility to deliver financial performance to our clients. However, I am strongly convinced that there is only upsides in doing so.

One of the core functions of the active asset management industry is price discovery. It is to identify pricing inefficiencies through data collection, filtering and analysis to derive actionable investment decisions. It is about having the discipline to do this in a robust and repeatable way, over time, integrating relevant information with material impact on the price of financial assets.

Our role as active managers has not changed, but rather the inputs required to deliver optimal risk-adjusted returns have. Now that we have the facts, environmental and social considerations simply cannot be ignored.

Investment portfolios that all of us manage are inevitably exposed to these growing and global economic costs. These costs will come to impact portfolios as insurance premiums, taxes, regulatory fines, inflated input prices, stranded assets, increasing litigation risks and the physical costs associated with disasters.

Conversely, efficient allocation of capital to issuers with low or diminishing externality costs, such as providers of green technology, or issuers that are transitioning from highly carbon-intensive to a net-zero state, will provide protection over the long-term, and we believe, will generate better quality and predictable profitability. They will also benefit from more resilient system that they help support and build.

How do active asset managers mitigate risks and capture opportunities?

By 2023, climate finance needs to increase by 600%. Achieving China’s goal for carbon neutrality by 2060 is estimated to require over 130 trillion yuan. As investors, we are able to participate and accelerate the transition to a low-carbon and nature positive economy from the following three aspects:

• First, we must direct capital towards the solutions. As stewards of long-term savings, our role is to finance the real economy, and ensure that capital is allocated effectively helping clients preserve and grow their assets.

Part of this capital needs to continue to be accelerator for technologies that displace fossil fuels, substitute high-carbon inputs and promote efficient design. For example, an exciting area for growth is the food system, which accounts for about 15% of emissions and 100% of our well-being. Improvements in efficiency are needed to reduce food waste from 33% to 10%.

Particularly, if we are to reduce emissions and feed a growing global population. Companies working on technologies to improve soil health, which in turn captures more carbon and improves crop yields, or develop lower-emission proteins, could help us halve emissions and ensure a healthy global population by 2050.

• Second, we must direct capital towards companies whose operations are aligned with science-based climate and environmental targets. Where those targets are absent, we commit to engaging with companies to ensure targets are set, measured and reported on, particularly as they are material to their business models.

• Last, we need to actively engage with the laggards. The easy approach of excluding “bad” players does not deliver the financial, environmental or social return we need. It is like throwing your garbage on your neighbour’s lawn. There will always be another investor willing to take on additional risk for greater potential return in the short term.

There have been several pieces of research, demonstrating that engagement is more effective at changing corporate behavior than exclusion. We are increasingly of the view that engagement in public markets is how we can get closer to capturing private equity-like transformation premiums.

ESG standardization requires concerted efforts

The lack of standardized ESG metrics and disclosure remains a pressing challenge globally. Regulation is accelerating globally as governments address some of the challenges in ESG-related data and metrics. The EU Sustainable Finance Action plan has mandated sweeping reforms which have impacted disclosures of corporates and investors over the last years. Efforts have been made for greater international alignment in taxonomy and standards, for instance the Common Ground Taxonomy jointly released by China and the EU.

Asset managers are required to define their ESG approaches and methodologies more specifically, they therefore are investing in proprietary tools.

Yet, the industry’s current focus on ESG ratings – which are averages that often obscure discriminating signals – may benefit from flow-driven momentum in the short term, but will not add value over the long run.

They are inherently backward looking and suffer from high dispersion and low quality. As with financial metrics, fundamental analysis of key ESG data and trends is necessary to identify risks and unearth investment opportunities.

Focused NGOs offer some of the most compelling and open-source ESG data available today. It can help us be better, more impactful investors today. The fruits of this collaboration are even more evident in collaborative initiatives like the Climate Action100+ which has gathered backing from USD 68 trillion in assets to engage the world’s 167 largest corporate Greenhouse gas emitters.

In Asia, the evolving ESG ecosystem and growing attention to sustainability are driven by both regulatory changes and investor demand.

Specifically in China, to fulfill its net-zero commitment, the government has introduced policies and guidelines that will help promote ESG disclosures and benefit transition financing standards. In the meantime, as a leader in renewable energy technologies and the largest investor in this field, China is a key driver of the global energy transition. These policies and public finance will drive the risk capital needed for innovation and scaling, thereby opening up new opportunities for asset owners and investors.

In conclusion, there may be hurdles to overcome and gaps to close before standardization is achieved, but there will also be opportunities for us all to share as the global economy transitions to a more sustainable and resilient one.

I believe we all have the capacity, and the responsibility, to focus on delivering value for the next generations because a well-functioning planet is essential to a well-functioning economy and society.

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Managing Partner of Pictet Group and Co-CEO of Pictet Asset Management