ESG front and centre

In the wake of the pandemic, environmental concerns like floods and droughts and social movements such as Black Lives Matter (BLM), sustainable investing has never been more important to investors across the globe. Governments are also forcing greater focus on ESG by partaking in a vast array of global and local initiatives.

Europe is leading the way by ramping up disclosure requirements and building a stronger regulatory framework. In the EU, the spotlight is firmly on ensuring investment managers can offer environmental, social and governance (ESG) products to clients without ‘greenwashing’ – where companies they invest in exaggerate or mispresent their ESG credentials.

We are also seeing significant progress being made in other regions, including China, which recently released a five-year plan for national economic and social development and long-range objectives through to 2035. A key takeaway is China is targeting 20 per cent of total energy use to be sourced from non-fossil fuel sources by 2025, from 15.3 per cent in 2020. We’ve also seen progress in Australia with the recent move by AGL to give shareholders a vote on climate reporting for both its demerged businesses as renewed pressures build up around its emissions commitments ahead of its annual shareholder meeting.

In addition, throughout the world there is now greater collaboration between governments, through the United Nations Framework Convention on Climate Change (UNFCC), the Kyoto Protocol and the Paris Agreement – and there is likely to be further development on this front later in 2021.

In October and November the UK will host the 26th UN Climate Change Conference of the Parties (COP26) in Glasgow. The goal of the COP26 summit is to bring parties together to accelerate action towards the goals of the Paris Agreement and the UNFCC.

In May 2022 the Intergovernmental Panel on Climate Change (IPCC), the leading international body for assessment of climate change, will release its sixth synthesis report. The report will provide updates on a range of issues, from climate change impacts to mitigation.

A recent Moody’s report highlights that governments around the world will also be focused on green stimulus as major economies attempt to integrate their economic recovery and job creation initiatives with their longer-term efforts to reduce carbon emissions.

The role of ESG in managing risks

As a result of this heightened focus on ESG globally, today more investors want to see their capital contribute to addressing global and local issues, as well as generating a sound risk-adjusted return. Investors should today seek companies that are able to manage risks effectively, including ESG risks which can impact on the value of companies. Some of the risks might include:

Physical risks

The physical risks stemming from climate change are a key reason financial markets are increasingly focused on global warming. Companies that have factories on flood planes or in areas with rising sea levels, for example, face higher insurance costs and risks to their ongoing operations and viability than those that do not.

Regulation

As outlined earlier, the pace of regulatory change is only increasing. As a result, companies with higher CO2 emissions are being punished. We are already seeing emissions trading schemes in Europe, North America and, more recently, China being used by governments to limit the output of CO2. This is a trend we expect will continue to gather pace.

Legal

Companies with sub-optimal ESG practices also face a number of legal risks. As an example, a major supermarket in the UK recently had a legal ruling against it for paying male employees more than females for doing the same job. As well as the cost of remediation, this business now faces an additional risk that customers may vote with their wallets and choose to buy their groceries elsewhere.

Climate value at risk

Climate Value at Risk (VaR) looks at risk to the value of investments through a carbon lens. This shows us to what extent the investments we manage for our clients are at risk of loss (or gain) from climate issues.

Under the Paris Climate Agreement, transition agreements are being put in place to ensure countries around the world align to the goal of net zero emissions by 2050. This means companies will have to invest in new technology, change their operating models and address CO2 emissions across their entire supply chain in order to remain viable.

A company might face significant regulatory costs for not transitioning quickly enough—or a project’s future revenues may be boosted by demand for its low carbon technologies—which must be considered when assessing companies in our universe.

Meeting the data challenge

A significant challenge for global asset managers is how to quantify these risks and work out how to apply their learnings to portfolio construction.

Currently there is no standardisation of data across the industry, with many differing methodologies being used. However, we are seeing a move to greater standardisation being driven by yet another global initiative, the Taskforce on Climate-Related Financial Disclosures. In the coming years, we expect to be able to see the profile of companies much more clearly, with the added benefit that investors should be able to compare the products of different investment managers more effectively.

Within AXA IM’s investment universe, we currently analyse around 9000 companies, generating an ESG score for every corporate we invest in. This allows us to choose ‘best in class’ companies from an ESG perspective while excluding the worst performing – those with a score of less than 2.

A permanent shift

Looking forward, our view is that global capital will ultimately flow to the best companies with the most sustainable business models.

While there is an ongoing debate about whether an active or passive approach to ESG investing is best, we believe an active approach will win out. Active managers use data and qualitative research to better understand businesses, challenge companies and engage with them.

In summary, global policy around ESG issues crossed the Rubicon in recent years and is not going back. In order to meet the challenges ahead, investment managers and the companies they invest in will need to be able to clearly demonstrate that they are placing ESG front and centre.