The $40trn question: investing our way out of the sustainability crisis
Externalities, infrastructure and public policy and a new mission for responsible investment
Thirty years after the anti-apartheid campaign, a new divestment movement is gaining momentum. Endowments and pension funds are under pressure to divest from the oil majors for being a ‘rogue industry’ bent on using its political power to block action on climate change. This campaign – spearheaded by influential climate activist Bill McKibben – raises some disturbing questions for the RI movement. Surely, after all the headway RI has made in the last decade, we can provide a better answer to the problem of climate change than dusting off an antique strategy developed in the 1970s? Surely, with all the resources embodied in the 1,200 and $35trn worth of PRI signatures, we have a mature, 21st century response to this problem?
Well, when the oil-divestment campaigners come calling, how will we respond? Drawing on the standard RI tool-kit we might say: ‘We’re engaging with the oil industry to encourage better disclosure of carbon emissions and climate change risks’ or ‘We’ve done some ESG-integration analysis and have concluded that if there’s a price on carbon, we’ll change our valuation forecasts for oil stocks.’ I doubt Bill McKibben will be convinced. Does doing these things make any material difference to climate change?
This question matters to investors not just because we will need to manage the reputational issues raised by a high-profile NGO campaign; but also from a fiduciary perspective. Global carbon emissions are radically reshaping the global climate, as this year’s record Arctic snow and ice melt demonstrates. When coupled with issues like water scarcity and food security, substantial climate change adds a major new source of uncertainty for long-term investment returns, including tail risks of lower growth rates and systemic economic shocks.To deserve any serious credibility, the methods employed by the RI movement must be up to the task of mitigating these risks, and doing so in a material way. If they are not, we need to be looking for better methods. As the PRI begins its new consultation about strategic direction, now is a good time to reconsider.
There is a fundamental reason for doubting that the core RI strategies of ‘active ownership’ and ‘ESG integration’ can play a material role in providing a solution to climate change and other serious environmental problems. It comes down to basic economics. Climate change, as the Stern Review said, ‘is the biggest market failure the world has ever seen’. Stern meant something specific by this: energy companies (and their customers) impose large costs on society, now and in the future, but they don’t pay for these costs – they are externalities. As a result their products are much cheaper than they ‘should’ be, and so undercut alternative forms of energy that do not externalise costs. Worse still, in competitive markets, even enlightened companies are unable to voluntarily ‘internalise’ these costs because doing so would make their products uncompetitive. It’s not just climate change: externalities are also the fundamental barrier in effective management of scarce water resources, fisheries, forests and other ecosystem services.
UN PRI Principle 1 says that responsible investors should ‘integrate’ environmental social and governance (ESG) issues into investment decision-making. While there’s a lot to be said for integrating ESG, it can do nothing to correct externalities. Part of what it means to say costs are ‘external’ is that they do not appear in
companies’ profit and loss accounts and so do not belong in a discounted cash flow (DCF) forecast.
Of course there is nothing wrong with engaging in hypothetical scenario analysis to see what happens if the true social costs of carbon emissions, say, $100/tCO2, are added to a cash flow forecast. If you do this, hypothetical valuations for hydrocarbon companies fall through the floor. A new HSBC report concludes that if governments were to introduce the carbon prices necessary to contain climate change to safe levels (450ppm), oil companies could see their value fall by 40-60%.
But, while this exercise is instructive, it remains a hypothetical what-if scenario. The impregnable barrier to actually integrating this piece of ESG analysis into investment decisions is that a 50% fall in value of oil stocks will only happen if and when high carbon prices look likely. Most analysts doubt that this will happen for many years. Until then, the oil sector will continue to be very profitable, ‘unburnable’ reserves will be burned, and fiduciary investors will continue to provide the capital to finance it – despite their commitment to PRI integration, and despite the vast external costs – and risks – created as a result.
The fundamental point here, is that while integration can react to potential government action to internalise an externality, it cannot make the internalisation happen.
‘Engagement’ fares little better. The investors who engage with companies to encourage action on carbon emissions mostly aim no higher than encouraging them to improve efficiency, risk management and disclosure. This is useful at the margins, but will not significantly alter our trajectory on climate change, water scarcity and other key exerternalities. There is no point in engaging to encourage oil companies to stop exploring for new reserves, for the simple reason that shareholders cannot realistically force companies to take action that destroys shareholder value. Engagement is powerless when the flaw isn’t in the business plan, the flaw is the business plan, as McKibben puts it.Integrating ESG into investment decisions and company engagement are useful disciplines. They can bring value to investment portfolios and can achieve useful change on non-externality issues (e.g. corporate governance, health and safety). But they are not much good for solving the externalities. Here’s the problem: if these methods are the core focus of the RI movement’s response to climate change and the other core sustainability problems, it risks losing its credibility, and it will play, at best, a marginal role in the attempt to mitigate these problems.
The $40trn solution
The irony is that investors could be absolutely central to solving the sustainability crisis. The consensus solution to climate change, water scarcity and food security is to deploy very large amounts of capital to replace today’s externalising infrastructure with new sustainable infrastructure that does not impose substantial external costs on the environment – low carbon power, energy efficient buildings, water-efficient agriculture. According to the IEA, this transformation will cost several tens of trillions of dollars in the next few decades.
Also – as if we needed any other problems – the financial crisis means that the traditional sources of infrastructure finance – governments and banks – are overstretched and may be unable to fulfil their historic infrastructure finance role. So it may be that this transformational investment will only happen if institutional investors supply the capital. This is a mission, should we choose to accept it, worthy of the $35tn RI movement that the UN PRI has assembled.
Luckily, there is also an alignment of interests. In a world of low yields and nascent inflation risk, infrastructure is an attractive asset class, with valuable diversification benefits. But more than this: by eliminating carbon and other environmental externalities, a shift to sustainable infrastructure could also reduce uncertainty for long-term investors and mitigate the tail risks associated with severe climate change and natural resource conflicts. A number of investors – both pension funds and asset managers – are already allocating capital
in this area – Walney, the world’s largest offshore wind farm, for example, is part financed by capital from major Dutch pension funds. Much, much more of this is needed.
Public policy advocacy
Gearing up to be the indispensable source of finance for the sustainable infrastructure that will transform our climate change fortunes certainly feels like a more promising approach than energy-efficiency engagement and hypothetical carbon-price integration. But there is one essential missing ingredient. We can only deploy capital to build this infrastructure if it is supported by public policies which enable investors to secure a competitive long-term risk-adjusted returns. Without the UK government’s renewable energy subsidy regime there would have been no pension fund investment in the Walney wind farm.
This takes us back to the externalities problem. If we want to unlock the $40 trillion sustainable infrastructure investment opportunity, history teaches us that investors cannot simply hope that governments adopt the necessary policies, and leave the debate to the historically entrenched, vested interests.
As central providers of capital for this transition – the voice of the future – responsible investors should be expected to actively and energetically support the process of achieving an investable climate policy. Responsible investors should convince governments, and their customers and beneficiaries, that they believe this transition is in our collective long-term interests – for the kind of reasons given above; and that, under the right risk-return conditions, they are able and willing to deploy capital to finance it. In addition, as providers of sustainable infrastructure capital, investors should invest resources in participating in detailed discussion about the design of policies that will deliver these conditions; and play a serious role in supporting the legislative process that enacts them.
This activity is not entirely new for RI investors. The various regional investor climate groups have been engaging with governments and the Kyoto process for several years. But support from institutional investors is often shallow and patchy, and the resources available to these networks are meagre, to say the least, hampering their ability to do the necessary research and deploy boots on the ground.One reason for this is that policy engagement on externalities is still marginal to the RI movement. There is, for example, no 7th PRI principle requiring a commitment to policy engagement to correct market failure; and this topic has the barest toehold in the new PRI Reporting and Assessment framework. Of course, not all investors will be able to move in this direction – some government pension funds, for example, may be barred from this activity. But if the RI movement wishes to play a material role in mitigating the severe long-term risks from climate change risks and other key sustainability problems, public policy engagement on externalities needs to be more central.
The PRI consultation
This brings us back to the PRI consultation. The UN PRI has recently shown some valuable leadership on this topic. At the PRI in Rio event in July, Executive Director James Gifford announced a new strategy, recognising the critical importance of systemic issues, and the need to address externalities and other collective action problems at the system level. The PRI is now consulting signatories about the direction this new strategy should take. This is a good opportunity for investors to signal their support for more RI effort on externalities and public policy. It is important that this does not simply rehash research about the impacts of externalities on investment portfolios. If it is to be effective, work must focus on how investors can play a material global role in supporting the design and implementation of policies to make sustainable infrastructure investable.
This is not just something for the PRI. Investors can also work to harness their own institutional resources, engage mainstream investor trade associations, and boost existing policy engagement efforts by investor networks. But the PRI is a powerful normative force, and it has a big part to play in shaping what it means to be serious about RI. So it is important that infrastructure, externalities and public policy become much more central to the PRI vision.
Dr. Craig Mackenzie is Head of Sustainability at Scottish Widows Investment Partnership.