MSCI: Environmental, Social and Governance Trends to Watch in 2012

Accounting for natural capital, conflicting water demands and the shifting debate on climate change

With budget cuts, high unemployment, and stagnant wages, countries and companies face a crisis of confidence from a public that is worried about their health, security, and, increasingly, basic social equity. Even as governments cut social benefits, the political will to enforce regulations will strengthen in reaction to public outcry, forcing companies to internalize unanticipated costs. In this context, MSCI’s ESG Research team is focusing on ten emerging trends for 2012 that are shaping up as key risk and return drivers for sectors ranging from financials to IT. Among these are three environmental themes, where we see shifts in how risks and opportunities will be distributed within and across sectors.

Accounting for Natural Capital

The rapid degradation of ecosystems and depletion of natural resources will weigh on the long-term sustainability of major economies around the world. According to the Global Footprint Network, humanity’s consumption surpassed earth’s bio-capacity in 2006, and on current trends, we will require two earths to sustain our consumption by 2030. Already, effects such as water scarcity, desertification, soil erosion, and depletion of fisheries are impacting the ability of some regions and sectors to sustain business-as-usual. As investors become more aware of the risks to long-term growth of degraded ecosystem services, the idea of accounting for ‘natural capital’ has started to take on momentum.

Assessing countries’ ability to protect and harness their endowed resources will be a crucial step to integrating country-level risks into investment decisions. Factors such as changes in forest area, renewable water resource, and environmental footprint of a country’s consumption versus its bio-capacity offer investors a glimpse into the underlying capacity of countries to propel future growth.The picture can be alarming: in over two-thirds of the 156 countries in our analysis, consumption and production levels have already exceeded their bio-capacity.

We anticipate that these countries’ attractiveness as investment destinations will increasingly be called into question by investors concerned about the long-term competitiveness and sustainability of their economic models.

Shifting Debate on Climate Change

Although climate-related legislation has not come fast enough or far enough for many environmental advocates, there has been a slow and upward trend in increased legal certainty around the shape of a low carbon economy in many markets. Most notably in 2011, the Australian legislation puts a price on greenhouse gas emissions and could link to other international trading schemes such as the European or the California one. Decisions coming from the Durban conference include an agreed pathway for a new international climate change treaty that will include developed as well as developing countries with legally binding targets for the first time.

According to the International Energy Agency, for every five dollars needed to tackle climate change, four will have to come from the private sector. Hence, increased clarity in regulatory frameworks provides greater legal certainties to the private sector, signals that are crucial for companies to prepare for a low carbon economy. We anticipate that as the vision of a low carbon economy takes hold, attention of consumers and policymakers will shift away from the obvious sectors with high direct carbon emissions.

Instead, the reality of a global economy that is driven by upstream processes that generate substantial emissions will shift the debate and the spotlight on industries and products that currently receive scant attention to the issue of climate change.

Our research has shown for some time that the textile & apparel industry, for example, is among the sectors with high carbon intensity in its supply chain. Yet, only one in every four companies in the MSCI World has strategies in place to identify the scope and extent of their risk exposure to higher energy costs throughout its supply chain. With respect to product offering, among major global industrial conglomerates, only one in every five companies offers products on energy efficiency or renewable energy.

We anticipate that a growing swath of downstream consumer and industrial companies will have to pony up the investments into a more efficient, low-emission supply chain, creating incentives for innovations in low-carbon technologies such as iron making through hydrogen and CO2 separation and recovery (30% less carbon intensive) or thermo acoustic refrigeration (HFC free, which has 22,000 times the global warming potential of CO2).

Conflicting Water Demands

Acute water shortages accounted for an estimated economic value loss of up to USD 5 billion to the agricultural sector in the state of Texas in 2011, where at least one-third of the wheat crop was lost to the worst drought in over 100 years. A drought in northern China, the heart of its wheat growing region, contributed to a spike in wheat prices earlier in the year. Meanwhile, many parts of Europe faced the driest conditions in a century.

Water shortages will increasingly pit industrial users against agricultural and residential users. Some of the highly intensive users of water from a lifecycle perspective include utilities, food, beverages, steel, and semiconductor industries. For some companies in these industries, a substantial portion of their assets are located in high water stress regions that carry increased risk of operational disruptions from water shortages.Our analysis of the semi-conductor industry shows, for example, that of the 15 companies in the MSCI World facing the highest risks from operating in water stressed basins, only 4 have strong risk management approaches with comprehensive strategies, quantitative reduction targets, and high water recycling rates.

We are able to estimate with growing accuracy the level of risks companies face on water shortages to their operations. However, our analysis finds that most companies continue to ignore these risks.

In our analysis of the steel industry, we find that only 3 of 45 companies currently report their water use to the Water Disclosure Project. Yet, for some steel companies, water availability is already an obstacle to ambitious growth plans.

In eastern India, where agrarian society conflicts with economically-advantageous mineral deposits for the steel industry, multi-national steel companies, such as ArcelorMittal and POSCO have hit roadblocks stemming from community opposition to water withdrawals and land acquisition. For POSCO, their USD 12 billion investment in an integrated steel plant has languished for the past six years as the company has struggled to acquire land and ensure local farmers that their water supplies will be unaffected. While India represents a huge growth opportunity for foreign steel companies, continued industrial growth in these regions will only put more stress on water resources, which in turn will lead to greater conflict with local communities.

We anticipate that as fixed water supplies collide with strong demands from population growth and industrial uses, conflicts with local communities will become a regular feature for companies seeking growth in water stressed regions.

Linda-Eling Lee is Global Head of ESG Ratings Research at MSCI