The impact of climate risk on investment portfolios is overblown and investors should not worry. After all, some mad person always screams about the world’s end, which has not occurred yet. Stuart Kirk, former global head of responsible investment at HSBC Asset Management, recently made these points in a presentation titled “Why investors need not worry about climate risk”.
Several investors, executives, politicians, and asset managers share this view. They condemn the obsessive focus on climate risk, and the environmental and social impacts of doing business, which inform the new wave of environmental, social and governance (ESG) reporting integration pressures.
To others, it is a plot by left-wing radicals to destroy the energy industry from within and inflame the culture wars. After all, a house divided against itself cannot stand.
Significant climate events do not occur everywhere at the same time and so the implications of climate risk on investment portfolios are not equally visible worldwide.
Due to the interconnected nature of the planet, these events increase the risk and fragility of the global economy.
Climate and environmental risks are, of course, not the only ones confronting the global economy. Social risks, such as inequality, human rights abuses and political instability, can disrupt the global economy too. To mitigate these risks and enable shared value and sustainable development, transparent governance must occur in governments and the private sector. At the core of ESG is this recognition.
Within this context, a new(er) normal confronts the global economy. The new(er) normal is the fruit of an unholy union between supply-chain bottlenecks and shortages, rising global inflation and an energy crisis.
The surrogates are the increasingly visible impacts of climate change and the urgent action needed to address it. The new(er) normal exemplifies the financial risks of inaction for the current economic system.
In Europe and the US, heatwaves and wildfires destroy property and kill hundreds. The homes and businesses consumed in the fires, the impending insurance claims, and the loss of human life bear witness to the financial cost of climate change.
At the same time, Russia’s invasion of Ukraine is upending global energy markets, unbalancing energy security and causing high energy prices. This has led the European Union to rethink its energy policy.
Similarly, the invasion of Ukraine has contributed to high food prices because Russia and Ukraine are major wheat exporters and Russia is a significant exporter of fertiliser. The latest deal to allow Ukraine to export grain holds promise but is yet to have a significant impact on rising prices.
Last, regulatory challenges and opposition to environmental management policies have become increasingly common. In the United States, the supreme court ruled to limit the powers of the Environmental Protection Agency to reduce carbon emissions from power plants. Some politicians have suggested that a carbon tax or stricter emissions management would result in consumers paying significantly more for goods and services.
The new(er) normal presents ESG proponents with a question. Can sustainability and environmental needs be balanced against the social needs of people? The evidence suggests that it is indeed possible. However, doing so requires a more significant emphasis on the “S” and “G” dimensions of ESG. These two concerns of ESG sometimes come into conflict with environmental concerns. For ESG to be able to confront the new(er) normal, it must deal with some of the criticisms levelled against it.
Robert Armstrong and Tariq Fancy have criticised ESG for being a dangerous distraction from the bold action required to mitigate climate risk. Moreover, they highlight the misalignment between incentives of asset managers and timelines needed to address deep-rooted ESG problems.
Instead of taking the necessary actions to address society’s challenges, and changing the way of doing business, ESG presents itself as an eloquent solution to society’s systemic issues. Both have also argued that unelected individuals such as Larry Fink, chief executive of BlackRock Investments, are not the proper vehicle through which to address society’s challenges. For them, the correct way is through the ballot box; through voters selecting their elected representatives.
To avoid the risk of ESG investing simply becoming an empty marketing tool to assuage guilt, effective regulation is essential to ensure that firms internalise the external costs that the current way of doing business offloads on the environment and poor communities. Armstrong and Fancy stress the need for a carbon tax on companies, for instance.
However, their argument about misaligned timelines could also replace asset managers with politicians. While asset managers focus on quarterly bonuses, politicians focus on the next election and increasing their power. Similarly, while the loan book for an asset manager may be for six years, the electoral cycle is every two to six years in the United States.
While Fancy and Armstrong are right about the crucial importance of regulation to direct corporate actors along a sustainable path, the partisan interests of politicians make the passage of climate-related legislation difficult in some countries.
For the growing emphasis on ESG performance to have a lasting positive impact, practitioners and politicians must look more closely at the United Nations Sustainable Development Goals (SDGs). The SDGs present a set of goals to be achieved by 2030. These include eradicating global hunger, ensuring affordable energy security and improving access to healthcare.
ESG and SDGs are complementary perspectives on sustainability. SDGs approach broader societal focused goals, while ESG focuses on how corporate entities approach sustainability. The current emphasis within ESG criteria is predominantly on the “E”, so the incorporation of SDGs offers an opportunity to raise the profile of the overlooked “S”.
Prioritising the achievement of the SDGs in ESG integration is a chance to integrate ESG into policies that meet the demands of the moment, especially where there are seeming contradictions between different elements and goals.
High inflationary pressure leads to reserve banks increasing interest rates. Higher interest rates suggest that companies will reduce the number of workers employed as part of their cost-cutting mechanisms. Increased unemployment means more individuals will fall into poverty. This will damage and hinder the achievement of SDG 8: Decent work and economic growth — having knock-on effects on other SDGs.
In essence, the market doing what it naturally does would worsen the systemic social ills ESG attempts to incentivise the private sector to take more responsibility for.
Greater incorporation of the SDGs as a crucial framework for reporting around ESG addresses Armstrong and Fancy’s criticism of unaligned timelines and contrasting incentives. The SDGs present a clearly defined timeline for achieving a goal, enabling quantifiable measurement towards this end.
Prioritising the SDGs in ESG does not mean that one should reduce environmental considerations. Indeed, the SDGs are fully compatible with a focus on reducing emissions, as reduced emissions would directly improve the attainment of several SDGs. However, the SDGs keep humans at the centre of efforts to craft a better future.
The negative impact of climate risk on investment portfolio performance is not overblown. The effect of social risks, similarly, is often severely understated. Climate change is a significant threat to the global economy and humanity. However, so too are poverty and inequality. Greater integration of the SDGs presents an opportunity for ESG to internalise the costs of the economic machine and push us towards a greener future.
Vincent Obisie-Orlu is a researcher in the natural resource governance programme at Good Governance Africa.