Environmental Investing; Carrot or Stick?

Environmental, Social and Governance (ESG) investment is a type of investment that seeks to promote a positive social and environmental impact as well as a financial return from the investor. The goal of ESG investors is to have their money generate not only profit but also positive change in society and the environment. ESG investing has become increasingly popular because it is appealing to socially responsible people who want to use their money for more than just profit. They also want their investments to have positive change in society and the environment. ESG investing became popular during the mid-2000s when investors started to merge the values of financial return and community values.

An example of this shift is the United Nations-supported Principles for Responsible Investment (PRI) which foster sustainable global finance by aiding over 4,800 signatories across 80 countries in integrating environmental, social and corporate governance considerations into their investment decisions and ownership practices. Managing roughly US$100 trillion as of March 2022, these signatories employ six aspirational principles as a flexible framework, adaptable to various organisational strategies and aligned with traditional fiduciary norms. This directly influences the cultivation of a sustainable financial system and potentially also impacts investment manager selection processes by institutional investors.

The E in ESG investing and climate change?

In the specific realm of climate change, ESG investing pertains to the adherence to environmentally sustainable practices by corporations, aiming to attenuate their adverse environmental impact whilst simultaneously securing profits. Such practices might encompass utilising recycled paper for communication, ensuring employees are remunerated with a living wage, enabling them to afford nutritious food and sufficient sleep, or crafting green buildings embedded with features such as solar panels.

ESG investing has the capacity to influence climate change either positively or negatively, contingent upon the environmental sustainability of the investment. If investments are channelled towards companies that are contributors to carbon dioxide pollution, it may inadvertently foster negative repercussions in the fight against climate change. Conversely, astutely targeted ESG investing harbours the potential to decelerate climate change, amplify equity for the disadvantaged and simultaneously realise profits.

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The Regulation of ESG and Climate Change

Unsurprisingly, in light of the potential impact of both physical and transitional climate-related risks on numerous businesses, specific climate change assessment and reporting standards are progressively being institutionalised as legal obligations, unfolding through regulatory and contractual avenues alike. A prime example of this is evident in an announcement by the UK Chancellor of the Exchequer, mandating certain entities to enhance their reporting of climate-related risks. More comprehensive climate change disclosure regulations are then likely to be being implemented by 2025. Anticipated to be grounded in The Task Force on Climate-related Financial Disclosures (TCFD) framework, which is experiencing notable global adoption and transitioning from a voluntary mechanism to becoming the principal worldwide regulatory reaction to climate risk, these rules are being mandated in various regions as an obligatory element of climate reporting.

In Canada, particularly within the jurisdiction of the Ontario Security Commission (OSC), guidance concerning climate change-related disclosure has been promulgated, and the OSC has engaged in the Capital Markets Modernization Taskforce Report, unveiled in January 2021. This report advocated for the obligatory disclosure of substantial ESG information, with a particular emphasis on climate change-related disclosure that aligns with the recommendations set forth by the TCFD, executed through the regulatory filing prerequisites of the OSC. Concurrently, the Office of the Superintendent of Financial Institutions (OSFI) is presently in active consultations with federally-regulated financial establishments and pension schemes concerning prospective supervisory strategies and prudential instruments to navigate climate-associated risks.

As these regulatory advancements take place, lenders along with other parties are amplifying their demands for contract counterparties to effectuate disclosures related to climate change. For instance, in its recent large employer loans scheme, formulated in response to COVID-19, the Government of Canada necessitated that recipients pledge to disseminate annual climate disclosures, ensuring consistency with the recommendations propounded by the TCFD.

Climate Change, Company Performance and Resilience

Besides regulatory measures, performance incentives for firms can play a pivotal role in addressing climate risks. The connection between corporate performance and dedication to ESG aspects, particularly climate change, is fervently analysed. Preliminary findings indicate potential value for entities with heightened ESG awareness and investments in climate solutions. London’s CDP (formerly the Carbon Disclosure Project), which ranks global firms on climate disclosures, revealed that companies on their ‘A List’ have seen annual returns surpass their rivals by 5.3% over the past seven years. Furthermore, the Morgan Stanley Institute for Sustainable Investing highlighted that from 2004 to 2018, sustainable funds’ median performance matched traditional ones, but they offered greater protection against downside volatility, exemplified during a notably turbulent period (Q4 2018) in the U.S. markets.

The early COVID-19 crisis market sell-off underscored sustainable investments’ notable resilience. A study revealing that global public companies, deriving at least 10% of revenues from climate solutions, saw their stocks outperform regional indices by an average of 7.6% between December 2019 and March 2020, and by 3% from February to March 2020, highlights this. Additionally, during the sell-off, traditional Exchange-Traded Funds (ETFs) experienced heavy outflows, whereas sustainable ETFs witnessed growing net inflows, despite presently constituting a minor portion of the global ETF market, indicating a potential surge in sustainable investing in the ensuing decades.

However, prominent research underscores a crucial qualifier to these trends, concluding that extensive investments in ESG factors don’t inherently drive enhanced profitability. Specifically, companies that score highly in industry-material ESG factors and lowly elsewhere tend to outperform the market, especially if they adeptly implement and transparently communicate a correlated corporate purpose. This insight is vital for companies where climate change risks are the most material, or among the most impactful, to their business.

Climate Change; Carrots, Sticks—Or a Combination of Both?

The amalgamation of regulatory mandates and financial incentives is progressively crystalising as the likely architect of forthcoming trends in climate change assessment, disclosures and investing. Performance incentives may persist in urging companies to allocate investments towards climate change solutions, or enhance their internal management processes for addressing climate change risks, possibly through embracing voluntary standards. With regulatory bodies and contract partners intensifying the enforcement of climate-centric requirements, a unified movement, perhaps proportional to the scale of climate change risk, is emerging among financially driven stakeholders globally.

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