Just as Covid-19 caused stock markets to suffer record investor withdrawals during the first half of 2020, investment banks saw one area of the investment markets flourish. Environmental, social and governance (ESG) funds experienced record inflows throughout the crisis.
Not only are people thinking more about long-term sustainability they’re also buying into it as sustainable funds themselves outperformed traditional peer funds and reduced investment risk during coronavirus, according to a report from the Morgan Stanley Institute for Sustainable Investing.
In this article, Pooja Khosla, vice president of client development at Entelligent, looks at how an increase in valuing the importance of all areas of sustainability, whether environmental, social or governance, can help banks tackle climate change.
Leaders agree that climate change poses a great threat to our planet, and that we should reshape our societies as well as business communities to protect against the dangers of it. These transformations will require policy, technology and energy transitions that will significantly change the investment landscape, both in the short term and further out.
The smartest financial institutions will be well aware that sustainable-based investment products and strategies are more popular among institutions and investors than ever before, and this trend is likely to continue, with institutions of all kinds continuing to tilt their product suite toward sustainable, climate-resilient and climate-aligned strategies.
The future winners will be those strategies that are pecuniary to financial and economic factors and are able to carry out the best practices for optimising risk-adjusted returns on investment portfolios when focused on companies that are demonstrating better preparedness for climate change.
Analysing climate risk, the most significant element of the E within ESG investing strategies is doing much of the heavy lifting in driving a large part of the acceleration in the understanding of product risk evaluation, as it is currently the most measurable in financial terms. So, how can financial institutions incorporate this into their product suite efficiently and effectively?
Climate Risks Involve Looking Forward Not Backward
As the business climate has transitioned toward a more sustainable model, so to has the marketplace of ESG solutions for institutions and individual investors. Herein lies the problem around the effectiveness of many existing financial products and solutions. The majority involve exclusionary approaches – including socially responsible investing, negative screening or divestment – that are not effective in mitigating ESG or climate risk. In practice, these approaches are more based on subjective value judgements. For instance, most climate-aware retail investors want to ditch oil and gas stocks from their portfolios as a first port of call. But this decision may not help global greenhouse gas carbon reductions as just 100 companies are responsible for 71% of global emissions according to a report from the Business and Human Rights Resource Centre.
Greenwashing is a well-worn rhetoric in the investment sector. It refers to the fact that many products labelled ESG or sustainable do not effectively mitigate future risks regarding the E, S or G at all, or necessarily provide superior risk-adjusted returns, hence the term ESG for ESG’s sake. US regulation, especially if the Department of Labor’s final rule is anything to go by, is not in favour of ESG for ESG’s sake. Instead, policy is in favour of ESG strategies if their addition provides lower risk and the potential for healthy returns or commensurate returns of non-ESG strategies.
Mitigating climate risks involves anticipating the future. It is important to note that the future is uncertain. That is why it is equally important to take multiple future scenarios into consideration to carefully evaluate risk. We need scientific approaches that translate forward-looking metrics and targets using scenario analysis that are beyond exclusionary solutions and value judgements. If desired, indexes can also be created to integrate forward-looking scientific analytics, while new innovative solutions such as ‘climate beta’ can be produced for listed equity stocks. Various ’smart beta’ exchange-traded funds already exist, although the development of such indices is significantly less progressed in ESG. This is where institutions and investors should be looking.
Technology Has Revolutionised the Risk Management Function
Addressing all ESG concerns at once is impossible even for the most future-gazing and well-intentioned financial institutions. Assistance is needed for banks and asset managers to tackle the sheer volume of portfolio evaluation disclosure legislation circulating from financial regulators keen to see ESG factors as a mainstream risk-factor, according to law firm Pinset Masons.
But as technology continues to revolutionise the way we see and do things; it must also advance the risk management function.
Machine learning and artificial intelligence has made future scenario evaluation possible, and climate scenario-based approaches pricing in future risks have been developed to provide banks and asset managers with a product suite fit to pass the climate change stress test.
There is expected to be a surge in climate-aligned investment products globally following the election of Joe Biden as US President. Those institutions that base their investment decisions on demonstrable, forward-looking risk analysis, will pass the global leadership sniff test being enforced by the United Nations Sustainable Development Goals and Task Force on Climate-Related Financial Disclosures, with leading governments likely to embrace the benefits of sustainable, climate-aware investing more than ever before.
This means that companies exhibiting good ESG behaviours, especially better strategies towards climate change that can directly be translated into economic and financial factsheets, will get more attention, with investors aligning investment strategies with the progress towards these changes, in compliance with new recommendations.
Central banks in countries including the United Kingdom, France and Japan have already unveiled their plans to roll out climate stress tests to gauge financial firms’ exposure to global warming.
President-elect Joe Biden will reenter the US into the Paris Climate Agreement, the global pact forged five years ago among nearly 200 nations to avoid the worst impacts of climate change. With this new presidency, the U.S. central bank is very likely to join the global superpowers in integrating and implementing climate risk factors to portfolio and investing decisions.
The technology is out there, but the banking institutions with a forward-looking, climate-resilient product suite that can deliver superior returns over the long-term, and can prove this, stand the best chance of building assets in a more climate-aware future.