Earlier this month I attended two investor-related events – the launch of the new report published by the Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment, and the RI Europe 2013: Investor-Corporate ESG Summit. Both events recognised the challenges of incorporating ESG considerations into company valuations, and discussed the growing set of initiatives and approaches that investors are taking to resolve the situation.
In the first report in the series – Unburnable Carbon: Are the world’s financial markets carrying a carbon bubble? – Carbon Tracker argued that if the world is to remain within the 2 degrees limit of tolerable global warming then it can only “afford” to burn approximately 20% of total known fossil fuel reserves, leaving 80% of assets technically stranded and meaning that investors who are valuing companies based on their ability to continue to burn these fossil fuels may be massively overpricing their assets.
In the new report Unburnable carbon 2013: Wasted capital and stranded assets it is argued that company valuation and credit ratings methodologies typically fail to inform investors about their exposure to these stranded assets despite these reserves supporting share value of $4 trillion in 2012 and servicing $1.27 trillion in outstanding corporate debt over the same period. That the methodologies currently used fail to go beyond the traditional definition of risk as underperforming the benchmark, is a key factor which means investors are typically unable to capture the longer term issues which will challenge company performance.
As we observed in our recent report, Changing Tack, “Markets as a whole still do little to encourage business to account for externalities, let alone reward them for doing so” however, there were some themes coming out of the RI Europe 2013: Investor-Corporate ESG Summit that suggest that both specialist and mainstream investors are paying more attention to ESG criteria in their strategies and valuation methodologies, including:
Rewarding short-termism: There was acute awareness of the inherent limitations of the current valuation methodologies, and the theoretical underpinnings of the market (i.e. the Efficient Market Hypothesis). Investors operate within a system that increasingly rewards short-term performance, punishes outliers, and fails to incorporate the long-term risks and opportunities from stemming from ESG issues which often fall well beyond their time horizons. Asset owner / fund manager contracts were highlighted as a key lever for change, for example, enabling asset owners to specify that their fund managers should not use market cap benchmarks for comparison, and promoting use of strategies that emphasize fundamental values which support long term investment (i.e. long term cash flows).
Influencing and being influenced by policy: The lack of clear governmental policy around climate change and the future energy mix was highlighted as a key challenge for investors in applying long-term valuation methodologies. From writing letters to lobbying (e.g. the work being carried out by the IIGCC), participants in the ESG conference discussed how to create and/or contribute to the policy framework that investment managers operate in. There was a recognition that a lot of progress could be made in this area.
Engaging with corporates: Asset owners discussed the need to be more actively engaged with their portfolio companies through increased interaction and voting. Although the concept of stewardship is on the rise, more could be done by investors to raise long-term issues in conversations with corporates, or through shareholder resolutions. Several businesses in the room highlighted that not only did they expect more detailed challenge from investors (i.e. on investor calls) on ESG performance, but they also would benefit from “positive reinforcement” on the sustainability strategies. At the moment, feedback from investors is lacking.
Investor reporting: Although still in its infancy, the benefits of investor reporting on internal ESG practices (both operational, and within the portfolio) showed a real appetite to go from “talking the talk” to “walking the walk.” The use of reporting to drive transparency, accountability, and behaviour change has been seen in the growth of corporate responsibility reporting over the last twenty years and the PRI Reporting Framework (due this October) provides reason to be optimistic that we might see the same trends in the investor space.
From specialist to mainstream: Investors were actively engaged on the question of how to make sustainable investing more widespread, and more than the focus of niche providers. Language was seen as a key driver – replacing terms such as “non-financial criteria” with alternatives with broader appeal. At both events the sentiment in the room was that progress was being made, but speed and coverage needs to be ramped up.
Action by institutional investors, such as those recommended in the Carbon Tracker report, is required in order to avoid the risk of stranded assets, and whilst the discussion and energy at the Investor-Corporate ESG Summit provides reason to be optimistic that momentum is building around incorporating ESG criteria into investment decisions the gap between what investors say is important, and what they do with their money shows that there is still some way to go.