I moved to a 72-acre farm in rural Ontario a couple of years ago. This experience provided me with a long list of handyman to-do’s and an ever-expanding file of lessons learned. I’ve come to learn that we require the right tools to achieve our objectives, and that no matter how good our toolbox, the outcome of our work remains highly dependent upon our skills and seriousness. These lessons apply equally to sustainable investing and finance, especially as the climate crisis increases the complexity of investing, and the number of themes related to sustainability are proliferating.
In the runup to 2022, it struck me that VUCA--a concept that originated in the mid-1980s at the U.S. Army War College to describe the volatility, uncertainty, complexity, and ambiguity of the world after the Cold War--is still a useful framework to think of where we are now. Greed and fear, as Warren Buffett has quipped, are "two super-contagious diseases [that] will forever occur in the investment community." From my perspective, the dominant feeling today is fear. New strains of the coronavirus continue to emerge; geopolitical tensions are on the rise, with a revisiting of Cold War tensions in Europe between longtime foes; and an increasingly assertive China is cracking down on religious minorities in Xinjiang while flexing its military muscle.
Clients and capital market colleagues often talk about how climate change is leading to systemic risks, thereby contributing to VUCA and an underlying sense of fear. Hence, the increased interest in what now falls under the rubric of sustainability--environmental, social, and governance practices. For example, heavy rains and flooding have devastated British Columbia in the past month, the third natural disaster to hit western Canada in the last year after a heat wave caused uncontrolled forest fires. Without trees and other vegetation, the barren landscape was vulnerable to flash floods and mudslides. Insurance and rebuilding costs are expected to top the CAD 12.7 billion (USD 10 billion) of Canada's most expensive natural disaster in Fort McMurray in 2016. That's just one example of the knock-on effects of climate change. You can see how sustainability challenges can lead to disproportionate negative outcomes for disadvantaged countries and people who don't have the same financial resiliency. Drought and flooding worsen their hardship and make it more difficult to supply basic needs. And that deepens inequality. Those issues were laid bare by some of the political divisions at the recently concluded climate summit, COP26. Developed nations, which arguably have contributed more to climate change, historically have failed to adequately support the financing of the energy transition for developing countries.
So, what do I expect from 2022? A few themes will help shape the discussion around sustainability.
Theme One: Climate has put sustainability, in general, on the agenda. We will now see a continuing proliferation of social issues intertwined with climate, such as the Just Transition. The Just Transition Declaration, signed by more than 30 countries at COP 26, reflects International Labour Organization guidelines and commits them to find strategies that support communities through the shift to a more sustainable economy. You will see more efforts, such as the EU's EUR 17.5 billion (USD 19.8 billion) Just Transition Fund as well as investor initiatives like the World Benchmarking Alliance, which will assess how well 180 companies are managing the Just Transition.
The climate crisis also encompasses a range of other issues, including deforestation, the destruction of biodiversity, pollution, and human rights, among others. Ultimately, these are about the health and resiliency of the planet, which underpins the health and well-being of those who inhabit it. Humans are part of, not separate from, nature. While climate change and weather-related events will dominate the coverage, discussions will be much broader. For example, there is evidence that air pollution worsens the severity of COVID-19. In October, the medical journal The Lancet, predicted that climate change would be the "defining narrative of human health." All these discussions will pick up momentum. If climate motivates people to think about these problems in a meaningful way, and turn that thinking into action, it can be very positive. The risk is that addressing climate change loses focus because people can use it to promote their varied agendas.
Theme Two: Net zero will focus the discussion for the foreseeable future. The Net-zero transition isn't simply about reducing carbon; it's a business model transformation akin to the Industrial Revolution. There will be winners, survivors, and casualties. If you're on a board of directors, in the C-suite, or allocating capital as an investor, you are trying to figure out what you need to do to be in the winner's circle, or at the very least to avoid being a casualty. Much is unknown--defining net zero is challenging, as is finding the best path to achieving net-zero emissions. More daunting is contemplating a new business model while the market is evolving swiftly and unpredictably. The investor community, a pillar of the capital markets, must absolutely focus on driving meaningful outcomes through their investments. I read a humorous article that poked fun at the net-zero movement. It was about an Australian man who set an ambitious target to quit drinking by 2050 when he turns 101. He didn't see that he needed to stop drinking in the short or medium term. That won't work for net zero. We need to have meaningful progress now or we're not going to make it.
Theme Three: Divestment and engagement both have a place in the conversation. One of the most critical questions of our time is how we can decarbonize investment portfolios. Thus, an old and much-trodden debate has again emerged on the front page: Divest from high-carbon emitters or engage with them? Divestment decisions are looking very different from the past. Consider Dutch pension fund ABP, which announced in October that it would divest from fossil-fuel producers, citing "insufficient opportunity for us as a shareholder to push for the necessary, significant acceleration of the energy transition at these companies." Critics of divestment argue that the assets simply end up in the hands of private equity or state-owned enterprises, neither of which has cared much about sustainability in the past. The SOEs will surely require political will to change. But even private equity and venture capital are increasingly paying attention to sustainability issues. More and more, owners of capital will demand that their private assets are also engaged in ESG. As banks face more scrutiny from global regulators about climate risk, you can expect to see nudging from the capital markets on the debt side, too.
As I shared at the beginning, that long list of to-do tasks at my farm has taught me that you need an array of tools, and the outcome depends on how seriously you wield those tools. Instead of simple letter-writing, those who engage with companies need to fundamentally challenge them on their underlying business models and call for significant change, which requires commitment and resources. Engine No. 1, the activist that elected three candidates to Exxon’s board this year, is a very different model of engagement. Can it be done at scale?
What is certainly true is that net zero represents a fundamental transition of the global economy, and grappling with it is part of fiduciary duty. Clients I speak with increasingly are undertaking stress-testing and scenario analysis to ascertain how to position their portfolios. According to one model, by FutureZero in collaboration with Credit Suisse HOLT, pricing carbon at USD 75/ton CO2 equivalent for scope 1 and 2 emissions, results in an erosion of more than $20 trillion to enterprise value globally, 83% of it from just five sectors: materials, utilities, energy, industrials, and consumer staples. I’m not arguing that this analysis can’t be challenged; I’m simply suggesting that the decision to divest from energy can be underpinned by an informed investment thesis that is guided by fiduciary duty.
Theme Four: Sustainability shifts from "nice to have" to "need to have." As more investors in both public and private assets insist on greater sustainability, a screaming need for consistent, shared disclosure and reporting standards has arisen. Imagine a world without generally accepted accounting principles or without international financial reporting standards. It would be chaos. That's essentially where we are now. Today, the infrastructure for sustainable finance is falling into place. Recently, the IFRS Foundation announced the formation of the International Sustainability Standards Board, or ISSB, which merges two important standards-setting entities. Meanwhile, efforts by Morningstar and others to clarify the terms used for sustainable investing can also help new investors who worry about green washing and other potential problems.
In 2022, as the influence of sustainability considerations on long-standing financial reporting, oversight, risk, and regulatory frameworks gain steam, I expect that our habit of speaking about sustainable and responsible investing, ESG, and sustainable finance will begin to fall by the wayside. Increasingly, we will simply refer to the work we do as investment or finance--one’s prefix of choice will no longer be necessary as sustainability becomes the norm.
Theme Five: Here come the retail investors. As Morningstar CEO Kunal Kapoor has noted, the number of ESG ETFs has exploded more than sixfold even as active ESG fund assets keep growing. That, alongside record-breaking asset flows into sustainable funds, may speak to the interest of retail investors who are traditionally last to the party--and whose arrival, to cynical investors, heralds the top of the market. This might be true if sustainable investing were simply a fad, but investors are adopting ESG as part of the transition to a net-zero world. Individuals in North America are a powerful client base for large institutional investors. More growth may come, in fact, as individual investors start investing in sustainable funds through their retirement plans.
I’d argue that retail investors have dual expectations: They care about a secure retirement, financial goals, and risk, but they also care about whether air pollution is giving their children asthma, or whether increased incidence of wildfires means home insurers are curtailing coverage. How ironic it might be that the final people to join this party may be a critical catalyst for moving the conversation toward the impact of portfolios to address these issues. In doing so, they could be the force that creates change.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.