Even investors who are skeptical about the case for incorporating Environmental, Social and Governance (ESG) factors into investments must recognize that growing interest in ESG has already significantly influenced trading. We believe this trend is still in early stages. Investors need to understand the powerful effect that ESG factors are having on capital flows, investment returns and the reshaping of economies in order to align their portfolios.
By Michael Baldinger, Global Head Sustainable and Impact Investing, UBS Asset Management
Our investment teams across UBS Asset Management have been studying the ways qualitative ESG factors affect corporate performance for over 20 years. The effort, especially with regard to climate risk, is vitally important to investors as momentum builds to reduce global carbon emissions by transitioning to a lower-carbon economy. This can be clearly seen by the steadily growing rate of new investments into ESG-focused funds.
Regulators, investors and companies are all behind this push
One driver of those flows is regulation. Principles for Responsible Investment, aligned with the UN's Sustainable Development Goals reports there have been over 730 policy revisions across the 50 largest global economies pushing investors to consider long-term value factors, including ESG. More than 3,000 institutional investors representing more than USD 100 trillion in invested assets have pledged to follow the PRI's responsible investment recommendations. Likewise, the Task Force in Climate-Related Financial Disclosures (TCFD), supported by organizations with a combined market capitalization of over USD 12.6 trillion, is working to develop consistent corporate climate-related financial risk disclosures.
Climate change creates investment risk and opportunity
Climate change is without question one of the most significant, but misunderstood risks confronting us today. They are two-fold: physical and transitional. We’re already feeling the physical effects of a warmer world: 2016 – 2018 were the hottest years on record . Extreme weather events doubled between 2001 – 2018, while droughts and wildfires increased exponentially.
The transition is gaining momentum, too. In 2015, governments around the world took action by joining the historic UN Climate Change Paris Agreement, pledging to reduce greenhouse gas emissions in their countries in order to limit the increase of global average temperatures to a maximum of 2°C above pre-industrial levels by 2100. Governments are fulfilling their agreement by supporting cleaner energy alternatives, which is accelerating the capital-intensive transition to a lower-carbon economy. Estimates say fulfilling these pledges may require as much as USD 95 trillion in investments by 2050 based on current government projections and energy plans. We believe this transition will have an enormous impact on investment portfolios, presenting both risks and opportunities, which wise investors cannot ignore.
Evaluating corporate response to ESG pressure
Investors are catching on to the impact of ESG on investment returns. In a survey of 600 institutional investors we conducted in 2019, a majority said they believe environmental factors will matter more than traditional financial criteria over the next five years in corporate performance. Many clients have asked us to help develop ways to align their portfolios with this transition.
To formalize our approach, we have developed a climate aware investment framework based on three pillars: identifying companies that offer products and services that form part of a solution, carbon-heavy companies that are successfully adapting their business models to the transition, and companies that can already demonstrate success in addressing climate change risks in their own operations. This is a complex process that calls for a depth and breadth of research expertise across disciplines to gauge the interplay of public policy and private sector response.
We maintain active engagement with companies to understand how they are modifying business models to successfully navigate this transition, and whether their plans are consistent with best practice. For investors who remain skeptical, we recommend a data-focused approach to already-demonstrated climate-related risks and potential financial impacts.
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