ESG integration is paving the way forward
Integrating environmental, social and governance (ESG) factors into the core of investment strategies and decision-making is becoming a reality. ESG criteria have made their way to institutional investors' active investment strategies as well as passive strategies, for example in the growth of exchange-traded funds (ETFs) considering ESG criteria.
The financial industry's adoption of ESG strategies is a clear and positive indication that sustainability factors are no longer considered in isolation. Instead of only seeking positive ESG-linked benefits as attributes on top of traditional investment strategies and evaluation, investors are increasingly interested in how ESG aspects link to the core business. Sustainable investment practices are applied increasingly as part of mainstream asset management practices - and not primarily because of environmental concerns but due to their higher potential to provide future returns. In 2018 a Bank of America Merrill Lynch report showed that adopting ESG metrics as part of investment strategies and analysis is likely to reflect positively in portfolio performance by decreasing risk while providing similar or higher returns.
Climate risks topping the agenda
Similarly to ESG criteria, climate change-related risks are gaining recognition for their importance in investment decisions. The threat climate change poses to businesses and investors alike is becoming increasingly evident, as highlighted by the World Economic Forum's annual Global Risks Report earlier this year. The report identified climate change related risks such as extreme weather events, natural disasters and the failure of climate change mitigation and adaptation among the most critical risks of our time both in terms of impact and likelihood. A failure to consider the negative impacts climate change poses on company's assets, operations, revenues and capital expenditure, may lead to significant misjudgement of a company's risk profile. One recent example was Pacific Gas and Electric Company (PG&E) filing for bankruptcy in early 2019 due to severe wildfires in California.
Investors are currently failing to fully price in physical climate risks and their effect on investment portfolios according to a BlackRock study from earlier this year. In essence, climate-related risks and opportunities should be included in investment analysis and strategic decisions alongside usual return, risk and cost assessments to avoid over or underestimating investment's value. Since the publication of the recommendations by the Financial Stability Board's (FSB) Task-Force on Climate-related Financial Disclosures (TCFD), sustainable investing professionals have been dedicating increasing efforts to identifying climate risks and opportunities in investment portfolios. Yet, when aiming to assess climate-related risks in investment portfolios, investors frequently face the challenge of data limitations and a lack of company reported information.This happens because the concept of materiality guides many of the existing non-financial reporting frameworks; what is considered material and significant varies across sectors and companies. For example, not all companies have identified climate risks as financially material and thus do not disclose on their potential financial impact. This creates a challenge for investors when assessing portfolio climate risks as the analysis cannot solely depend on the information provided by corporate disclosures. More corporates are beginning to disclose on financially material climate-related risks, however progress needs to be made for investors to have sufficient - and comparable - information available.
Regulatory push, voluntary market initiatives and emerging recommendations for the application of best-practice approaches are driving action towards better climate risk disclosure and integration in investment strategies and decision-making. Recent examples of such external drivers include PRI announcement to make reporting on TCFD-related indicators obligatory for PRI signatories in 2020. In June 2019, the European Commission updated the guidelines on non-financial reporting by adding a specific supplement on reporting climate-related information, complementing the existing Non-Financial Reporting Directive (NFRD). Although currently voluntary, further regulation may require disclosing on climate-related risks on a mandatory basis in the future.
More than anything, priority shifts such as encouraging - and requiring for - increased financial disclosure on climate-related risks have notable cascade effects. Investors are called upon to assess and report on their investments' alignment with the Paris Agreement and to identify to what degree investee companies are on a 1.5°C-2°C temperature change pathway. This creates pressure - but also an opportunity - for investors to engage with portfolio companies to ensure risks are being identified and communicated, and that adequate mitigation and adaptation strategies are in place. Mainstreaming climate risk assessment is vital for well-informed investment analysis and decision making, but also to guide structured engagement on the topic of climate change.
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