For an evolved, intelligent species, we’re a bit slow on the uptake when it comes to climate change and the wider range of environment and social challenges facing us. However, things are changing. Louise Tong looks at why the financial sector is helping to drive this change.
The science has been around for over 150 years, and yet we’ve failed to act with sufficient speed or impact. The scientific literature clearly shows a robust consensus that human-induced global climate change is occurring. The evidence abounds – the ice caps are melting, temperatures are rising, and extreme weather events are becoming more common. For those still not convinced, I recommend reading ‘Hope in Hell’ by Jonathon Porritt.
It seems the action required to address climate change – and the wider range of environmental and social challenges facing us – is happening at a rather glacial pace. However, that appears to be changing in response to economic and societal forces. Corporates, consumers, communities, regulators, and nations are focusing on how we build a world in which we can all live sustainably. One of the most influential forces – financial and capital markets – is also helping to drive this change.
Why does the financial sector care about a more sustainable and inclusive world?
It’s not just a moral and social imperative, there are financial reasons too. A key strength of financial institutions is their ability to allocate capital in order to optimise risk-adjusted returns. To date, risk assessments have largely focused on traditional financial metrics, but the market is rapidly broadening that view of risk to incorporate wider Environmental, Social, and Governance (ESG) factors. These risks can manifest in many ways:
Asset risk: Assets may become stranded and unusable, triggering write-offs, such as the US$40 billion recently announced by BP and Shell. Another example is the assets in the automotive sector (plant and vehicles) currently centred on the combustion engine – how might that fare in the coming decades? Assets may also become physically damaged. For example, NIWA estimated^ in 2019 that NZ$12.5 billion of New Zealand property is already exposed to extreme coastal flooding, and each additional 10 centimetres of sea level rise puts another $2.4 billion of assets at risk.
Operational risk: There are a number of ways ESG risks could affect the operation of companies, from supply chain disruption (due to storms, labour disputes, corruption, and disease) to running costs (carbon taxes, waste levies, and water charges) and to the impact of changes in temperature and hydrology.
Changing consumer demand: Asset stranding and operational risk can be triggered by consumers reacting to ESG issues, particularly in today’s age of pervasive social media. For example, the apparel industry offshore has issues in relation to diversity, labour conditions, and emissions, to name a few. The bulk of the industry’s asset value is intangible (brand) or held in property and equipment, and it is very driven by short term cashflow. If these ESG issues spill over to impact a company’s brand, the liquidity, and asset value impacts can be severe and sudden.
Legal/litigation risk: Litigation risk is prominent and gaining momentum in relation to sustainability and ESG matters, particularly with respect to climate change actions. As cited in a recent Chapman Tripp report*, legal opinions in New Zealand and offshore all say the same thing: directors’ duties of due care require them to consider climate-related financial risk when making decisions. In November a 25-year old man successfully sued one of Australia’s biggest super funds over its handling of climate change, forcing it to commit to net zero emissions by 2050 and Ngāi Tahu took legal action against the Crown to assert its rights over freshwater in the South Island, frustrated by authorities’ ongoing failure to protect the health and quality of the wai (water).
The evidence is mounting that a long-term, holistic view of risk in lending and investment decisions delivers better outcomes. The NZ Super Fund’s recent climate change report stated their carbon exclusion policy added approximately NZ$800 million to the Fund and about 0.60% per annum to performance since it was adopted in 2016. And, in January, BlackRock, the world’s largest investment management firm, overseeing about US$7 trillion, announced it would exit some investments related to coal production and make sustainability a central part of its portfolio. “I believe we are on the edge of a fundamental reshaping of finance,” BlackRock chief executive Larry Fink wrote.
It’s not all about risk
A focus on directing capital to sustainable outcomes also provides significant growth opportunities for the financial sector. A speech from Andrew Hauser at the Bank of England earlier this year cited the global investment required to limit global warming to 1.5°C would be at least US$3.5 trillion per annum, for the foreseeable future. That’s a doubling in capital spending in the power sector alone.
Closer to home, electrification of transport is the most obvious and lowest-hanging fruit when it comes to decarbonisation in New Zealand. Converting even half of the 4 million light vehicle fleet to electric vehicles (EVs) at a cost of say $40,000 per car equates to an $80 billion investment. That may be conservative – according to the 1Point5 Project, we need to almost completely decarbonise transport by 2030.
As with many ESG-positive initiatives, there are many other benefits, including fewer deaths from air pollution, less reliance on imported fuels, and improving our security of supply and trade balance in the process. Indeed, the UK’s experience is that decarbonisation has led to a 10% increase in GDP per capita.
At its simplest, and as evidenced in a recent Deloitte report**, a focus on material sustainability issues is not only the right thing to do, it’s also good business.
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