Risks & opportunities
HOW E&S ISSUES IMPACT INVESTMENT PORTFOLIOS
Environmental and social (E&S) issues - from climate change to labour rights - can pose material risks to businesses, financiers, governments and societies. Physical risks, like flooding or severe storms, can damage assets and reduce their value. Market risks, like failing to respond to changing consumer preferences for sustainable sourcing, can negatively impact a company’s share price, as they fall behind competitors who are successfully transitioning their business models. Reputational risks, like human rights abuses and corruption, can disrupt supply chains and reduce consumer demand for products enmeshed in scandal.
Proactively identifying and addressing issues like these can not only help companies to avoid risks, but also uncover opportunities to innovate and lead the transition to the sustainable economy of the future. Asset managers are uniquely positioned to guide this transition by evaluating their portfolio companies’ exposure to E&S risks, engaging with them to develop more sustainable and resilient business models, and allocating capital to support sustainable development and drive positive impact on the ground.
Recent regulatory and industry developments reinforce the need for investors to address E&S issues in their portfolios. RESPOND aims to build on this momentum by supporting asset managers to benchmark their ESG integration progress, identify areas for improvement, and develop robust and science-based ESG capabilities.
Risks and Opportunities for Investors: 5 Key E&S Issues
At a glanceAs of 2020, human activities have already led to 1.2°C warming since the pre-industrial level, with middle-income countries and the Asia-Pacific region now driving emissions faster than the rest of the world. As a consequence, we are already seeing more frequent and extreme weather events, from forest fires in the Americas and bushfires in Australia to heatwaves in Europe and severe flooding across Asia. Asia is disproportionately exposed to climate change and its impacts. The ADB estimates that 11% of the region’s GDP could be wiped out by the end of the century if climate change is left unchecked. Myanmar, the Philippines, Pakistan, Viet Nam, Bangladesh, Thailand and Nepal are among the top 10 countries most affected by climate change from 1999 to 2018. Time is running out and in order to keep warming below the 1.5°C target by the end of this century, we must cut emissions nearly in half (by 45%) by 2030, and reach net-zero emissions by 2050.
Risks to investors
- Physical asset damage, weaker growth and lower returns: Researchers have calculated the average potential Value at Risk (VaR) to the world’s current stock of manageable assets due to climate change to be US$4.2T by 2100. This is more than the current GDP of Japan. Risks could be direct (e.g. damage from severe weather) or indirect (e.g. weaker growth or lower asset returns). Similarly, Indonesia’s National Development Planning Agency estimated an economic loss due to the Greater Jakarta floods of up to US$355M. The region is also exposed to chronic physical risks such as sea level rise. In Singapore, 30% of the land is less than 5 metres above sea level and the government has announced a US$74B fund dedicated to adapt the country’s infrastructure to the rising water levels over the next 100 years.
- Stranded assets: Carbon-intensive assets may become “stranded” as regulations tighten and consumer demand shifts towards sustainable alternatives. Current projections of total electricity generation by coal plants are set to be five times higher than IPCC pathways compatible with the Paris Agreement by 2030, and 28 times higher by 2040, underlining the large risk of stranded assets the coal sector is facing, especially in Asia.
- Transition risks: In addition to the risks linked to stranded assets, companies and investors are facing other key transition risks such as policy and legal risks, technology risks, market risks and reputational risks.
Opportunities and action
- Opportunities: The TCFD underlines that when responding to climate change, organizations also create opportunities through resource efficiency and linked cost savings, the usage of low-emission energy sources, the development of new products and services, the access to new markets or the increased resilience within their own operations and supply chains. CDP estimates that the potential value of sustainable, low-carbon business opportunities - US$2.1T - is almost seven times the cost of achieving them - US$311B.
- In light of the economic recovery from the COVID-19 pandemic, over 150 companies with a collective market capitalization of US$2.4T have jointly called for world leaders ‘to prioritize a faster and fairer transition from a grey to a green economy by aligning policies and recovery plans with the latest climate science’.
- In December 2020, 1,106 companies with a collective market capitalization of over US$15.4T are actively aligning their business models with the Paris Agreement by setting science-based targets for carbon emissions reductions. Such targets provide clear pathways for companies and financial institutions to future-proof their growth by specifying how much and how quickly they need to reduce their greenhouse gas emissions.
- Collaborative initiatives like the Global Investor Coalition and the Net Zero Asset Owner Alliance provide platforms for dialogue between and among investors and/or governments to accelerate low-carbon investment practices, corporate actions on climate risk and opportunities, and policies that support the goals of the Paris Agreement.
Deforestation and biodiversity loss
At a glanceThe global Living Planet Index continues to decline and shows an average 68% decrease in population of mammals, birds, fish, amphibians and reptiles sizes between 1970 and 2016. Concurrently, for the first time, environmental concerns dominate the long-term risks classification by likelihood of the 15th edition of the WEF’s Global Risks Report. The 2020 report ranks biodiversity loss as one of the top five risks in terms of both likelihood and impact. The WEF also estimates that US$44T of economic value generation, more than half of the world’s GDP, is moderately or highly dependent on nature and the services it provides. Forests for instance provide key services like water filtration, oxygen generation, and soil production, as well as the provision of habitats and raw materials. Yet it is estimated that 4.3M hectares of humid tropical forest are lost each year. Southeast Asia is particularly at risk and lost 80M hectares of forest, an area twice the size of Malaysia, between 2005 and 2015. The impacts of these deforestation activities have implications beyond the agriculture sector with the World Bank estimating, for example, that deforestation-linked fires in Indonesia cost the country’s economy US$16B through disruption of economic activities and reduced GDP growth. What’s more, deforestation associated with the expansion of agricultural land and the intensification of livestock production is amongst the key anthropogenic changes that drive the emergence of zoonotic diseases such as COVID-19.
Risks to investors
- Physical risks: Deforestation and land degradation have reduced the productivity of 23% of the global land surface. Pollinator populations - birds, insects, etc. - have been particularly affected, and their loss threatens up to US$577B in annual global crop value. In addition, deforestation weakens natural storm protection systems, putting 100-300M people at increased risk from floods and hurricanes. Additionally, deforestation, responsible for 11% of global GHG emissions, accelerates and exacerbates climate change impacts.
- Market risk: For companies in sectors at high risk of causing deforestation, such as tropical agriculture, these links can impact their access to both buyers and financial markets. For example, in 2016, Indonesian palm oil producer IOI had its RSPO membership suspended for six months after it was revealed that the company was sourcing palm oil from cleared forest and peatland; as a result, 27 of IOI’s largest corporate buyers suspended their contracts and the company’s market capitalization dropped by 17%. Additionally, Nestlé announced that it stopped sourcing Brazilian soy from Cargill in May 2019 after Cargill failed to guarantee traceability.
- Reputational risk: Increased stakeholder concern over biodiversity loss is a key driver of reputational risk. L’Oréal, aware of the value of its brand, estimates the financial impact of being potentially associated with deforestation activities to over US$180M.
- Regulatory risks: In recent years, some governments have begun taking action to protect their forest resources from illegal deforestation through regulations and fines (e.g. Colombia, Côte d’Ivoire, Ghana, and others). Major importers, such as the United States and the European Union, have also enforced legislation to prevent the import of illegally deforested products.
Opportunities and action
- Opportunities: The Tropical Forest Alliance 2020 estimates that there may be an investment opportunity worth up to US$200B/year in transforming the supply chains of four major commodities - cattle, soy, palm oil, and pulp and paper - to deforestation-free models. According to the WEF, the sustainable management of forests could translate to creating US$230B in business opportunities and 16M jobs by 2030.
- During the past decade, a number of initiatives to reduce and ultimately halt deforestation have emerged, with supporters and signatories spanning governments, companies, community groups and NGOs. These initiatives include the Bonn Challenge, the New York Declaration on Forests, the Aichi Biodiversity Targets, the Sustainable Development Goals, the Accountability Framework Initiative, and the Business for Nature coalition, among others - and the number of supporters are in the hundreds. While it is unlikely that we will achieve global deforestation reduction targets set for 2020, progress is being made and lessons related to transparently measuring, monitoring and enhancing this progress have and will continue to be learned.
- Investors are also taking responsibility. In light of the Amazonian forest fires in 2019, 230 investors with US$16.2T in AUM have signed an open letter to denounce commodity-driven deforestation and call for more transparency on deforestation within supply chains and operations. Similarly, the PRI Investor Working Group on Sustainable Palm Oil, comprising more than 50 PRI signatories, continues to raise awareness on the ESG issues within the palm oil value chain and to engage with companies on these issues. In April 2019, the working group led the publication of the Investor Expectations on Sustainable Palm Oil which is endorsed by 62 investment organizations representing US$7.9T in AUM.
- In addition to deforestation, financial institutions are also taking broader nature-related risks into account. July 2020 saw the creation of a Task Force on Nature-related Financial Disclosures (TNFD), which aims to redirect financial flows towards nature-positive business activities and will work towards creating a reporting framework to enhance nature- and biodiversity-related disclosures. In December 2020, 37 financial institutions with €4.8T in AUM signed the Finance for Biodiversity Pledge, committing to conserve biodiversity through their financial activities and calling upon world leaders to reverse nature loss by 2030.
At a glanceGlobal water demand is growing on average by 1% annually, leading to a forecasted increase of water needs by 20-30% by 2050. Fresh water is an essential input into nearly all social and economic activities, from agriculture to energy production to manufacturing. Yet, these dependencies now demand increasingly close attention as the world’s water systems face growing threats from unsustainable economic activities. This is further exacerbated by the impacts of intensifying climate change, which may expose up to ⅔ of the global population to intermittent water shortages by 2025. Already today, 44 countries or ⅓ of the world’s population face high levels of water stress and 4.2B people still lack safely managed sanitation. Freshwater pollution is equally concerning, and the World Bank estimates that in countries experiencing severe water pollution, economic growth may be reduced by more than ⅓.
Risks to investors
- Supply chain risks: A wide range of sectors are highly water-dependent, and thus are exposed to water-related risks across their supply chains. The agriculture sector is a good example: with 70% of the world’s water used to grow crops and animal feed, water scarcity may significantly impact agricultural production and thus the prices for raw materials. CDP Water Security estimates that in 2018 alone, companies took a financial hit of US$38.5B in reported losses due to water risk.
- Operational risks: In addition to agriculture, a range of other sectors rely on water as a key input. For instance, thermal power production depends on water for cooling. Drought can therefore significantly reduce energy production - and in extreme cases may even force power plants to shut down. In 2016, water shortages in India forced shutdowns that translated to losses of US$614M in revenue, or 2.3% of thermal power revenues that year.
- Regulatory risks: Companies can also face water-related regulatory risks. In particular, they can be affected by the violations of existing water regulations within their own operations or in their supply chain, or stricter upcoming laws which can increase costs.
- Reputational risks: Companies can come into conflict with local communities over competing demands for water or pollution of local water bodies. This can result in damaging campaigns, negative publicity and even boycotts, all of which can harm brand value and reduce corporate revenue. For example, in 2015, Coca-Cola ended up scrapping a US$81M bottling plant following community pressure related to competition for groundwater.
Opportunities and action
- Opportunities: Growth in global demand for freshwater and changing patterns of water distribution are not just a source of risk; they also provide opportunities for investors to finance companies and technologies dedicated to improving the sustainable management of water resources. For example, by 2050, US$22.6T will be needed to finance water infrastructure worldwide - on par with the amount of investment required for the energy sector. This will include necessary investments in nature-based solutions, water treatment facilities, drought and flood mitigation solutions, and water supply conservation systems.
- Action: Governments, businesses, financial institutions and communities have increasingly begun taking steps to address water sustainability issues.
- For example, in an effort to achieve SDG 6 - the availability and sustainable management of water and sanitation for all - in 2018, 172 countries reported to the UN on their baseline status for implementing integrated water resources management (IWRM) - water resources planning that simultaneously considers the economic, social and environmental dimensions of sustainable development. Of these, 80% of countries have laid the groundwork for IWRM, but most must rapidly accelerate implementation in order to achieve SDG 6 by 2030.
- Nearly 150 of the world’s largest companies are now using WWF’s Water Risk Filter to assess and take action to address their exposure to water risks. Over 170 companies have also endorsed the CEO Water Mandate - a leading global effort to mobilize business leaders to address water challenges through stewardship.
- In May 2019, the Dutch government announced that it had awarded a €160M mandate to a consortium of financiers and NGOs - Dutch Development Bank FMO, SNV Netherlands Development Organisation, Climate Fund Managers, and WWF. The Dutch Fund for Climate and Development (DFCD) will target investments in enhancing ecosystem health (especially rivers and water basins, tropical rainforests, marshland and mangroves) and the wellbeing of vulnerable communities. This unique financial product seeks to demonstrate that deploying public and private capital to solve critical environmental and social issues can generate on-the-ground impact alongside financial returns.
Marine sustainability & the blue economy
At a glance
Our oceans play a critical role in regulating the Earth’s climate; they produce 50% of the oxygen we breathe, absorb 30% of global CO2 emissions, and fuel the water cycle responsible for rainstorms and evaporation. In addition, they provide immense value in the form of tourism, fishing and transportation. Yet pollution and overfishing, alongside other unsustainable actions, have reduced the oceans' ability to provide these vital services. In 2018, total global fisheries production reached the highest level ever recorded at 96.4M tonnes, with nearly two thirds of the catches coming from unsustainable stocks.
In 2020, the WEF’s Nature Risk Rising report outlined that at least 55% of ocean area is covered by industrial fishing, 33% of fish stocks are overfished and 50% of the world’s coral reef system has been destroyed. Additionally, global warming has likely caused marine heatwaves to double in frequency and grow in intensity, depriving marine life of oxygen and nutrients. This combination of events poses a serious threat to marine ecosystems and the communities and economies that depend on them.
Risks to investors
- Lower revenues: Each year, unsustainable fishing practices deprive the seafood industry of upwards of US$83B in potential revenues, a figure representing value which could have been accrued had fish stocks recovered to sustainable levels. For many countries in the Asia Pacific region - from Japan to Thailand to the Philippines - fisheries serve as a cornerstone of national economies. The Coral Triangle, home to 37% of the world’s coral reef fish species, supports the livelihood of more than 120M people. The FAO estimates that fishing provides more than 3.3B people with at least 20% of their animal protein intake, and that the fishing sector employs 59.5M people directly.
- Physical damage and reduced asset value: In addition to fisheries, both the coastal real estate and tourism industries face serious market risks if coral reefs and mangroves continue to decline. A 2020 study estimated that mangroves provide flood protection benefits exceeding US$65B per year. If mangroves were lost, over 15M people’s homes would be flooded annually across the world. Similarly, the destruction of coral reefs puts 300M people living within coastal 100-year flood zones at risk. What’s more, coral reefs provide US$36B in annual economic value through tourism. Yet if global warming increases to 2°C, the IPCC estimates that 99% of all coral reefs will be lost.
- Regulatory risks: Failure to adhere to regulations may cause companies to lose access to key markets. For example, the two biggest seafood importers, the EU and the US, have imposed regulations to curtail illegal fishing. In the EU, seafood imports cannot be accepted without a Catch Certificate. These can only be issued by a regulatory authority after assessing disclosures of the entire process of the catch.
Opportunities and action
- Opportunities: The ocean – and the economic sectors it enables such as shipping, tourism, energy, transportation and food production – is estimated to be worth US$24T. The WEF also calculates that healthy and productive ocean solutions could generate USD$170B and 14M jobs by 2030. But this value will only continue to be realized if the international finance community identifies and supports opportunities to restore and protect the world’s marine resources.
- International efforts to safeguard critical ocean habitats have resulted in a measurable increase in marine protected areas - global marine key biodiversity areas covered by protected areas have increased from 30.5% in 2000 to 46% in 2019. Still, more areas must be protected to effectively combat issues related to climate change, overfishing, ocean acidification and pollution, as billions of people depend on our oceans to support their livelihoods.
- In an effort to combat illegal, unreported and unregulated (IUU) fishing, 97 countries have signed up to the Agreement on Port State Measures to Prevent, Deter and Eliminate IUU Fishing - the first international binding agreement on this issue. In addition, technologies such as blockchain are being trialled to track products from production to distribution in real time.
- In 2018, WWF, in collaboration with the Prince of Wales’ International Sustainability Unit, the European Commission, and the European Investment bank, launched the Sustainable Blue Economy Finance Principles. The voluntary principles serve as a framework for investment and development policy decisions, and a number of financial institutions have already signed on as signatories.
- In 2019, ADB launched a US$5B Oceans Financing Initiative, designed in collaboration with WWF. The effort aims to leverage public sector funds to reduce technical and financial risks of projects that support sustainable marine business efforts.
- In 2020, the Global Fund for Coral Reefs was launched, seeking to raise and invest USD$500M in coral reef conservation over the next 10 years. The fund is a blended finance instrument that will also support businesses and finance mechanisms that improve the health and sustainability of coral reefs and associated ecosystems while empowering local communities and enterprises.
Human, labour & community rights
At a glanceUnfortunately, human and labour rights abuses still plague many global businesses and supply chains. The magnitude of these violations, often hidden by the complexity of multinational supply chains, is huge, with 25M people being exploited through forced labour and thousands of communities impacted by issues like pollution and resource depletion due to corporate misbehavior. Children are a particularly vulnerable group with a total of 152M of them in child labor, accounting for almost one in ten of all children globally. According to the ILO, the exploitation of vulnerable individuals generates an estimated US$150B/yr in illegal profits globally for the private sector in industries such as construction, manufacturing, mining, utilities, and agriculture, forestry and fishing. Gender imbalance is also a global and persisting issue. According to the WEF’s Global Gender Report 2020, the overall global gender gap will close in 99.5 years. Bridging the economic participation and opportunity gap will take even longer: 257 years. Today, women remain globally underrepresented in the workforce, leading to lost opportunities for businesses and growth.
Risks to investors
- Legal risks: In many cases, instances of human and labour rights abuses are treated by authorities as criminal matters, leaving companies exposed to potentially significant financial penalties. These penalties can, in turn, affect investors, by reducing a company’s profits and in many cases exposing the company to compounding reputational risks. For example, in 2015, Signal International lost a lawsuit filed by Indian citizens who became victims of forced labour as a part of clean up efforts following Hurricane Katrina. Signal subsequently filed for bankruptcy, leaving investors, including two major public pension funds, on the hook for US$70M.
- Reputational risks: Given the fast pace and international nature of today’s news cycles, companies that fail to sufficiently respond to allegations of human or labour rights abuses can quickly become exposed to reputational risks, often damaging brand value and negatively impacting revenues. For example, companies in the extractives industry must pay close attention to the impacts of their operations on the communities in which they work - e.g. impacts of operations on water quality, important cultural heritage sites, local livelihoods, etc. Failure to do so can lead to community protests, negative press, and ultimately project delays, cancelations, fines, lawsuits, and boycotts.
- International standards such as the ILO Conventions, MNE Declaration, UNGPs and OECD Guidelines enable governments to more effectively address human rights abuses in corporate operations and supply chains. Signing up to these standards has, in many industries, become something of a license to do business, and can be an easy way for investors to make decisions about whether or not to invest in a particular company based on their appetite for potential exposure to human and labour risks.
- The legal landscape is quickly changing to reflect the demand for businesses to address sustainability issues across their supply chains. For example, both the California Transparency in Supply Chain Act and the Australian and UK’s Modern Slavery Acts are leading pieces of legislation that require high revenue companies to disclose actions taken to address modern slavery in their operations and supply chains. Such legislation can help improve transparency around human rights violations, and can support stakeholder efforts to engage with companies on these issues.
- The finance sector also has a key role to play in advancing gender diversity. They can work on developing their own talent pipeline to take full advantage of the opportunity that a more diverse team represents and raise their gender diversity requirements towards the companies they invest in.