Risks & opportunities
HOW E&S ISSUES IMPACT INVESTMENT PORTFOLIOS
Present day investors are faced with the reality that the earth’s resources are not an infinite asset, the unchecked exploitation of which comes with potentially devastating economic and existential costs. Over the recent years, the rising frequency of devastating climate events, epidemics, and ensuing disruptions to food and water supplies has brought forward the payback period. Once perceived as distant future problems, issues like stranded assets, transition costs, volatile commodity prices and potential regulatory sanctions have become current day investment risk considerations. Expectations on and commitments from the investment community are growing to account for ESG factors in investment decisions and the resultant environmental impact from such investment activities.
Incorporating ESG factors into the investment process entails an asset manager evaluating 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. Monitoring and reporting of the impacts on the environment from investment portfolios is also key to responsible investing
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. The report from Working Group 1 of the IPCC’s Sixth Assessment Group presents “unequivocal” evidence of human influence in warming the atmosphere, oceans and land. It warns of changes “unprecedented over many centuries” and that are already “irreversible for centuries to millennia”. Currently, 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, Bangladesh, Thailand and Nepal are among the top 10 countries most affected by climate change from 2000 to 2019. 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. The UN Climate Change NDC Synthesis Report, released in September 2021, concludes that the current commitments will amount to a reduction of only 12% of emissions by 2030 compared to 2010 levels, indicating a clear need for further and wider commitments from nations globally.
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. The electricity sector emitted 36% of all energy-related emissions in 2020, which is more than any other sector. Coal remains the largest single source of electricity worldwide, and by far the largest source of electricity sector emissions: it contributes just over one-third of electricity supply but is responsible for nearly three-quarters of electricity sector CO2 emissions. 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. The issue of dislocation of employment is prevalent, especially when skill sets are not automatically transferable from carbon-intensive sources to renewable ones.
Opportunities and action
- Opportunities: In 2020, investors globally have committed a record $501.3 billion to decarbonization in 2020. In the same year, companies, governments and households invested $303.5 billion in new renewable energy capacity alone.
- 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’.
- As of October 2021, over 2,007 companies are actively aligning their business models with the Paris Agreement, with 983 committing to 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.
- The Glasgow Financial Alliance for Net Zero (GFANZ) was launched in April 2021. It brings together existing and new net zero initiatives onto a centralised platform for leading financial institutions to accelerate the transition to a net-zero global economy. GFANZ currently include over 450 financial firms across 45 countries responsible for assets of over $130 trillion.
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. According to the 16th edition of the WEF’s Global Risks Report, biodiversity loss continues to be top tier threats to humanity in the coming decade.The 2021 report ranks nature-loss as one of the top five risks in terms of both likelihood and impact. The World Bank estimates that the collapse of select ecosystem services provided by nature could result in a decline in global GDP of $2.7 trillion annually by 2030. Forests are home to more than half of the world’s land-based species, support the livelihoods of over 1.6 billion people, absorb 30% of annual global anthropogenic CO2 emissions, and over 75% of the world’s accessible freshwater comes from forested watersheds. Healthy forests are therefore critical to human and planetary health. 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 the world loses almost 6 million hectares of forest each year to deforestation, an area equal to half the size of Portugal. 95% of this occurs in the tropics. The COVID-19 pandemic disrupted lives and livelihoods around the world, and the global economy contracted by around 3.5% in 2020. Yet despite the economic downturn, the loss of primary tropical forests ticked up by 12% compared to 2019, continuing an upward trend. In total,the financial impact risks from deforestation was estimated at US$53.1billion while the cost of responding to all risks was just over US$6.6 billion.
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: With greater regulatory push and heightened investor awareness, upstream suppliers in agriculture, forestry and animal produce that engage in unsustainable deforestation practices may face the risk of asset stranding as some landholdings may be blocked from development due to policy and market shifts. Policy shifts towards greater supply chain transparency may in turn impact upstream and downstream companies in the form of supply chain disruptions, reputational damage, litigation risks, and potentially an increase in cost of capital. 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. In the UK, the government has announced plans to introduce a new legislation to cut down illegal deforestation by targeting the UK’s supply chains.
Opportunities and action
- Close cooperation between the public and private sectors tends to lead to deeper stakeholder engagement, stronger technical support and equitable sharing of risk. As such, greater potential investment returns may be actualised for the private sector investor.
- 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.
- 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 the COP 15 hosted by China in October 2021, the Kunming Declaration on Biodiversity Conservation was signed by over 100 countries. In addition, China initiated the Kunming Biodiversity Fund with initial funding of 1.5 billion Yuan (~$230 million) to support developing countries’ efforts on biodiversity protection.
- In what is being billed as one of the first significant steps of the COP26 summit in Glasgow, more than 100 global leaders committed on Tuesday to halt deforestation by 2030, while 30 financial institutions who collectively manage nearly $9tn in assets, including Aviva and Schroders, commit to eliminating agricultural commodity-driven deforestation from their investment and lending portfolios by 2025.
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. The World Bank predicts a growth rate decline of 6% of GDP by 2050 as competition for water intensifies.
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
- 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. More than 90 per cent of the heat from global warming is stored in the global ocean. This suggests that ocean sustainability and climate change are very much linked.
- Exposure to value-at-risk: It is estimated that 66% of global listed companies could be exposed to value at risk of up to US$8.5 trillion over the next 15 years if no action is taken to secure a sustainable ocean economy . For almost all sectors the absolute risk to assets and revenues is reduced under a more sustainable scenario, amounting to US$5.1 trillion in savings. This value at risk accounts for about 3% of the total value of the blue economy.
- 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. On average, only 1.2% of national research budgets are allocated for ocean science. This suggests that much more weightage can be placed on marine sustainability.
- 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 160 million boys and girls worldwide, almost one in ten, are forced to work. The majority, 112 million, or around 70 per cent, work in crop production, livestock, forestry, fisheries and aquaculture. 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.