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 unnecessary risks, but can 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, science-based, ESG capabilities.
The below statistics highlight some of the current and future impacts of E&S issues, such as climate change, water scarcity, deforestation, ocean exploitation and human rights and labour abuses.
Risks and Opportunities for Investors: 5 Key E&S Issues
At a glance
- As of 2017, human activities have already led to ~1°C warming, with middle-income countries and the Asia-Pacific region now driving emissions faster than the rest of the world. As a consequence, we are seeing more frequent and extreme weather events, from forest fires in the Americas and bushfires in Australia, to heatwaves in Europe, to severe flooding across Asia. In order to keep warming below the 1.5 degree 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 (weaker growth or lower asset returns).
- Stranded assets: Carbon-intensive assets may become “stranded” as regulations tighten and consumer-demand shifts towards sustainable alternatives. Already in 2018, 215 of the world’s largest companies reported US$250B in potential losses linked to asset stranding from climate-related transition and physical risks.
- Supply chain risks: Climate-related physical damage (e.g. destruction of transportation infrastructure or impacts on raw material production), reputational issues (e.g. community protests or labour disputes), and regulatory changes (e.g. policies that impact production costs or trade flows) can all adversely affect supply chains and negatively affect corporate earnings and valuations.
Opportunities and action:
- Opportunities: The 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.
- To date, 87 large companies with a collective market cap of US$2.3T 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 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 glance
- On an annual basis, forests provide ecosystem services worth US$16T; the equivalent of the entire US GDP in 2012. These include services like water filtration, oxygen generation, and soil production, as well as the provision of habitats and raw materials (timber, fruits, nuts, etc.). Despite this immense value, we have lost 129M hectares of forest (an area the size of South Africa) over the past ~25 years, primarily due to the expansion of agriculture and human settlements. In recent years, forest fires exacerbated by climate change have also played an increasing role in forest loss; in the US alone, wildfires have cleared an average of 7M acres - an area the size of Hawaii - each year since 2000. As a result of these losses, biodiversity has declined dramatically - by an average of 60% since 1970 - threatening the delicate ecological balance underpinning the provision of vital ecosystem goods and services.
Risks to Investors
- Physical risks: Reduced land productivity and lost protection capacity: 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 100-300 million people at increased risk from floods and hurricanes.
- Loss of market access: 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 6 months after it came out 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 cap dropped by 17%. Yet while hundreds of companies publicly recognize the potential financial risks that deforestation poses and have made high level commitments to eliminate it from their supply chains, less than 30% have reported quantitative progress against these commitments as of 2019.
- 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.
Opportunties and Actions
- Opportunities: The Tropical Forest Alliance 2020 estimates that there may be an investment opportunity worth up to US$200B/yr by 2020 in transforming the supply chains of four major commodities - cattle, soy, palm oil, and pulp and paper - to deforestation-free models.
- Action: 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, and the Accountability Framework Initiative, among others - and supporters number 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 continue to be learned.
At a glance
- 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 activity. 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. Fresh water 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 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. For example, in 2012, drought conditions and unusually warm temperatures in the American midwest reduced agricultural yields and caused the price of crops like corn, wheat and soya to surge to record highs.
- 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 in its operations. Drought can therefore significantly reduce energy production - and in extreme cases 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.
- 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.
Opportunties and Actions
- 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: In the last few years, 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. Just over 160 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 (esp. 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; in total it is estimated that the value of the goods and services the ocean provides is approximately US$2.5T/yr. Yet pollution and overfishing, alongside other unsustainable actions, have reduced the oceans' ability to provide these vital services; 90 percent of global marine fisheries are now in decline, and as a result of global warming, marine heatwaves have doubled in frequency and grown 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 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; Yet according to the IPBES, the region’s fish stocks may be completely wiped out by 2048 if current fishing practices continue.
- 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 2018 study estimates that mangroves currently prevent annual property damage equivalent to ~US$82B/yr; And estimates suggest that continued reef decline could cause losses of up to US$5.3B/yr (US$2.2B in the Coral Triangle and US$3.1B in Mesoamerica) by 2030.
- Regulatory risks: Failure to adhere to regulations 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.
Opportunties and Actions
- 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. 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 resulted in a measurable increase in marine protected areas - 24M km2 as of 2018 - double the extent covered in 2010. 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, more than 58 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 already a number of financial institutions have 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.
Human, labour & community rights
At a glance
- Unfortunately, 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. 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.
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.