Menu Close

Climate Action Is Too Big for ESG Mandates

As a macro risk factor, climate change should be disentangled from other social and governance mandates.

 

Since the 1990s, it has become increasingly normal to take environmental (E), social (S), and governance (G) factors into account when considering investing decisions. Yet the roots of what we now call “ESG investing” go as far back as the 1800s, when religious beliefs were an investing criterion for Methodists, Muslims, and Quakers. More recently, social issues like the anti-war sentiment in the Vietnam War-era of the 1970s and anti-apartheid sentiment in the 1980s have been part of the conversation about business, just as new demands for good governance grew after the governance scandals in the early 2000s (e.g. Enron). In short, each new generation of socially-responsible business mandates grows out of the defining issues of that era.

 

Climate change is our era’s defining issue, and, especially given the sluggish climate action by business and society so far, we need to rethink how we recognize the problem and propose solutions.

 

Although environmental concerns first entered public sentiment in the 1960s, public consciousness of climate change has moved dramatically in the last decade, perhaps because once-hypothetical consequences are now a reality. The landmark 2015 Paris Climate Agreement, for example—signed by nearly 200 countries to combat climate change—was guided by a scientific consensus that the effects of climate change are an alarming, existential risk factor for the world today. The acceptance and call to action on the growing risk of climate change in the scientific community has been focused and urgent. However, the response to climate change in financial markets has lacked the same urgency and focus, with climate change often subsumed in broader discussions of ESG as an ethical philosophy and fiduciary mandate. For example, a survey of institutional investors conducted by State Street Global Advisors shows that, despite the rapidly growing interest in ESG, the scale of adoption of ESG considerations among institutional investors remains low and mired in confusion, with many of the ESG factors lacking definition and standards of measurement. Three-quarters of respondents said that there is a lack of clarity around ESG terminology in their organizations.

 

Moreover, while ESG issues differ dramatically in the severity of their societal and business consequences, there is no standard framework for prioritizing among those issues when defining ethical and fiduciary duties. Environmental, social, and governance concerns were originally grouped together because social good connects all ESG issues, and it was conventional wisdom to view all ESG concerns as “extraneous” to corporate profit-seeking. However, it is time to unpack those assumptions and to delineate how environmental concerns, at a fundamental and practical level, are defining fiduciary duties. Given the effects of climate change already in evidence, society and business can ill-afford confusion around defining and prioritizing climate risk. While asset managers’ mandates typically combine climate risk with important but less existential social and governance issues, such as board quality and executive compensation, the nature of climate risk makes this combination problematic. Climate risk, in scientific as well as economic terms, is simply a different type of issue than most other ESG issues.

 

Climate Change Is Different

For one thing, climate risk diverges from most social and governance concerns, because it impacts physical assets and often results in direct costs. According to Barron’s, 60 percent of companies in the S&P 500 Index “hold assets that are at high risk of at least one type of climate-change physical risk.” For example, several natural disasters linked to the effects of climate change have cost AT&T $847 million since 2016 due to damages to their telecommunications assets and services, leading the company to unveil a 30-year climate change model. The ongoing wildfires in California, exacerbated by climate change, are racking up economic costs including over $20 billion potentially in 2020 just as direct cost (e.g. for damage repairs). This is apart from the irrecoverable cost of human life and indirect costs (e.g. health care bills, falling property values). Though “sustainability” is often used interchangeably with ESG, environmental concerns are a particular focal point when sustainability is defined as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.” Sustainability is at the very core of climate risk. But combining ESG mandates when referring to sustainable development goals in business could inadvertently dilute the awareness, understanding, and action pertaining to climate risk in particular.

 

Additionally, climate change is a macro risk factor, unlike other ESG concerns such as board quality and employee relations, whose effects manifest through multiple, interconnected channels like economic risk and public health risk. A large group of 74 medical and public health groups, including the American Medical Association, has called climate change “the greatest public health challenge of the 21st century” and the COVID-19 pandemic—estimated to leave a $8.5 trillion dent in the global economy in two years—has taught us that public health crises should not be underestimated. While not as sudden and dramatic as COVID-19, one study projects economic losses of nearly $70 trillion by 2100 from global warming, absent mitigation. In short, climate risk is impossible to segment across markets and cannot be diversified away: all businesses have exposure to climate risk, whether directly or via their customers, suppliers, and other stakeholders. Therefore, exposure to climate risk has fundamentally different implications for asset valuation and portfolio diversification than relatively micro risk factors. To the extent that environmental, social, and governance issues differ in being macro or micro risks, they should be treated differently in defining fiduciary duties.

 

There is also a pragmatic argument for disentangling environmental concerns from combined ESG mandates: while some of the most consequential social and governance issues are implicated in conflicts of interest between managers and other stakeholders, climate risk is less encumbered. Researchers from the Economic Policy Institute report that executive pay grew by more than 1,000 percent from 1978 to 2018—nearly 100 times the 11.9 percent growth for average workers—and serious conflicts of interest are embedded in addressing the pay gap within businesses (not to speak of income inequality more broadly). But for most businesses, addressing climate risk appears less plagued by conflicts of interest of this sort. Environmental responsibility and risk management could grow faster relieved of the burden of the conflicts of interests attached to other ESG concerns.

 

Moving Forward

The market has already begun to treat environmental concerns as a standalone, launching novel financial instruments focused on environmental responsibility, such as green and blue bonds. Treating environmental concerns more independently would help asset managers distinguish between companies like Amazon or Netflix and fossil fuel companies like Exxon Mobil. Currently, due to their low social and governance scores, combined ESG mandates put Amazon and Netflix in the same excluded category as Exxon for most ESG exchange-traded funds (ETFs).

 

This movement should continue. Of course, environmental concerns are correlated with other serious socio-economic concerns, such as poverty; areas with poorer populations often have higher exposure to extreme events exacerbated by climate change (e.g. floods). However, given the scale and speed of response needed to mitigate climate risk, the tent of environmentally responsible stakeholders needs to expand rapidly. Market-based solutions to climate risk should include the widest spectrum of stakeholders, ranging from ethically motivated stakeholders who view business through a social good lens, to financially-motivated stakeholders who understand that climate risk can no longer be ignored.

 

Climate change looms unavoidably over business and society in this era. Yet, individual and collective action to mitigate climate change has failed to meet meaningful targets set by scientific guidance and aspirational policy goals. It should be much harder for businesses of all kinds to explain why they should not be environmentally responsible, as opposed to why they should. One way to do that is for E to distance itself from S&G in ESG mandates, to focus the narrative and action on climate change. Science, business, and society must be on the same team to combat unmitigated climate risk. All hands must be on deck. The clock is ticking.

 

View: Source

View: More news

Related Posts

Leave a Reply

Your email address will not be published. Required fields are marked *