Crystal Ball gazing is notoriously challenging but it is the essence of the investment industry. As we start a new year, there are a range of high impact environmental themes posing risks as well as opportunities to long-term corporate value, such as carbon risk, water stress, air pollution, disruptive technologies, sustainability targets, green bonds and biodiversity. These issues are the focus of the corporate engagement activities of Hermes EOS, and key themes for integration into Hermes Investment Management’s own portfolio management strategies.
The carbon risk to corporate value rises with every year that passes, with increasing odds of catastrophic climate change events triggering a rapid policy response, yet reducing options for a policy ‘soft-landing’. Events in 2014 only served to emphasise this further. Contrast the hardening of scientific evidence for action – ‘equivocal’ according to the Intergovernmental Panel on Climate Change with Lima’s demonstration of the difficulty of obtaining a global deal on climate change. It was perhaps not surprising that the Bank of England launched an investigation into the risk to financial stability from climate policy. Currently, the world’s economy is on a de-facto trajectory of 4°C global warming although leaders have individually pledged to achieve a 3°C pathway and collectively still aspire to keep global warming to 2°C. In reality, remaining below 2°C will be hugely challenging, as it requires a more than five-fold improvement in global rates of decarbonisation. The Paris UN climate conference in December 2015 may help reduce uncertainty by clearly defining global ambition. However, equally likely is a deal with relatively low-stated ambition but the ability to ratchet up commitments over time. For the moment, this means companies must continue to plan under conditions of uncertainty. This, in turn, will require further investment in scenario planning, identification of no regrets moves and an increased value of options. Carbon-exposed businesses must be challenged on their approach to these issues.
Water stress will continue as a theme and, at first blush, it is a little hard to see what will be different this year. However, in 2014 only 60% of Global 500 companies approached by CDP replied to its survey on water risk – as opposed to more than 80% on carbon – and yet nearly 70% of those respondents reported exposure to water-related risk that could generate a substantive change in their business, operations or revenue. This disparity will need to close with improved rates and quality of water stress reporting. There are also signs of increased interest in water risks for fixed income, with applied academic work taking place and due to report in spring 2015. Given the nature of water risks, we will continue to press for companies to conduct a local-level analysis of potential water stress, together with comprehensive reporting to CDP and in their corporate sustainability reports.
The regulation of coal-fired power announced by the US Environmental Protection Agency in May 2014 strongly promoted the benefits to controlling local air pollution, although it was primarily motivated by the need to reduce carbon emissions. It also opened the way to the November US-China bilateral pledge to reduce US emissions to 26-28% below 2005 levels by 2025. Similarly, in Europe – through its early closure of coal-fired plants that do not meet NOx/SOx emissions standards – the Industrial Emissions Directive is likely to achieve more for carbon reduction than the EU Emissions Trading Scheme. Many developing countries would also stand to benefit significantly from switching from coal and other carbon-intensive fuels to renewables or cleaner-burning natural gas through improvements to local air pollution, according to the New Climate Economy report published in autumn 2014. Given the likelihood of tightening regulatory standards in all markets, we will increase our engagements on local pollution standards and the deployment of best practice technologies, which are generally the best defence against value destruction from failure to comply with impending regulatory standards.
In 2014, US electric vehicle manufacturer Tesla Motors began construction at their Gigafactory, a huge battery manufacturing plant in Nevada which aims to single-handedly match 2013 global lithium battery production by 2020. This scale alone offers the prospect of a 30% reduction in unit costs, while a number of other announcements promised the doubling of a range of electric vehicles, potentially via the use of graphene nanotechnology. The Boundary Dam power plant in Estevan, Saskatchewan, became the world’s first commercial scale carbon capture and storage (CCS) project and the UK announced support of up to £1 billion for two projects in the UK at Drax and Peterhead. Following a 75% cost reduction over the last five years, Citibank and UBS recognised the potential for solar, combined with battery storage, to be cheaper than fossil fuel power at some point in the 2020s. Technological innovation may become a deadlier foe to the value of old economy stocks such as oil, gas and utility stocks than any global deal, and yet CCS could prove their salvation. These companies’ participation in, and response to, technology innovation will therefore be critical to avoiding the creative destruction of their shareholder value.
Many companies – including more than 15 FTSE 100 companies – will experience a year of reckoning, with sustainability targets set five to 10 years ago, once seemingly far away, requiring discussion and examination this year. Having set the expectation for targets, it is hard to row back, so this will also be a year in which a disproportionately large new batch of five to 10 year targets will be set, offering an opportunity for engagement by shareholders on the governance and rationale for levels of ambition.
2014 was heralded as the year of the green bond. On the heels of the launch of the Green Bond Principles there followed a seminal HSBC report on the emerging asset class and a well-attended conference at the Principles for Responsible Investment on fixed income and climate in the spring. And 2014 did not disappoint, with start-of-year projections of a doubling of 2013 capacity to $20 billion of issuance being exceeded by almost 100% ($37 billion). In 2015, green bond capacity is projected to reach $100 billion, with plenty of further growth potential before making a dent in the global $100 trillion market. A key question is whether 2015 is the breakthrough year for the Climate Bonds Initiative, which offers the potential to set a new global standard for green bond issuance that is aligned to genuine levels of environmental ambition. To aid market development and reduce long-term corporate borrowing costs, we will call upon corporate leaders to support a consensus for a more concrete definition of a green bond and to consider the benefits of issuing green bonds.
Behind the scenes, much work has been going on to define a metric for the impact of corporate activity on biodiversity, including efforts by the Natural Capital Coalition, formerly The Economics of Ecosystems and Biodiversity “TEEB” project, and the UK’s Natural Capital Committee. The next frontier in corporate reporting is likely to concern the direct impact on natural capital rather than the more indirect effects of carbon emissions, water consumption and other pollutants. This presents an opportunity to define and implement reporting on biodiversity impacts.
This year promises to be an impactful year for the environment and investments as ESG risks continue to become incorporated into investment decision-making. At Hermes EOS, we aim to protect and enhance our client’s investment value through integration of these themes into our mainstream fund management, as well as by making these a focal point of our global corporate engagement programme.