The systems underpinning society and the economy are deeply interconnected, and sustainability approaches are going to be central to addressing the interconnected challenges of the 21st century.
Thinking about economic activity in terms of systems – like ecological analysis, exploring how different elements of systems impact on each other – is going to be critical if ESG is going to prove an effective tool for positive change.
Remember that today ESG is used to identify financially material risks and is a tool for optimising the current system. That’s why the recent comments from Stuart Kirk, head of Responsible Investment at HSBC (LON:HSBA), about the ‘irrelevancy’ of climate concerns have set the cat amongst the pigeons.
Is climate risk an irrelevancy to the financial system?
At an FT conference earlier this year, Kirk pointed out that most climate risk is irrelevant to investments, specifically loans. He has been quoted as saying that, given that the average length of a loan is round six years, ‘What happens to the planet in year seven is actually irrelevant to our loan book.’
His perspective is a core argument behind the desire to look at investment through a different lens – if we don’t look at long-term horizons and long-term impact, we will continue to operate on a business as usual (BAU) basis and fail to act in time to minimise longer-term risk and impacts.
This will not only be a failure in risk management, but a failure in recognising opportunity in building resilience, mitigating emissions across global industries (not just energy) and adaptation to transition.
The important thing is that Kirk is not wrong in terms of what his job asks him to do. Why should investors be concerned about the impact of climate change – perhaps the most infamous quote from the event was ‘Who cares if Miami is six metres under water in 100 years?’
After all, Amsterdam has been below sea level for years and is lovely. Nor is he alone. Blackrock, which has been leading the moral charge on investor action on climate change in the last couple of years, said it would no longer support shareholder resolutions on climate change, as the impact of the war in Ukraine made short-term investment in fossil fuels more important.
Inconsistency between financial institutional behaviour and net zero targets
Given that both HSBC and Blackrock are both members of the Climate Action 100+, the Net Zero Asset Managers Initiative and of the Glasgow Financial Alliance for Net Zero (GFANZ), their positions undermine the notion that capital is being effectively realigned towards net zero.
The focus on short-term risk management means the disconnect between financial goals and the longer-term requirements of society, the environment and the economy overall continues to grow. This is not simply a failure of imagination but a failure to understand the basic lesson that actions have consequences.
Ignoring the consequences of industrial activities, or the systems on which they rely, has resulted in massive exploitation of nature and culture by industry and business.
The failure to include externalities in economic analysis was said by Nicholas Stern in 2015 to be ‘the greatest market failure ever seen” because it ignores the value of land, water, clean air, of natural system services from pollination and fertilisation, etc. Most natural assets, for example, are grossly underpriced in the market, which results in companies using them at an unsustainable rate.
Integration of externalities could change our perception of value
Ignoring externalities requires ignoring the reality that the economy and society are embedded in nature. Johan Rockstrom’s work on planetary boundaries, at the Stockholm Institute, provides a clear introduction to such a reality, and alongside Pavan Sukdev has developed what’s known as the ‘wedding cake picture’, an image designed to show the relationship of the sustainable development goals (SDGs) to food security.
Systems thinking demands that we look at the bigger picture. Fundamentally, economics has failed to incorporate externalities, such as the impact of pollution, resource extraction and exploitation, into the valuation of a business.
It has traditionally been more concerned with prices than with values or importance, which can otherwise be considered as impacts. It is the failure to make connections at a systemic level that is stopping finance from properly aligning with net zero and SDGs.
Corporate profits ignore environmental and social cost of operations
There are many ways of looking at the issue. A recent study from Profundo reported that Europe’s five biggest oil producers – BP (LON:BP), Eni, Repsol, Shell (LON:SHEL) and TotalEnergies – took home €47 billion in 2021, mostly in profit for shareholders and management.
Overall, these five firms have recorded €850 billion in profits since 1993, while in the same period, their activities have incurred an estimated €13 trillion in environmental and health costs, of which just 5% has been repaid through corporate taxes, leaving most unpaid costs to fall on consumers.
The report also calculated that they are responsible for around 13% of global CO2 emissions over the time frame, resulting in huge costs to society in the form of pollution, carbon emissions and damage to public health. This includes an estimated €9 trillion in health costs from air pollution, and €4.2 trillion in carbon costs.
It’s not for nothing that when the concept of carbon taxation was first discussed, massive oil industry lobbying was focused on ensuring it didn’t target upstream producers like these five. So the question then becomes: why are we effectively subsidising actions that cost society as a whole?
The importance of the economics of ecosystems and biodiversity
The challenge goes beyond simple emissions. In 2021 the UK government published the Economics of Biodiversity: the Dasgupta Review, which explored the ways in which economic and financial systems needed to be reformed to allow for accounting for nature.
It argued that because we don’t value important elements of natural capital, and the ecosystem services that it supports, we don’t have a sensible understanding of the impacts of our actions.
In the UK, for example, trees provide around £275 in timber sales – but they also sequester carbon, help prevent floods, clean air of pollution, regulate temperature and more. The natural capital value of UK trees is estimated to be 12x their timber value but that’s not factored into their valuation or their market price.
The World Economic Forum has calculated that more than half of the world’s economic output, or around $44 trillion of economic value generation, is moderately or highly dependent on nature, according to estimates by the World Economic Forum.
Such high dependencies means that nature loss, as well as climate change, constitutes a significant risk to corporate and financial stability – the converging crisis of climate and the destruction of nature have been described as inextricably linked and compounding; unfortunately, not in a way that makes sense to today’s bankers within a system focused on immediate short term financial risk management.
Our political and economic systems are set up to look at short-term risk management, and we need to find new models with which to make decisions. Long‐term development is a process of building up and managing a portfolio of assets of different types of capital — financial, intellectual, manufactured, natural and even human and social capital (although there are a range of definitions of the types of capital that should be assessed).
This is driving a fundamental reassessment of how we should look at the economy, because looking at the impacts of and on these different elements allows companies and investors to optimise their decision making.
There is more than financial capital to value
We’re seeing a slow but important big shift in how we look at these different capital stores and how they can be accounted for, at a corporate level and at a portfolio level. There are two main reasons for this. On the one hand, sustainability requires that proper account should be taken of capital depreciation and, therefore, there is a need to value other capital changes.
On the corporate side, the growing importance of including sustainability impacts in reporting is akin to the creation of double ledger accounting in the 14th Century – it’s about having a clear understanding of assets and liabilities and ensuring that the company’s accounts remain balanced, and provide an accurate picture of the company’s actual financial position.
Time horizons are critical to understanding impact
At its most basic level, this is an approach that demands that we look at the consequences of our actions, over a longer time frame. While climate change, and climate risk, are at the top of today’s reporting agenda, the challenges we face encompass the health of our overall ecosystems, and we need to take multi-dimensional views of the world around us in order to understand what we truly mean by value.
In the end, ESG is only going to be really effective if it’s employed in a unified way at the systemic, portfolio and company level. That’s the direction of travel and it’s increasingly important to be ready. Failure to meet that challenge shows both a lack of imagination and is likely to have significant consequences.