A Risky Environment for Investment

Abstract

Floods in Europe. Heat waves in the United States. Snowfall in the deserts of the United Arab Emirates. These are among the unusual weather conditions witnessed in different parts of the world in the past five years, conditions that demonstrate how climate change is beginning to impact people. While governments negotiate targets for cutting down emissions of greenhouse gases—seen by bodies such as the Intergovernmental Panel on Climate Change as the most viable mitigation measure to slow down the processes causing global warming—the fallout from rapid climate change has already set alarm bells ringing in the financial sector. Institutional investors are realizing that taking environmental, social, and corporate governance, or ESG, issues onboard is in the long-term interest of the investments they hold. Not doing so could pose a financial risk to their investments. Yet, in the absence of any pressure from market regulators to disclose information on environmental issues, and given the focus of markets on short-term profit, companies are not always forthcoming with full disclosures on environmental risks. According to a May 2006 report titled Climate Risk and Energy in the Auto Sector: Guidance for Investors and Analysts on Key Off-Balance Sheet Drivers, by the Ceres network for socially responsible investment (SRI), investors and analysts are finding it difficult to assess automotive companies due to lack of disclosure from companies and uncertainty about the future course of U.S. energy and climate change policies. At the same time, market research firms—which give investors “buy” and “sell” advice—need to be educated about climate change and other nonfinancial risks. In the February 2004 study Values for Money: Reviewing the Quality of SRI Research, the European action groups SustainAbility and Swedish Foundation for Strategic Environmental Research showed that only 3 of 35 stock market research firms specializing in SRI actually analyzed the link between ESG issues and material impacts on investment value drivers. Most used generic research methodologies and gathered data primarily from the companies themselves with little, if any, verification. Today a number of initiatives seek to weave ESG factors into virtually every segment of the market. Most recently, the UN launched the Principles for Responsible Investment (PRI), and a pact for financial institutions known as the Equator Principles was just revised to broaden its scope and thereby extend environmental protection. The blending of sustainability and profitability can, however, seem at times an uneasy marriage, at others a battle royale.