13 Jun 2022
Can ESG prevail during economic uncertainty?
As rising energy and commodity prices stoke inflation, institutional investors are under pressure to stick to their environmental and social goals.
Six months on from COP26, the climate change summit’s president, Alok Sharma, used a speech in Glasgow to issue a stark warning: “The window of time we have left to act is closing fast. We need every nation to pick up the pace.”
The United Nations (UN) conference was hailed for raising global ambitions to tackle climate change, despite its concessions to China and India to “phase down” rather than “phase out” the burning of coal. Several key agreements were reached around green finance, including the Glasgow Financial Alliance for Net Zero – which aims to mobilise $130trn from banks, institutional investors, and other sources of private capital to accelerate decarbonisation – and the creation of the International Sustainability Standards Board (ISSB) to develop global agreements for environmental, social and governance (ESG) disclosures.
Yet, in the time since the summit ended, the global energy markets have been rocked by wider economic events, raising questions over government and corporate commitment to their climate promises. As economies have emerged from their coronavirus lockdowns, requirements for goods and services from consumers and businesses have increased, leading to rising demand for energy and commodities and resulting in higher prices.
The conflict in Ukraine has also pushed up energy prices – with countries around Europe looking to increase their energy security by weaning themselves off Russian oil and gas – and interrupted wheat supplies, triggering a warning from the UN of potential shortages and even famines. Rising energy costs have filtered through to the rest of the economy, forcing producers to increase the prices of everything from fuel to food, and stoking inflation, with the UK’s consumer prices index hitting 9% in the year to April, a 40-year high, according to the Office for National Statistics.
A change in corporate mindsets
As businesses and households face economic uncertainties from rising energy prices and their knock-on effect for wider inflation, will ESG goals be sacrificed?
“Everyone becomes more insular when uncertainty rises,” explains Bradley Davidson, ESG Lead at RBS International. “For the first time, we’re faced with the idea that investment in ESG strategies may not continue to rise at the speed we need it to.
“The economy has been supported by Covid relief packages and so it’s felt like a time of economic prosperity, although that sounds counterintuitive, given the social impacts. There was a sense of confidence – we saw equities doing incredibly well, a flight to technology, and a focus on innovation – and, when businesses are confident, they have space to focus on additional things, like ESG strategies.
“When they face economic hardship – and these unique circumstances that we find ourselves in, with potentially 10% or more inflation in the UK – everything becomes a little bit more insular, and companies focus on their financials. What we’re encouraging people to do is to consider ESG as a component of their financials – it’s about rewiring the economy to include ESG within financial metrics.”
Hardwiring ESG into financials
Davidson says rewiring the economy must include placing a value on natural capital and ecosystem services. “We have until 2030 to prevent the worst impacts of climate change – the slower that transition to 2030, the worse impacts we’re going to have, so investors can’t put their ESG goals on hold,” he points out.
“Regulation will also require institutions to consider ESG factors. If investors put their ESG goals on hold then they’ll end up racing to keep up with regulations instead of being one step ahead. This is why the work that the ISSB produces will be critical in supporting governments to harmonise credible ESG regulation across borders.”
A recent report from campaign group ShareAction found only 21% of ESG resolutions received majority support in proxy voting by investors last year. Despite continuing pressure from activist shareholders, Davidson fears that percentage could fall unless ESG factors are wired into the economy.
“It’s about rewiring the economy to include ESG within financial metrics”
Bradley Davidson, ESG lead, RBS International
He thinks that changes will also need to be made to how passive and tracker funds operate, so they don’t become the owners of last resort for fossil fuel stocks. A report by the Common Wealth think tank found passive funds’ stakes in oil and gas companies were rising as active investors sold their holdings.
But many investors are maintaining their ESG goals, despite the current economic headwinds. “Our shareholders aren’t saying ‘put ESG on hold’,” reports Maria Carvalho, Head of Climate Economics and Data at NatWest Group. “Indeed, we have seen other financial institutions being publicly criticised by investors, civil society and the media if their solution is to slow down climate ambition as a response to the fossil fuel and food crisis. That tells me there’s a shift on holding financial institutions to account for their climate, environmental and social impacts.”
“Faster and harder on decarbonisation”
Carvalho agrees that investment must be accelerated. “The current cost of living crisis, energy and food price spikes are forcing a very necessary conversation across the economy, from farmers to food retailers, energy producers, governments and consumers,” she says.
“The risk is that the crisis will push people towards high-carbon options in the short term to meet their respective needs, but actually the crisis highlights the need to go faster and harder on decarbonisation. It should also make people realise that if they’d thought about security of supply and energy efficiency a long time ago, then they’d be less exposed to the current crisis.”
While households must focus on the cost-of-living crisis in the short term, Davidson says institutional investors can afford to take a longer term view. “The drive for energy independence and security will accelerate the transition to clean energy – oil and gas reserves are geographically constrained, and so energy security means looking at alternatives, like wind and solar,” he says.
“The energy crisis is a lesson for times to come. Demand for energy will increase as global temperatures rise so, to prevent issues down the line, we should continue to focus on a blend of renewables and fossil fuels in the short term, moving to net-zero energy supplies in the longer term.”
The need for a vision for the economy
In the shorter term, Carvalho wants to see greater focus on a comprehensive overhaul of the system in regard to energy and food. NatWest’s Sustainable Homes and Buildings Coalition is calling for the UK government to use regulatory pressure to stimulate investment across the supply chain to help different households in the UK to retrofit their homes to save on energy costs.
“Improving energy efficiency in homes would deliver savings faster than building new power sources,” she says. “At the moment, people are spending money on energy that’s lost and doesn’t go towards heating their homes. And we have seen such investments pay off in the past.”
The UK Committee on Climate Change’s 2017 report shows that, although climate policy costs to deploy low-carbon solutions added around £9 a month to the typical UK household energy bill in 2016, this was more than offset by a cut of over £20 per month due to reduced energy demand, mainly from more efficient lights and appliances (including boilers). She says: “This meant that the average household bill in the UK actually decreased by £290 each year due to energy savings. Can you imagine how much more energy could be saved if homes were draught-free?”
Carvalho has a vision of a smart and integrated system that will create opportunities for investors across the energy supply chain. It requires an entire rethink of the structure, moving on from the one-way system of large-scale generation with separate networks for electricity, heat and transport currently delivered to customers. That was the 20th century way of doing things.
The 21st century energy system would be a more integrated infrastructure for electricity, heat and transport – with a digital overlay ranging from a national to household level. This would make the system ‘smarter’ in balancing the supply of energy coming from multiple low-carbon sources (including homes) with demand.
“This smart system would allow producers and consumers to be paid for supplying and balancing the energy system, and could lead to exciting business models,” she says. Ultimately, these investments will pay off in the long term as costs for low-carbon generation reduce with the scaling of deployment. She adds: “This could solve the energy trilemma of being equitable, energy secure and environmentally sustainable – but you need that vision.
“Crises can lead to ideas, and I hope that the current energy and food crisis leads institutional investors to have a vision of how the economy would look if we actually achieved our climate and UN Sustainable Development Goals – ultimately an economy where individuals, communities, businesses and the environment can thrive,” Carvalho says.
“What we’re seeing at the moment is piecemeal, thinking in sectors, thinking about transport, thinking about electricity, thinking about buildings. Right now, that vision is the missing piece.”
Turning targets into transition plans
Companies can convince investors that they’re committed to their ESG goals by turning their pledges into actions. “The targets alone are not enough,” she warns.
“A credible transition plan involves laying out how a company will achieve both its long-term and interim targets over the next five to 10 years. What this crisis has done is basically put a high price on carbon-intensive commodities.
“For example, if a company in Germany is drawing electricity from the grid that’s been generated by burning coal – because gas is so expensive – then I would want to see it justify that high-carbon option. Ultimately, the crisis actually forces you to look at your alternatives and see to what extent they are accessible now, but also what you should invest into is the changes needed in the future to be socially equitable and environmentally resilient.”
The UK Budget due out on 17 November is expected to bring significant fiscal tightening in a bid to restore the government’s financial credibility
As consolidation in the alternative fund market continues, general partners are looking for other means to fund their commitments.
We’re joined by guest Gary Kendall, as our focus turns to the implementation of ESG strategies and the need to track action rather than targets.