Large institutional investors relying on modern portfolio theory can be considered “universal owners”: their highly-diversified, long-term portfolios are sufficiently representative of global capital markets that they effectively hold a slice of the overall market, making their investment returns dependent on the continuing good health of the overall economy. They can therefore improve their longterm financial performance by acting in such a way as to encourage sustainable economies and markets, and must act – including acting collectively – to reduce the economic risk presented by sustainability challenges. Even for nonuniversal owners, major environmental and social issues will represent risks to their business.
The way that past economic growth has been achieved cannot be maintained: it has been responsible for an expanding list of environmental and social burdens. With many of the catalysts of past growth (e.g. use of fossil fuels and rapid urbanisation) no longer sustainable in their current form, future growth is likely to be much slower and more erratic over the next 30 years than over the past 30.
The Financial Stability Board (FSB) has already identified climate change as a potential systemic risk. This may also be the case for other issues addressed by the SDGs, such as clean water, biodiversity and inequality. The economic implications of these environmental issues (such as climate change, resource scarcity, biodiversity loss and deforestation), and social challenges (such as poverty, income inequality and human rights) are increasingly being recognised, as evidenced by the global growth of responsible investment, for which understanding the risks posed by externalised environmental and social costs in the real economy is central.
Universal owners’ portfolios are inevitably exposed to these growing and widespread economic costs – which are in large part caused by the companies and other entities in which they are invested. Inefficiently allocating capital to companies with high external costs, such as those engaged in highly-polluting or socially disruptive activities, can over time lower asset values, reducing returns to investors: one company’s externalities can damage the profitability of other portfolio companies and overall market return.
For a universal owner, environmental costs are unavoidable as they come back into the portfolio as insurance premiums, taxes, inflated input prices and the physical cost associated with disasters. Social concerns, such as poverty and inequality, can lead to societal and political unrest and instability, which can also create costs that will reduce future cash flows and dividends. The macro financial or even systemic risks that may materialise if one or more of the SDGs are not achieved can have enormous negative consequences for financial returns.
There is therefore a growing school of thought that investors should integrate the price of externalities into the investment process, and take into account the wider effects of investments by considering the impact on society and future generations. This will ensure that investors can pay benefits to their beneficiaries, but also provides collateral benefits to the wider community. The active ownership model gives more weight than traditional portfolio management to inter-generational concerns and to the sustainability of the economy as factors affecting future risk-adjusted returns.
For more than a decade, responsible investors have been calling for governments to set policies in line with the fundamental challenges to our future. The SDGs, including their targets and detailed indicators, provide an agreed framework for all UN member state governments to work towards in aligning with global priorities such as the transition to a low-carbon economy and the elimination of human rights abuses in corporate supply chains.
Ultimately, a failure to meet the challenges of the SDGs could significantly affect the value of capital markets or their potential for growth, and with that, the value of diversified portfolios.
We are demanding more from the planet than it can sustain. In 2016, the Global Footprint Network (GFN) estimated that our demands on renewable natural resources would need 1.6 earths to be met, and more that 80% of people now live in countries that demand more from nature than their ecosystem can regenerate. With the population forecast to reach 8.3 billion people by 2030, we will need 50% more energy, 40% more water and 35% more food.
In 2010 the PRI and the UNEP FI commissioned Trucost to calculate the cost of global environmental damage and to examine why this is important to the economy, capital markets, companies and institutional investors. Annual environmental costs from global human activity were calculated at US$6.6 trillion in 2008, equivalent to 11% of GDP, with the top 3,000 public companies – i.e. those that make up large, diversified equity portfolios – responsible for a third of this (US$2.15 trillion). In a hypothetical investor equity portfolio weighted according to the MSCI All Country World Index, environmental externalities alone could equate to over 50% of the companies’ combined earnings.
The Stockholm Resilience Centre has identified nine “planetary boundaries” within which humanity can continue to develop and thrive for generations to come, but in 2015 found that four – climate change, loss of biosphere integrity, land-system change and altered biogeochemical cycles (phosphorus and nitrogen) – have been crossed. Two of these – climate change and biosphere integrity – are deemed “core boundaries”, for which significant alteration would “drive the Earth System into a new state”.
Without radical changes in the current food and agriculture system, the cost of biodiversity and ecosystem damage could reach up to 18% of global economic output by 2050 (up from around 3.1% (US$2 trillion) in 2008. The costs of runaway climate change would be even greater, acting as a risk multiplier across already fragile environmental and social systems. The global cost of flooding alone will reach US$17 trillion a year by 2030.
Impact of climate change on a portfolio
CISL (2015) calculate that the long-term impact of climate change on the performance of a balanced portfolio in a no mitigation scenario (i.e. no special efforts are made to contain environmental challenges) is -30% in nominal terms, compared to +17% in a 2°C scenario (i.e. policies are implemented to restrict the increase in global temperature to 2°C above pre-industrial levels).
They warn that such risks are not just long-term concerns related to the physical effects of climate change. There is also a danger that financial actors could anticipate future climate-related risks by abruptly changing their portfolio strategy. This could lead to losses of up to 45% for equity portfolios and 23% for fixed income portfolios. Only around half of the equity losses could be hedged through the financial markets, so investors risk seeing the value of their portfolios reduced by over 20%.
There are vast numbers of people who do not have access to basic services such as healthcare, clean water, energy and sanitation. Income inequality in OECD countries is at its highest level for 30 years, and Oxfam estimates that the 62 richest people in the world have the same wealth as half the world’s population. This significant level of income inequality is creating a number of social stresses, including mistrust of governments and business, as well as governance and security-related issues. In 2014, the world spent 9.1% of its GDP on costs associated with violence.
Undernutrition is a huge killer in developing economies, including through increasing vulnerability to pathologies such as malaria, anaemia and acute respiratory infection, and has severe economic consequences: the economic cost of undernutrition to families in Ethiopia alone is just under US$70 million per annum. While the number of undernourished people in the world has declined sharply, there are still estimated to be almost 870 million people, or one in eight, suffering from chronic malnutrition, mostly in developing countries.
Non-communicative diseases (NCDs), though historically an affliction for the richest nations, are increasingly affecting the large populations of developing economies as well. In 2011, it was estimated that over the next 20 years, NCDs would cost more than US$30 trillion (48% of global GDP in 2010) and push millions of people below the poverty line.
A study by Jensen (2012) demonstrated that supplying work opportunities to girls in India, at a cost of US$100 annually, returned an increased annual income of over US$2,000.
Produced in collaboration with PwC