Investors should bear in mind that climate risks eventually translate into financial risks.
As climate change delivers extreme heat, drought, and heavy rain, urban dwelling has become more challenging with each passing year. Demand for innovative financial solutions that deliver both financial returns and environmental benefits would be ideal but these are currently lacking. Eric Pedersen, Head of Responsible Investments at Nordea Asset Management, explains how responsible investing guided by financial materiality and social impact can help mobilise capital towards building more resilient cities.
What does responsible investing actually mean? And how can you invest responsibly and help facilitate or create urban transformation?
To some, responsible investing is really about full-information investing — taking into account not just what is in the company’s financial report, but also how that company is influenced by, and influences, the world around it. That includes the natural world, the local communities that the company is active in, its consumers, and so on.
One thing that’s very much in focus at the moment is physical climate risk, which refers to the danger of a company’s operating assets getting caught in events such as floods or fires. Let’s say you are a soft drinks manufacturer, and the water table is exhausted in the place where you operate. The authorities will tell you to stop drawing water because people living around that factory need water to drink. That is the type of risk we refer to as the financially material ESG (environmental, social, and governance) aspects. So one part of responsible investing is to consider more dimensions of risk and opportunity than just the financials.
At the other end of the spectrum is investing that takes into account the investors’ values, whereby the companies whose stocks you buy, or whose bonds you invest in, act in a way that corresponds with your values as a person and investor. For instance, some people do not want to invest in arms production, others are guided by religious beliefs and may avoid alcohol-related businesses, or there might be a doctor’s pension fund that doesn’t want to invest in tobacco companies. Institutions might have stakeholders that have other motives and goals than just achieving the highest return at any given point in time. So responsible investing is any combination of the two approaches.
What makes this very difficult is that almost every individual has a different concept of what is acceptable, responsible, or sustainable. There is really no way to get to that consensus, so asset managers have to triangulate among the return motive, physical climate risks, and investors’ values. For instance, regulators in the US tell asset managers to focus on returns, but the UK courts have ruled that pension funds must look at the long-term interest of members – not just financial returns – which includes a responsibility to prevent climate change and so on.
How does this relate to urban development, and the concepts of sustainable cities and resilient cities? While the responsibility for urban development in the vast majority of cases lies with public entities such as the city government, investors can potentially still get directly involved via bonds issued by those cities. There are cities that have issued green bonds, for instance, or other sustainability bonds that are tied to actions that the city will need to take to make it more sustainable, resilient, and observant of the needs of all its inhabitants.
Investors can also try to understand the situation of the company vis-à-vis the local community. For example, would investors always be interested in having the companies they invest in pay as little tax as possible? If you adopt a very narrow financial perspective, you would say ‘yes’ since less tax means more profit. But let us say you have invested in a company that has assets located in an area that is prone to wildfire. Wouldn’t you want local authorities to have the infrastructure to prevent such incidents, or a well-functioning fire department? And roads without too many potholes, so that fire trucks can actually reach your factory? So you would look at a company and think, “Is this company behaving as a responsible corporate citizen in those communities where its assets are located?”
That feels like the ideal vision of responsible investing, that is, ethical businesses thrive and their investors are rewarded. But is that scenario realistic today? What changes have you observed in the field of ESG and responsible investing over the course of your career?
I came from a world where responsible investing was somewhat of a niche practice. While there were private foundations or union funds that did not want to invest in certain industries, or wanted us to uphold certain standards such as the OECD (Organisation for Economic Co-operation and Development) standards for investment, generally speaking, responsible investing as an ESG concept was niche. We had that capability in the company that I worked for, but it was a small part of what we were doing.
But over the last 10 years, it appears that everyone has started realising just how dire the climate change situation actually is. And that has accelerated over the last five years. Climate change has manifested itself through extreme temperatures, flooding, fires, and so on. So much of that was on television screens and in the news that you really could not escape it. Moreover, with EU regulatory action seeking the finance industry’s help to contribute to a more sustainable society, it is now easier to uncover investors’ latent wish to invest responsibly. Around 2020 to 2022, a lot of funds were rebranded in some way as being sustainable, whether it’s light green Article 8 or dark green Article 9, or other options.
And then came COVID-19, which accelerated the idea of responsible investing because some of these investment vehicles tended to perform better than others. It created this craze in which everything must now be ESG-led. From a commercial point of view, it felt like you could hold up a sign that said ‘ESG’ and people would throw money at you. When Russia invaded Ukraine in February 2022, the oil and gas sector became almost the only part of the global equity market that performed well, because oil and gas prices shot up. But by the end of the year, the belief that ESG-led investment vehicles will always outperform was proven to be untrue.
However, I still believe that taking ESG issues into account will give you better returns in the long run. We sort ESG issues into those that are financially material and those that have what we call ‘impact materiality’. Very often, impact materiality issues can, over time, become financially material as well. One very good example is the issue of the so-called forever chemicals, or PFAS. These are chemical compounds that did not exist before the 1950s but which have since been produced in great quantities to make products such as non-stick pans and raincoats. These carcinogenic products are found everywhere on earth, including in our own bodies, and we will basically never be able to get rid of them.
This was a worry only for values-based investors until regulation was enacted in the EU, and lawsuits worth billions of dollars were filed in the US against companies that had produced or are still producing these products. So something that is an impact or values issue can become a financial issue, and hence, in the long run, it is a safer bet to take these things into account.
Are financial analysts and portfolio managers today equipped with the knowledge and capability to know what climate and ESG issues they need to integrate into their financial risk assessments? In your view, what are some of the emerging risks which we should be paying more attention to?
The short answer to the first question is ‘No’ because these are the unknown unknowns. There is always something that we have not thought of. It could be a real risk that you do not even realise you need to watch out for. Clearly, there are many things that we have not paid enough attention to or not given enough weight.
That leads me to the second part of the question, which are the emerging risks. The one that is growing very quickly in terms of both importance and the attention it is getting is physical climate risk. For a while, because of the steady advances in regulation, the climate risk that we were looking at most closely was the so-called transition risk or policy risk, i.e., the risk the companies might get caught breaching regulations. Let us say a utilities company does not invest in renewables and suddenly gets told that it can no longer operate its large fleet of coal power plants. That was the big risk that was incorporated into all the models. However, at the same time, physical risk was not something that was monitored closely; now, it is what everyone talks about. It is difficult to account for this because it is very local, and you need to know where the assets of a company are actually physically located. So we come back to the theme of resilient cities or communities. You need to know if those assets are located in places that are prone to flooding or fire risk, and if so, whether they are located in communities that are resilient and can handle that risk. This is the kind of granularity that you need to have in your analysis to say something serious about such risks.
The other issue that we do not really know how to handle yet is biodiversity risk. Practically every institutional investor that I talk to is very interested in knowing how to deal with, and think about, biodiversity in terms of investing – is it just an impact risk or is there also some financial materiality to it? I think it is very hard to say from the point of view of short-term financial materiality, as very few companies have exposure to biodiversity risk that would hurt them in the short term. In the longer term, this might be the case, and for the global economy as a whole, it definitely will be. But for individual companies right now to be incentivised to do something about it, or to determine if they are more at risk than others, it is not easy to figure that out.
Artificial Intelligence (AI) and smart grids are part of the formula for the cities of the future, but the other side of the coin is the attendant high energy and water consumption. The data centres required for such technology also need water, which might be scarce. How do you decide whether to invest in such tech companies? What kinds of investment structures are most effective in mobilising capital towards sustainable city projects?
This is an area where we as investors in listed markets do not really have that much access to. For instance, with regard to smart cities and how public authorities are using the relevant technology, we do not have any influence over them because they do not issue shares. We don’t vote at their AGMs (annual general meetings). Instead, it is the voters in the city who decide who the mayor is and what the policy is there.
I sometimes joke that now is the worst possible time to have an AI boom, because this is the moment when we really need to do something about climate change. And here, you introduce a technology that is hugely demanding of energy into the mix, and which is actually causing some of the big tech firms that had very ambitious climate targets to abandon or try to work around those targets. From the point of view of trying to mitigate climate change, it is not ideal. But we live in a capitalist economy where these things are driven by what the market demands.
However, there are areas where AI can play a hugely beneficial role. For instance, we have invested in several waste management companies where AI has enabled the ability to recognise different types of plastic. In some parts of the world, people are being asked to separate garbage into different streams. One stream is plastic, but it turns out that there are many different types of plastic. If you want to use it for something other than very rough shopping bags, then you need to actually separate those different types of plastic.
Ultimately, we just need to be on top of the companies that are opening all these new data centres to try and understand how much of this is real and how much will turn out to be a bubble, because there is also a risk of that.
There has been pushback against sustainability reporting, particularly regarding its costs, complexity, and effectiveness. For instance, the EU is scaling back its Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CSDDD). Is effective regulation achievable?
What’s happening in the EU at the moment is paradoxical because you have a situation where there was a very quick process to streamline the CSRD and some of the other regulations, yet many large companies that have struggled with how difficult the reporting is have come out saying that it should be retained!
I have actually worked on both sides. I am a user of sustainability-related and ESG data as an investor, and I have also been part of the process where the bank that owns the company that I work for has to report according to CSRD. So I have seen what that reporting looks like, and it is onerous.
It could definitely be simplified and made easier to compile, and also easier to use. That is always the case when something is a product of a bureaucratic process. But somehow this became a knee-jerk reaction that said, “Okay, let's cut it down to almost nothing.” Now many very large companies in the EU are coming out and saying, “No, hold your horses. We’re actually for this! We were going to do this because we think it’s relevant. Could it be streamlined here and there? Please don’t throw the baby out with the bathwater.” That’s what we are hearing from the larger companies.
Going forward, where do you see the future of responsible investing going?
In the short term, I do not see a return to the sort of the heyday or the crest of the wave that we had in 2020 and 2021, but at the same time, fund flows into sustainable investment products in places such as Thailand, Japan, and China have been considerable. I think we saw a noisy big wave of ESG hype which subsequently sort of crashed but the underlying current is still there, and will continue to be there.
People do have values, and sustainability risks are real risks. You cannot suddenly decide that climate change does not exist, and biodiversity loss is indeed occurring. How do we deal with these situations? That’s what we do as responsible investors and we will continue to do so.
