At Lykeion, we cover a lot of ground. The broad Macro landscape, global Markets, the intersection of the two with the nascent world of Cryptocurrencies, and wide-ranging, market-driven Editorials. The world around us is interconnected and complex, but we try to simplify and add meaning, not noise.
With that, we’re launching a new coverage vertical this week, one that we’re super excited and passionate about, but one that needs a LOT of explaining as it’s become strangely controversial: Sustainable Finance.
Bear with us. If you’ve been reading our content for a while, you know we’re NOT tribalists, we’re NOT maximalists. We do everything we can to stay balanced and view the world through an objective lens, and our coverage of this vertical will be no different. We’re not greenwashed eco-warriors, but we do believe (supported by plenty of facts) the current path we’re on isn’t sustainable. The traditional old-world way of thinking needs to evolve to include the real, identifiable issues taking place around the globe, and conversely, the uber-progressive AOC-esq line of thinking needs to be reined in to work within the confines of the real-world economy. Said more succinctly, we believe both sides need to realize that in order to make the future work, we all need to meet somewhere in the middle.
We chose to add this coverage because 1) It’s fully aligned with our values, beliefs, and who we are, and 2) It’s a theme that, whether you like it or not, is here to stay, and will have a meaningful impact on the investment landscape around us.
This first Sustainable Finance piece reads as a Primer, to get you up to speed on where the world currently stands on this topic, and to give you insights into what we believe the future holds. This will become a recurring theme we cover, and we’ll begin incorporating the ideas explored here, into our other, more traditional finance publications.
With that, we want to introduce Manuel Antunes, our new Editor leading Sustainable Finance coverage. (You can give him an applause at your home office rig if you’d like. He appreciates you, even if you haven’t been wearing pants to your Zoom meetings for the last year).
We were in the middle of brainstorming our Sustainable Finance vertical when we came across this meme that very accurately captures the current state of the ‘Green Movement’:
Admit it, we all have that friend/colleague who’s become an ESG specialist overnight (cut from the same cloth as the overnight epidemiologists of 2020 and the overnight marine engineers during the Evergreen Suez incident). Usually, the ESG narrative is based around the increased consumer preference for green products (even if at a premium cost) or the asset inflow that stems from the boomer-millennial wealth transfer. We think these arguments, whilst real and can be impactful, act as a supplement to our primary thesis, on why ESG, or Sustainable Finance (as we prefer to call it), is important.
We believe sustainable finance is the natural evolution of efficient markets. Capitalism has been, so far, the greatest wealth-generating system we’ve ever come up with, but we’ve spent too much time ignoring the externalities adjacent to this system (some of which are no longer adjacent, but front and center).
In our view, these externalities do not make the case against capitalism, but simply argue for the current capitalist mindset to expand and include a financial assessment of these externalities simply because of their real economic and financial impact. Sustainability, in our view, is not merely a moral, but also a financially relevant input that will impact the future level of returns. This is why sustainability matters.
We’re sympathetic with the reason why we’ve spent so long ignoring these externalities – their impacts are mainly felt at the social (rather than individual) level and their consequences lie somewhere in the future. So why slow down such a successful wealth-generating system only to take into account something that might happen down the road? Well, because we now have sufficient evidence that what might happen down the road is becoming increasingly more likely to happen, which makes the case for sustainability more a matter of timing rather than an eventuality.
Bringing you back to what we consider the roots of sustainable finance, we would like to invite you to name some of the financial risks you’re aware of. Some examples:
For as long as finance theory has existed, risks have been identified and incorporated into financial and economic forecasts. More recently, climate and reputation risks have also made it on the list (though much harder to measure). That’s where environmental and social considerations start to make financial sense – when bundled in an investment risk assessment alongside other, more traditional, risk measurements.
In the same way we address inflation risk by (a) simply searching for inflation protection or (b) searching for sectors benefiting from inflation, once we begin to look at climate and social risks as relevant for financial consideration, we can address those risks in the same fashion and focus on (a) aiming to avoid these climate and social risks or (b) solving for these environmental or social risks.
To prove this point, while avoiding the usual references to the stratospheric, and therefore highly unprecise costs associated with climate change, the ECB published in March 2021 a 30-year climate stress-test analysis on over 4 million companies. This report highlights the central bank’s major concern that climate risk represents a major source of systemic risk (there are two types of people in this world: those that spend Friday nights reading Central Bank stress-test reports, and those that still think drinking hard seltzers is cool. You choose which side you’re on). The FT aggregated the key data points in this report in this glowy chart:
If you tried to pitch an idea based on sustainability in the 70s and 80s, you would have been told that greed is good, and that you should go back to the drawing board (thanks to the hippies getting just a little too high in the late 60s and Michael Douglas’s perfectly coifed hair elegantly explaining to us why Teldar Paper has entirely too many VPs who do nothing all day). At the time, if it was considered at all, it was mostly by philanthropic investors. Fast forward to today, and most asset managers will have some sort of sustainability or ESG offering (not necessarily because they want to, but more likely because momentum is forcing them to).
Our best efforts would lead us to believe that the very beginning of sustainability talks was in 1992, when the UN Environmental Programme created the Finance Initiative. This was a group of 13 global financial institutions (see here the full list) that aimed to finance sustainable development projects (it now has over 200 members). This leading initiative was followed by several UN summits, where large financial institutions would be educated on the subject. This led to important progress, especially as service providers started offering investors products to measure sustainability in a tangible way.
In the early 90s, sustainability rating agencies appeared (the likes of Sustainalytics and RobecoSAM), in the late 90s the first sustainability index benchmarks began being used (with the Dow Jones Sustainability Index as a leader in the space), and in the early 2000s some guidelines on corporate reporting practices were created (the Global Reporting Initiative).
Gradually, supranational organizations helped the space gain some structure (e.g. the creation of the now widely used Principles for Responsible Investment, PRI, which now covers over $70 trillion of AUM) whilst further research was being done on the economics of climate change and social standards.
The growing awareness of the environmental and social pressures the world is facing, the increased scrutiny of corporates externalities (e.g. the 2010 Deepwater Horizon oil spill, the more recent PG&E relationship with California’s wildfires, aided by the idiotic management of the states forest brush), and the greater focus on corporate governance (from gender pay gaps, to diversity & inclusion) have led market participants to build management systems that focus on incentivizing good and penalizing bad behavior.
More recently, in 2015, the creation of the Sustainable Development Goals (SDGs) created by the UN, the predecessors of the Millennium Development Goals, has helped the finance industry align its efforts to these same goals when including in its investment mandates their environmental or social impact. More guidance has then followed with the creation of detailed frameworks for green bonds (in 2018 with the International Capital Markets Association, ICMA, defining the Green Bond Principles), and for sustainability-linked bonds (in 2020 with the ICMA Sustainability-Linked Bond Principles).
This is where we are today, for better or worse. As with everything, there’s a lot of progress being made, and a similar amount of hidden agendas and inefficiencies threatening to slow down the efficiency and efficacy of the sustainable movement. We’ll let you be the judge – we’ll focus on bringing to the surface the most relevant matters to be discussed.
Sustainability is generally visualized through what is conventionally known as the ESG spectrum: a spectrum of investment strategies ranging from the avoidance of climate and social risks, all the way to purely focusing on finding solutions to those outlined climate and social challenges.
The consideration for social and environmental factors in the investment decision process materializes across various investment strategies:
Either on the left-hand side of the spectrum or on the right-hand side, assets flowing into this space have been growing rapidly, with asset inflows in 2020 doubling year-on-year (FT, Morningstar).
As per the acronym ESG – Environmental, Social, and Governance – there are multiple lenses we can peer through when screening a company for these initiatives. We can focus on everything climate-related, from the CO2 emissions of a business, the wastewater it produces, to the age of its fleet. We can explore its social aspects, like the gender pay gaps, diversity & inclusion policies, maternity and paternity policies, etc. Or view it from a governance angle and assess the diversity and complexity of governance bodies of companies.
There are multiple frameworks we can follow, but ultimately, they all rely on one very important thing: company data. The same way financial analysis of a given company is only possible if we have access to their financial information, considering a sustainability analysis of a business can only be possible if that business provides sustainability data on their practices. That’s why multiple supranational efforts have been made across the world to improve and encourage sustainability reporting practices. It began with the creation of a global standard list of relevant sustainability fields to be reported by companies under the Global Reporting Initiative (the GRI), which has then seen follower initiatives like the Sustainability Accounting Standards Board (the SASB) and the Taskforce for Climate Financial Disclosures (the TCFD).
Today, most large-listed organizations report sustainability data of some sort, but much more can be done to improve the quality of that data, its consistency, and the wider reporting of smaller listed businesses. The new EU regulation on non-financial disclosures supports this view of a more consistent and widely adopted sustainability reporting for all listed entities.
Once these data points are in the public domain, investors typically either run their own sustainability analysis or rely on 3rd parties to do it for them. In a similar way to credit analysis, where the credit portfolio manager will run its own credit analysis and the average investor will rely on 3rd party credit ratings, sustainability should be no different. Investors can build their own analysis over or under-weighting certain parameters relevant to their mandates (e.g. an investor caring more for social factors over environmental factors), or investors can rely on 3rd party standardized research. When relying on 3rd party research, investors typically rely on ESG ratings or scores.
There’s been a lot of discussion about these scores, the methodologies underlying them, and their impact. And rightfully so. The almost subjective nature and lack of standardization of reporting by which companies have traditionally produced their social impact data have left an equal amount of subjective and non-standardized analysis of what this data actually means. A comparison with the credit rating space does justice to the skeptics of ESG scores – all these new ESG fund managers are addressing their core problem at hand (the creation of some sort of sustainability assessment) by purely outsourcing it. This leads to managers outsourcing their core offering (the ESG screen) when it should be taken as their core responsibility to build their own. We’ll dig more into the use cases for these scores, their impact narrative, and their credibility in a future note.
Well… for some market participants, it’s likely more than just consumers will demand it in the future (though let’s not downplay the importance of this perspective – after all, consumer behavior drives, on average, more than 60% of a country’s GDP, and shifts in this behavior can move markets overnight). Pension funds, endowments, and other very long-term investors are the ones most exposed to these risks due to their exposure to very long-term tail risks. What for a stonks trader is a marginal climate/social risk over its holding period, for a pension fund is a sizeable risk consideration. The longer the investment horizon, the more climate and social risks will be taken into consideration in the investment case. And given the sheer size of AUM sitting under these long-term focused institutions, sustainability will have a major impact on market flows.
If these long-term investors do require their mandates to take into consideration sustainability risks, they’ll incorporate that analysis for their directly managed assets, and will demand the same investment framework to be incorporated into their externally managed assets. These external managers – most often the widely known fund managers – will therefore need to incorporate such risk analysis into their own investment framework to appropriately serve their customers (long-term investors). Same for investment banks (who serve these widely know fund managers).
If pension funds, fund managers, and investment banks are pulling in one direction, the underlying companies will follow suit (the equity and debt issuers). This, compounded by Institutions (governments, regulators, consultants, etc.) and the shifting consumer demand creates a positive feedback loop that drives the adoption of Sustainable Finance.
This is what Sustainable Finance really is. It’s not a hipster-like market movement that aspires to bring down capitalism, but rather the conscious intersection of what the market participants are demanding (and will increasingly demand more of) given this generationally shifting landscape and the adjustments needed from the world’s leading institutions and corporations to service those demands.
You might be asking “But will this not end up out of fashion sometime soon? Maybe as soon as we see a market correction?”. It’s unfortunate, but the base case scenario is that sustainability will be a financial concern for a while – climate risk is not expected to be gone with a vaccine, and the social risks associated with the current social system either. We, therefore, see Sustainable Finance as less of a ‘bandwagon’ movement and more of a Wayne “Mr. Las Vegas” Newton Vegas act (can you imagine 60+ years on the strip? After two days in that city we feel like Hunter S. Thompson trying to check into a hotel). Note, the two Portuguese editors tried two different analogies here, but they (Manuel and Diego) have the humor rating of most standard-sized cinder blocks. Tim to the rescue once again. (Portuguese editors’ edit: At least we have the looks and youth on our side).