Trucost Blog / 08 Apr 2015

Natural capital is one of the critical investment themes for 2015

Some investors may think environmental risks are way off into the future, but others are clear that these costs are hitting companies now.

The use of natural capital indicators by investors to measure and manage financial risks and opportunities is one of the big themes of the year, according to a conference held last week by the UN’s Principles for Responsible Investment initiative.

The PRI, a network of over 1,300 investors with $45 trillion in assets, looked at a range of emerging themes for investors committed to incorporating environmental, social and governance best practice into their asset management strategies.

One topic was progress with the PRI’s Montreal Pledge which requires signatories to measure and disclose the carbon footprint of their investment portfolio. Launched in September last year, the initiative aims to get investors worth a total of $3tn to make the pledge before the Paris UN climate change conference in December. A good start has been made with 39 financial institutions signing up including CalPERS, Secom, the Environment Agency pension fund and Joseph Rowntree Charitable Trust. But many more are needed.

Some investors have concerns that carbon footprinting is difficult to do, lacks accuracy and has limited value to the business. But several speakers allayed these fears.

Antti Savilaakso, responsible investment director at Nordea, said that forming a consensus on what was the right responsible investment strategy to take was very difficult – but robust measurement of carbon was an action on which everyone could agree. It gives clients the information they need to choose how to manage the issue.

Delegates debated the merits of divestment versus engagement as strategies to reduce financing of carbon-intensive companies. There is a growing divestment campaign focused on encouraging investors to stop investing in fossil fuel activities such as coal-fired power generation and oil exploration. Nevertheless, research by the University of St Andrews presented at the conference found that of 380 organizations considering divestment, only 3% had done so. Student activists at universities and colleges such as Stanford and Glasgow appear to be leading the charge.

Many investors prefer engaging with companies to make the case for improvements in environmental performance or even a change in business strategy. They argue that by divesting from a company, influence is lost, and the investor will simply be replaced by another, potentially one that is less responsible.

The balance of opinion seemed to be that choice between whether to divest or engage was false. An effective strategy could include both, for example by rebalancing investments away from the worst performing companies in their sectors towards the best. There was a call by the PRI for investors to talk much more about the benefits and achievements of engagement.

Whatever strategy investors take, it is clear that doing nothing is not an option.

Simone Dettling, from German development bank GIZ, highlighted the risks faced by institutions financing sectors with huge environmental costs. GIZ was a partner with Brazilian business organization CEBDS in an Emerging Markets Dialogue project to assess the natural capital risks of financial institutions in Brazil.

The research, conducted by Trucost, found that the annual natural capital cost of sectors in Brazil which banks and pension funds are financing amounts to $1,646bn. The sectors with the biggest impacts were cattle ranching and soybean farming. Even if some of the sectors only had to pay a small proportion of these costs as a result of extreme weather events such as droughts, tougher environmental legislation, and changes in consumer demand, shareholder returns and loan repayments would be adversely affected. In the abattoir sector, for instance, paying just 2% of its natural capital costs would be enough to wipe out its profits.

Some investors may think these risks are way off into the future, but other speakers made it clear that these costs are hitting companies now. Neil Brown, SRI investment manager at Alliance Trust, said clothing retailing H&M decided to switch to sourcing more expensive sustainable cotton to reduce the increasing cost of water scarcity to its business, as demonstrated by a recent drought.

The governor of California issued the first-ever mandatory restrictions on water use in the state last week as a result of a four-year drought. Researchers at the University of California are predicting that the 2015 drought could cost $3bn compared to $2bn last year, with farming among the worst affected.

Richard Mattison, chief executive of Trucost, said the good news is that the cost of taking action now to minimize natural capital impacts is far lower than the cost of being forced to take action later on. For both investors and companies, the first step is to understand your impacts and the risks these create for your business, so you can manage them more effectively.

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