BUSINESS CASE – INVESTMENT
More than 1,600 asset owners and managers, with around $70 trillion of assets, have signed the Principles for Responsible Investment, committing to incorporate environmental, social and governance (ESG) issues into their investment process.
Institutional asset owners, asset managers and even individual retail investors have begun to embrace the idea of using some level of environmental, social, and governance (ESG) analysis when considering investments – including assessments of natural capital dependencies and impacts. A shared methodology and common tools to identify natural capital-related risks and opportunities across portfolios would provide investors, including asset managers and other financial institutions, with measurable natural capital performance indicators and a standard framework for measuring improvement.
- ^ GSIA, Global Sustainable Investment Review, 2016
Risks & Threats
Natural capital risks can be examined from both an asset-level and a portfolio-level perspective.
Understanding how a potential investment relies on inputs from natural capital as well as how it affects natural capital can help an investor more accurately value the investment, as well as ensure the risks are accounted for in the price. As an example, when considering an investment in a Brazilian meatpacker in 2008, looking at natural capital risks may have enabled an asset manager to avoid – or at least appropriately price in – the risks to revenue that were realised a year later when the links between deforestation and cattle ranching led to legal action by the Public Prosecutor’s Office as well as the cancellation of contracts by seven major international customers with one of the meatpackers.
From a portfolio-wide perspective, managers of portfolios with significant exposure to sectors reliant on natural capital-related inputs – such as water, products from forest ecosystems, and other natural resources – need to be aware of how the depletion of natural resources can affect the financial condition or operating performance of companies and thus the valuations or credit-worthiness of investments. Managers can then adjust their exposures to achieve the desired risk/return profiles. In addition to sector-concentration, a geographic lens can also be applied to portfolios, examining how multiple investments in a single area may be affected by climate change or the degradation of natural capital. Portfolios with concentrations in areas experiencing droughts, such as Australia, can see company returns and valuations drop due to the decrease in economic activity associated with a severe drought. The effects of natural capital events can go beyond the directly affected sectors such as agriculture, because such risks, when they manifest, can affect the price of electricity as well as other natural capital inputs used by other sectors. In Australia, the 2002-2003 drought was estimated to have reduced GDP by 1%.
For investors, the systemic risks associated with the depletion of natural capital can have significant effects on the value of an investment portfolio. For a diversified investor, one portfolio company’s externalities can result in increased costs or reduced revenues for other portfolio companies, thus reducing total return. The Principles for Responsible Investment (PRI) has estimated that over 50% of all companies’ combined earnings could be at risk from environmental externalities in a hypothetical equity portfolio weighted according to the MSCI All Country World Index.
- ^ United Nations Environment Programme, Bank and Investor Risk Policies on Soft Commodities – A framework to evaluate deforestation and forest degradation risk in the agricultural value chain, 2015
- ^ Climate Council, Parches Country: Climate Change and Drought in Australia, 2015
- ^ PRI and UNEP Finance Initiative, Universal Ownership: Why externalities matter to institutional investors, 2010
While the natural capital risks to investment decisions are compelling, there are also opportunities for asset managers and investors.
For example, properly accounting for natural capital risks can lead to more informed investment decisions that are more likely to meet risk/return targets. In this way, natural capital can potentially act as an opportunity for information arbitrage – managers can incorporate information and tools that other managers are not yet evaluating, which can lead to improved investment decisions.
There are also opportunities to develop products and strategies that incorporate natural capital criteria, including funds which aim to have a positive impact on natural capital. As impact investing continues to grow rapidly, there is an increasing need for consistent metrics to measure the various impacts of an investment, and a natural capital framework can be an excellent way of accounting for environmental impacts.