The COVID-19 Diaries – Week 4 – ESG Investing & Climate change

Climate change should hire Corona’s PR manager

There is zero doubt that the economy is experiencing a flu, but the extent of damages cannot be reliably estimated. However, throughout the past couple of years Coronavirus was not the only externality that the markets experienced.

There is no single externality on the planet larger than carbon emissions.

To put it into perspective

El Niño

El Niño is a period with rising temperature and less rain in the Caribbean. Historically, it lasted for a year on average. In 2019 it closed its 6^th consecutive year. Commodities are gone in the region, leaving over 2 million people on the edge.

Rumble in the (Jungle) Desert

Climate change leads to a doubled likelihood of drought in the Horn of Africa region. Severe droughts in 2011, 2017 and 2019 wiped out commodities. Circa 15 million people are short of food and water. The lifeline project is 35% funded.

Ring of Fire

The wildfires in Australia do not need much of an introduction but statistics wise, it burned through close to 20 million hectares. That is Austria and Slovenia combined. Twice.

Externalities and hedging

The financial sector is fairly capable of dealing with high-frequency, low-impact disruptions, but never passed the exam at managing a low-frequency, high-impact dilemma.

Externality by definition is a cost or benefit that is not reflected in market pricing of a given security. Fair to say if it is not priced, it is also ignored in financial decision making. However, banks cannot afford to ignore externalities much longer. It is an opportunity to take financial resilience seriously before climate change blows up the system.

“The digital advances of the past decade have expanded our confidence that everything can be app-ified: efficiently and easily distributed, quickly and at a low cost. The equivalent in finance is the conviction that every risk can be securitized and transferred to whomever is most prepared to bear it.”

But in this context, who is most prepared and willing to bear the risk? Catastrophe bonds are currently the closest alternatives which can be used as hedging instruments for unforeseen events.

Catastrophe bonds are on average BB rated with maturities less than 3 years. If no catastrophe occurred, the issuer would pay a coupon to the investors. If a catastrophe did occur, then the principal would be forgiven, leaving the issuer with additional liquidity.

From a common-sense perspective, catastrophe bonds are zero-sum-games. Whereas to achieve a sustainable and resilient financial sector, win-win scenarios have to be established. Instead of hedging or treating the risk, it could be more beneficial for all parties to eliminate or prevent the root cause of the problem. ESG investing and products may offer a longer-term solution.

ESG on the rise

Definition

“As the world recovers from coronavirus, it will be looking with fresh eyes at its resilience in the face of global threats—and asking anew whether we’re investing to avert future catastrophes.” (Bloomberg)

The term ESG appeared in high finance in the middle of the past decade. And since then it has been used sometimes vaguely. The abbreviation stands for environment, social and governance. In essence, it captures factors such as climate change, water scarcity, energy sufficiency and air pollution from an environmental point of view.  On a social scale, it includes customer satisfaction, gender diversity and human rights. And from a governance perspective, ESG focuses on board composition, political contributions and executive compensation.

ESG investing is a practice that considers not only the traditional value drivers when allocating capital to a product or company but also includes ESG factors to its pricing.

Proposition

“Climate change has become an investment consideration impossible to ignore, as related disasters and economic losses grow1 and regulators increasingly recognize it as a systemic financial risk.” (Bloomberg)

The European Council proposed that each transaction and financial product – debt offering, refinancing, M&A will receive ESG rating in the future. As an example, the better the ESG rating, the cheaper the debt therefore more value is funneled to collective stakeholders. From a bank’s perspective, a better ESG rated loan could receive lower capital requirements thus positively impacting the RWA of the institution.

“Moreover, among institutional and individual investors, demand to integrate climate change as a factor in portfolios is high. More than 40% of institutions are actively considering or seeking to address climate change as a sustainability issue and over 75% of individuals are interested in it as an investment theme.” (Morgan Stanley)

On the one hand it is great that attention is drawn to ESG investing and climate change. On the other hand, it is fairly disappointing that it only happened when there is a clear monetary compensation to succeed in the field. Nevertheless, it provides a new wave of opportunities to be discovered for both sell-side and buy-side participants.