Values Approach to Investing - Risks

Values Approach to Investing - Risks

• Risk management is crucial for aligning financial systems with sustainability. Risks are categorized as physical and transition risks, impacting asset values and business operations.
• Physical Risks:
  • Acute: Sudden climate events (hurricanes, floods, wildfires) cause immediate severe damage to infrastructure, disrupting businesses and supply chains.
  • Chronic: Long-term climate shifts (sea-level rise, increased temperatures, changing precipitation) increase physical asset depreciation, raising operating costs, repair expenses, and insurance premiums.
• Transition Risks: Result from the economic shift toward low-carbon and sustainable practices.
  • Regulatory and Policy Risks: Changes in regulations (carbon taxes, stricter environmental regulations) can increase costs or limit revenue opportunities. Fines for non-compliance are significant. Uncertainty about future laws, regulations, and policies affect a firm's attractiveness and risk, increasing transparency and accountability. Legal risks create uncertainty about future earnings and liabilities.
  • Technology Risks: Failure to adopt emerging technologies (renewable energy) can disrupt cash flow and increase capital expenditures (capex). Innovation risk is associated with lack of investment and unsuccessful innovation attempts.
  • Market Risks: Shifting consumer preferences for sustainable products affect demand for traditional, carbon-intensive industries. This impacts commodity prices and supply chains, increasing production costs. Increased market uncertainty affects future earnings, costs, and repricing of assets.
  • Reputational Risks: Public perceptions of a firm's environmental impact influence access to capital and consumer loyalty (e.g., boycotts). Investor perception can reduce capital access and increase costs due to negative impacts on workforce management and planning. Sectors (oil/mining) are highly vulnerable to negative perceptions.
• Temporal Variation in Transition Risk: Transition risk is non-linear, unpredictable, and evolves over time with feedback loops. Probabilities and impacts vary temporally. Delayed emissions reductions increase risk and future target attainment challenges. Delays also result in locked-in future outcomes.

Corporate Concerns of Risk Management

• Regional disparities in the perceived significance of climate risks exist (e.g., lower concerns in Europe/UK/US than Asia/Latin America).
• Regulatory risk is the top business concern in the next five years, while physical risk is predicted as the top concern within the next thirty years (Strobel & Wurgler, 2021).

Impact on Commercial Real Estate

• Cash flow is affected: Reduced rent, lower occupancy rates, longer re-letting times, and changes to feasible uses.
• Increased outgoings include higher operating costs, capital costs, premiums and property taxes.
• Capitalization rates are impacted: Risk premium increases due to cash flow volatility, reduced liquidity, reduced insurability, and higher site/location risks. Expected growth diminishes, and rental prospects and future occupancy rates decline, along with increased depreciation and costs.
• Financing is affected: Higher financing margins due to increased risks, and higher debt service cover ratios are expected to cover cash flow fluctuations. Financing availability is reduced (fewer willing lenders, amounts, and equity partners).

Climate Risk in Asset Pricing

• The key question is whether climate risks are reflected in asset prices (stocks, bonds, real estate, commodities).
• Assets exposed to high climate risks have lower valuations, while resilient/sustainable investments have higher valuations.
• Underpricing or overlooking climate risks indicates a disconnect between asset values and climate risk's long-term impact.
• Market inefficiencies, information gaps (incomplete or inconsistent data/standardized metrics) and behavioural biases influence underestimation of climate risks. Short-term gains are prioritized over systemic long-term risks.
• Fragmented policies/regulations exacerbate the issue.
• Physical & Transition risks require forward-looking models for scenario analysis.

Opportunities

• Resource Efficiency: Improves cash flow and lowers operational costs (reducing water/raw material use, minimizing waste). Better preparation for resource-related regulations and raw material price volatility.
• Energy Efficiency: Transition to renewables/clean energy creates higher and more predictable cash flows, reducing long-term energy costs and fossil fuel exposure, aligning with investor preferences.
• Products and Services: Demand from environmentally conscious consumers and businesses increases cash flow. Climate-aligned products & services demonstrate forward thinking and resilience. Examples include green credit/bonds/mortgages
• Resilience: Stronger operations, supply chains, and infrastructure minimize climate-related losses, preserving and enhancing future cash flows. Resilience to climate risks translates into reduced future climate disruption vulnerability and perceived lower risk.
• Markets: New markets for climate-related goods offer revenue streams. Reduced exposure to traditional carbon-intensive industries (high regulatory and market risks). Markets are emerging for ESG metrics, indices, and ratings (MSCI, Sustainalytics). However, standardized frameworks are lacking. Design limitations exist, as metrics don't always assess material issues relevant to investors and are biased toward larger firms.

Values-Based Investing

• This approach integrates social values into financial decisions for long-term value creation.
• Investors increasingly prioritize environmental and social impact alongside financial returns. Tools (GIIN, PRI, SBTI, GRI) guide ESG factor incorporation into investment strategies.
  • Positive ESG factors, along with financial returns, are the driver for sustainable finance models and investments that screen/integrate/invest in ESG goals.
  • Firms and investors trade-offs maximum profits for sustainability, investing to create positive ESG factors and financial returns.
• Focusing on long-term value creation, six capitals (natural, social, human, intellectual, financial, and manufactured) contribute to wealth creation, preserving assets and addressing climate change risks through internalizing negative externalities.

Pushback Against Sustainability

• Political and shareholder resistance to ESG initiatives is increasing.
• Implementing sustainability goals is complex. Unrealistic targets and greenwashing allegations pose challenges.
• Return expectations not matching sustainability investment returns prompts re-evaluation of goals.

Fragmentation of Interests in Investment Chains

• Investment chains are often complex, and principal-agent problems exist (investors delegate tasks to fund managers).
• Challenges include asymmetric information, moral hazard, adverse selection, and incentive misalignment.
• Solutions involve incentive alignment, transparency, and shareholder engagement.

ESG in Portfolios - Investment Strategy

• ESG factors are increasingly integrated into portfolio management.
• Portfolio returns are a weighted aggregate of individual asset returns.
• Asset prices depend on fundamental value and ESG investor preferences.

Modern Portfolio Theory

• Modern Portfolio Theory (MPT) focuses on optimizing portfolios for risk and return, seeking maximum returns with minimized risk through diversification.
• Diversified portfolios enhance investment performance and hedge against specific risks.
• Equity funds combine money from various investors for diversified stock investments.

Interpreting Correlations

• Correlations help understand diversification benefits.

Short & Long Run ESG Investment

• ESG-CAPM incorporates ESG factors into Capital Asset Pricing Model (CAPM), where higher/lower ESG alignment creates higher/lower desired returns.

• High ESG assets often have lower expected returns due to higher prices but are seen as less risky in the long term.

• Low ESG assets may have higher expected returns but are perceived as riskier.

• ESG-unaware investors may misprice ESG risks, potentially leading to "carbon bubbles".

• ESG-aware investors usually partially price ESG risks, resulting in relatively stable markets but incomplete ESG integration.

• ESG-motivated investors heavily favor high ESG performance assets, leading to higher pricing and lower expected returns for lower scoring assets. This ultimately results in higher long-run stability as sustainability is integrated into asset pricing, but may result in perceived tradeoffs in financial performance.

Explore the crucial aspects of risk management in sustainable investing. This quiz covers physical risks from acute climate events and chronic shifts, as well as transition risks related to regulatory changes impacting financial systems. Test your knowledge on how these risks affect asset values and business operations.