Environmental issues are a game changer for investors

The environment plays a pivotal role in the functioning of our global economies and is a growing risk that needs our immediate attention. Understanding these environmental risks is key to maximising returns over the long term. The Global Risk Report 2016 published by the World Economic Forum has listed the top 5 global risks of highest concern for the next 10 years. They include water crisis, failure of climate change mitigation/adaptation, extreme weather events, food crisis and profound social instability. These risks can be broadly grouped under 2 categories – climate change and over exploitation of natural resources.

Climate change is currently accepted as the most pressing global environmental issue that needs to be addressed. Climate change refers to a gradual rise in temperature of the Earth’s atmosphere and oceans caused by increasing concentrations of greenhouse gases. A report by The Economist has estimated the Value at Risk (VAR) to manageable assets from climate change at US$4.2 Trillion.

Climate change is expected to manifest itself in the form of rising sea levels and increasingly unpredictable and extreme weather patterns.

Rising sea levels will result in the submerging of low-lying islands, impacting coastal communities. Other consequences will include increasing salinity of ground water, erosion, and changes to coastal landscapes. At risk from rising sea levels are our major ports and related infrastructure, real estate, tourism, fisheries with impacts on the insurance sector.

Erratic global weather will have a direct effect on agriculture and food production impacting agri- businesses and their supply chains. Severe flooding and droughts will impact property and infrastructure resulting in higher insurance claims. A report by the World Bank estimates damages from extreme weather related events of US$200Bn a year over the past decade, up from US$50Bn in the 80’s.

An important trend that is gathering momentum is the change in our energy consumption – the shift from fossil fuels to more renewable sources. This will impact carbon intensive industries such as electricity, oil and gas, construction and transport. Share prices of energy companies evidence this. Recently US coal giant Peabody filed for bankruptcy primarily due to falling coal prices and the shift to alternate sources.

Governments over the world are slowly realising the need to be better stewards of the environment. They are increasingly imposing stringent emission and pollution standards and calling large companies to account. Examples include GE and their efforts to clean up the Hudson River of PCBs (at a cost of over USD 1.6 Billion) and VW and their transgressions with emission standards. Late last year Volkswagen’s admission of the transgressions led to its share prices dropping 23 %. The U.S Justice department has sued VW for up to $46 billion for breaching US Environmental laws. Locally, SGX listed Linc Energy’s shares have plummeted 79% this year in the wake of the collapse in oil prices, it’s debt burden and from being caught up in one of the biggest environmental prosecutions in Australia.

The recent COP21 talks were a landmark event with 195 countries agreeing to embark on measures to voluntarily reduce emissions in an effort to contain the impacts of climate change.

Along with climate change, the other major challenge is the over-exploitation of natural resources. Our planet’s resources are being used at a rate much faster than the rate at which it can be replenished. This will have a direct impact on the long-term viability of businesses.

Of these, our overuse of fresh water is of immediate concern. According to the Water Resources Group, in 2015, fresh water consumption mostly for agriculture increased to about 5,000 cubic km while sustainable annual supply is only 4,200 cubic km. Almost all of the world’s major rivers and water bodies have been taken up for agricultural purposes and are under varying levels of stress. It is projected that by 2030, the world will face a 40% global water deficit assuming the current climatic conditions continue.

Approximately 70% of the planet’s fresh water sources are used for agriculture, often for the growing of crops such as cotton, rice, sugar cane and wheat. As water scarcity grows as an issue, this could result in sudden shifts in the price of these commodities.

Poor land management leads to deforestation and biodiversity loss. The annual haze that chokes S.E Asia is primarily due to poor land management and slash & burn techniques used to clear forests for palm oil and paper. Apart from the impact on human health and the environment, the annual haze causes losses in millions to the retail and tourism sectors.

An underlying problem is that we do not have the mechanisms in place to value natural capital. Natural capital is the stock of nature’s assets such as land, air, water, biodiversity and ecosystems. Poorly devised government subsidies and incentives mask or distort the true cost and lead to over-exploitation of these resources. For example water is not priced according to its scarcity. Fuel subsidies exist in many countries for specific industries such as agriculture and fisheries.

What would be the return to investors if these externalities were to be fully factored in? A PRI Report says that up to 50% of company earnings could be at risk from environmental externalities. As an example, it is estimated that bees contribute 200 million pounds a year to the UK economy through the pollination of commercially important crops.

Global efforts to manage the above risks are growing, through the use of alternate energy sources and technological innovation for effective use of scarce resources. There is increasing demand on businesses from governments, investors and consumers to measure and report the environmental impact of their operations.

Specific studies have shown that by managing these risks and adopting sustainable practices progressive companies outperform their more conventional counterparts. A January 2016 report in The Guardian mentions 9 companies globally, that are generating a billion dollars through sustainable practices. These include companies such as IKEA, Nike, Unilever and Tesla.

On the down side businesses that do not adapt lose out. A recent example in our region is that of Malaysian conglomerate IOI. It was recently suspended by RSPO (certifying body for sustainable palm oil) leading to companies like Nestle, Hershey’s and Unilever cutting back on their purchases from IOI. IOI’s shares have lost 18 % in value since the suspension.

Institutional investors like the Norwegian Sovereign wealth fund, Allianz, Aviva are already taking these factors into consideration. They have robust ESG (Environmental, Social and Governance) standards in place to guide their investment strategy. As an example, in 2015, the Norwegian Government Pension Fund, one of the world’s largest sovereign wealth funds dropped 11 companies because of their link to deforestation.

Investors are important stakeholders who can bring about change by demanding greater transparency, better accounting for externalities and overall better governance. A company’s sustainability report is a good first step in understanding how an organisation is dealing with environmental issues. Also available are specific indices such as the Dow Jones Sustainability Index and the Global Compact 100 Index.