The Environmental Investment Rationale

‘While it is difficult to precisely measure global spending on existential risk, we can state with confidence that humanity spends more on ice cream every year than on ensuring that the technologies we develop do not destroy us.’

Toby Ord, The Precipice, March 2020

University of Oxford, Future of Humanity Institute

Existential investments, broadly defined, are investments that relate to mass human or animal extinction. Classic examples of substantial existential investments are The Global Seed Vault in Norway, international climate and nuclear weapons treaties and NASA’s 90’s asteroid detection program, ‘The Spaceguard Project’.

Many economic theories tell us that existential investments are undervalued because they are usually ‘public goods’, rather than goods that can be attributed to individuals or corporations for a competitive benefit. They are subject to ‘free riders’. For example, the positive effects of better air quality because of anti-pollution programs are dispersed throughout the entire community, rather than to an individual or corporation. An obvious and emergent example is global warming; a recent example is global pandemic.

Usually we rely on governments to step in to regulate and fund these sorts of projects. The problem with global warming is that it is a ‘global’ threat, which means that governments need to be not legislating just for their country, but for the world. It is also an ‘intergenerational’ threat, so governments need to be legislating for future generations as well.

Compounded by the arc of recent political trends, such as weakened global institutions and a reduced geopolitical trust between global powers, this leaves us with a situation where more and more countries are risk-driven over reward-driven in determining whether to invest in environmental policies.

Stock markets, acting much like many politicians, can be similarly short termist. Despite this, there is certainly some room for optimism in the private investment sphere. According to the US SIF Forum for Sustainable and Responsible Investment, Environmental, Social and Governance investments (ESG) reached 12 Trillion USD by October 2019. About one 1 in 4 dollars in assets under management. So, in some sense, the numbers speak for themselves.

Environmental Stock Performance: Reasons for Optimism

In a recent article published by Man Group, the world’s largest publicly traded hedge fund; the question of whether Covid-19 would interrupt the trend of investment in products that adhere to ESG criteria was raised. Their answer was no, it won’t be interrupted, for three reasons:

ESG Performance;
No Bubble; and
Structural Drivers.

In short: firstly, ESG fund performance has continued from 2019 into 2020.

Secondly, there is no evidence of an ESG bubble, ‘In fact, quite the contrary. There is a good chance, in our view, that this theme is one of the dominant factors of the coming decade.’

Thirdly, the structural driver of climate change, as a large existential threat, that needs to be addressed.

The main detractors of ESG investing point to its performance following the 2008/9 financial crisis, but things have changed a lot in the past decade. We can now include a 4th reason for optimism: technological advances leading to decreased costs of implementing environmentally friendly and profitable energy sources across the globe, most importantly, in developing countries.

A good example of how emerging energy markets are being transformed by technology is Okra Solar. Okra is a Cambodia based energy access technology company; it provides utility companies in emerging markets solar microgrids that operate autonomously through software. I reached out to Afnan Hannan, CO-Founder and CEO of Okra for comment:

‘30% is the average income increase after 3 months of being connected to 24/7 energy. And now with IoT (the Internet of Things), distributed energy and digital payments, the roughly 900 million people in the world without power, can now access energy cheaply. It’s going to be a goldrush opportunity for the private sector, particularly private equity firms, to energise these people.

Funnily enough, my internet in Cambodia gives me more bandwidth than what my team gets in Sydney. Just like the internet, energy is going to leapfrog in developing countries. More than $150 Billion is going to be invested into solar microgrids this decade to ensure energy access for all. Investing in grid extensions would have cost 4 to 10 times more. This is going to be the decade of decentralised energy, of automation and of 1 billion people entering the digital economy.’

Afnan Hannan, CEO of Okra Solar, May 2020

Marketing ESG Investments, the Legal Risks and Opportunities

As always, when the rubber hits the road, the legal and compliance team needs to be there to advise asset managers on their strategies. Especially in relation to the legal implications of products touting social or environmental impact.

Financial firms need to avoid ‘greenwashing’ (hyperbolising the fund’s environmental impact) in any potential marketing material to avoid misleading and deceptive conduct. It may be a good idea to maintain focus on the fund’s performance to avoid these risks. It’s always going to be a balancing act between effective marketing and legal risks.

Further to these considerations, any investment style change must be closely monitored as well. As ESG is performing well during Covid-19, investment styles are changing to incorporate ESG holdings. Any changes to investment style need to be properly reported to investors and regulators, at the risk of unsanctioned ‘style drift’.

Reporting, to institutional investors especially, shouldn’t be seen as just a burden on compliance; but a marketing activity; it is an opportunity, to report to investors about the social impact of their investments. Increasingly institutional investors are expecting:

Asset management staff to be properly trained in the principles of responsible investment;
Firm policies in relation to responsible investment;
Firm investment screening policies;
Strong internal controls to ensure the investment policy is being followed; and
Reporting on outcomes.

The Need for Expertise in Environmental Investing

According to a survey conducted by KMPG, CAIA, AIMA & CREATE, 63% of hedge fund managers say their progress is being hampered by lack of robust templates, consistent definitions and reliable data.

Data sets in this area can be behemoth in size and of varying quality. To extrapolate actionable investment decisions from the data, many hedge funds are better able than most asset managers to engage their advanced teams of data scientists, using machine learning tools.

As discussed in an earlier article about alternative data compliance this can mean investment funds having to find very specific types of people to undertake the examination of information, trade on the information and then to properly frame the investment decision within a legal context. According to the KPMG report, many funds will require specialist recruitment agencies to find professionals with both finance and ESG experience.

Despite the hurdles of legal risk and resourcing, the global trend towards investment in ESG products will likely mean we, and future generations, are able to enjoy a safer future.