ESG goes mainstream

This week I’ve been thinking about climate change. Specifically the COP 24 United Nations climate conference going on right now, and the Fourth National Climate Assessment produced by 13 US federal agencies and derided by the Trump administration.

The government report warns that climate change is already harming Americans’ lives with “substantial damages” set to occur as global temperatures threaten to surge beyond internationally agreed limits.

It’s clear that climate change is becoming a defining theme of our age. It’s perhaps a little less obvious that increased awareness of the risks presented by climate change is affecting behaviour in financial markets. All this might sound a little leftfield for the Origin blog, but I believe it’s important and somewhat overlooked.

The discourse around climate change has increased in temperature over the past 12 months (pun intended). In turn, this is elevating the status of ESG investing, with interest in green bonds, sustainable bonds, social bonds skyrocketing. Make no mistake, a profound change is underway. A niche sector that only a few years ago seemed to be a nice little PR exercise for issuers and dealers is morphing into a meaningful driver of revenue and prestige. ESG is fast becoming a mainstream part of assessing market risks and a financial necessity. But why?

Given the size, scale, and increasing frequency of natural disasters, asset allocators are starting to assess the risks presented by climate change to their investments. This is most apparent in the insurance and asset management industries.

The US government report attributes the recent disastrous wildfires in the west, flooding on the east coast, soil loss in the midwest and coastal erosion in Alaska to climate change, stating that the “impacts of climate change are intensifying across the country, and that climate-related threats to Americans’ physical, social, and economic wellbeing are rising”. This is having a huge impact on the insurance industry.

Insurance companies tend to build their models around what’s happened in specific geographies over recent decades. But as climate change accelerates, more locations are experiencing natural disasters like flooding and hurricane damage. The relationship between the past and the future is breaking down, making risk harder to price.

With insurance companies struggling to update their models, reinsurance companies are upping their charges. Costs are rising across the value chain, resulting in higher prices for end customers. Indeed, home insurance rates in the US increased more than 50% from 2005 to 2015, with the increase driven by inflation, rising real estate values, construction costs and you’ve guessed it, natural disasters.

The asset management industry is also experiencing upheaval thanks to climate change. Barron’s recently published an interesting interview with Blackrock’s Global Head Of Sustainability, Brian Deese, who points out that we’re seeing greater physical manifestations of changes in the climate alongside accelerations in technological and regulatory trends, all of which are having real-world impacts and real financial impacts. Over the last year, Blackrock has seen a significant acceleration in interest in ESG, as investors gravitate towards the asset class in order to mitigate risks to their portfolios.

The focus on sustainable investing is no longer a superficial trend driven by PR and corporate virtue signalling. Rather, it’s a function of risk management. It would be a dereliction of duty for a portfolio manager at an insurer or a large asset manager to assume their huge portfolio of investments isn’t at risk from climate change and its second order impacts. So, expect ESG to become a dominant feature of financial markets going forward, one that presents huge opportunities for forward-thinking issuers, investors and dealers.