Will sustainability be the global economy's ultimate disruptor?

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Three of the world’s leading central banks have sounded a warning call about the risks that climate change poses to the financial system. On this, we believe that investors can no longer afford to treat environmental and other ESG¹ issues as a niche concern in portfolios.

Responsible investing already accounts for more than one in five dollars managed professionally in the US, and studies suggest that the proportion could be almost 53% for European assets². With this growth poised to accelerate, sustainability is quickly becoming a ‘whole portfolio’ affair – and we would encourage investors to think of it as such.
 

A quiet revolution

The global economy is on the cusp of a sustainability revolution that will have meaningful implications for investors. Industries and businesses that fail to adapt to the need for a more sustainable growth model will ultimately be penalised by the market.

2015 marked an important turning point in this journey. That year, 193 countries agreed to adopt the UN's 17 Sustainable Development Goals aimed at ending poverty, fighting inequality and tackling climate change. It also saw the introduction of the Paris Accord, which established a wide-reaching set of global goals to address climate change over the coming decades.

2015 also served as a transition point in how capital markets reflect this policy trend. Our analyses show a relationship appears to have formed over the last two years between ESG criteria and stock valuation.

As long-term investors, we seek to progress our understanding of the impact of sustainability on 'whole portfolio' performance by focusing on its increasingly profound relationship to risk.
 

Regulation, reputation and risk

ESG-related failures can have devastating financial consequences for companies and investors; we also believe that such failures can be an early indicator of short-termism in a business' strategy, operational inefficiency, gaps in leadership etc.

We monitor a 'Controversy Radar' that allows us to monitor the returns of the companies in our ESG database. Over seven years, we have found that whenever a stock jumped from a low category on the radar up to the most severe category-four or five controversies, it lost an average of 3% in one month (the two weeks before and the two weeks after its peak controversy rating). Moreover, over the past three years that average loss jumped to an astonishing 15%.

With this relationship in mind, we believe that sustainable investing is fundamentally about identifying well-managed companies that are positioned to thrive in a global economy that simply cannot keep on growing in the manner that it has thus far.
 

The world is not enough?

According to Jean-Claude Junker, President of the European Commission, we would need around four planets to maintain our current lifestyle. Climate-related extreme weather events cost the global economy USD300bn in 2017; in the last 40 years, the world lost a third of its arable land; in the next 40 years, 25% of the world's population will be above working age. Over this period, trillions of dollars of global wealth will move into the hands of a generation of millennial consumers for whom ESG is a leading investment priority³. In the same way that this generation will move markets, they will also motivate governments towards more stringent ESG regulation. The European Commission's Action Plan on Financing Sustainable Development and the ratification of the Paris Accord are two of examples of far-reaching regulations that will impact business, industries, economies – and ultimately portfolios.

But on the flipside of every risk lies opportunity. At our Responsible Capital Symposium in March, former US vice president Al Gore described the revolution in sustainability as the single largest investment opportunity in history.

As active managers, we analyse the market to isolate the potential winners in each sector and understand which industries and economies are adapting and innovating to meet the challenges that lie ahead. We then take this information and integrate it with the priorities of each client to build portfolios that are robustly positioned for the long term.
 

A 'whole portfolio' approach

With every sector of the global economy – from agriculture and industrials to autos and tech – likely to be touched by the oncoming seachange in regulation, resource availability and mindset, we see ESG as a multi-sector, multi-asset class, multi-jurisdictional issue. That said, the task of aligning these issues across asset classes and investment styles is not a simple one. As a result, we draw on a range of approaches that we have developed over 20 years of sustainable investing.

This experience allows us to seamlessly integrate extra-financial considerations into mainstream investment processes, and offers a robust solution to investors that want to invest responsibly without changing their core investment strategies. But we also acknowledge that more can be done better to integrate impact considerations into the ESG process.
 

What steps do we take to ensure that your portfolio can be more sustainable?

• Know what you own: Compute the ESG characteristics of the portfolio
• Define the 'sustainability' objectives that matter most to each individual client
• Implement into portfolios
• Impact investing: consider increasing the allocation to strategies that have a direct impact (e.g. green bonds).
• Stewardship: Using our rights as shareholders, we employ dialogue, engagement and our voting rights as a means of influencing companies towards best practice.

Finally, we do not presume that every investor's values are identical, or that each client will wish to implement ESG opportunities in their portfolios in exactly the same way. Our sustainable investment approach begins with understanding the objectives, principles and values of each client. We then use this as a starting point from which we integrate the issues that you care about into a portfolio that is designed to deliver the financial, environmental and social returns that you seek.
 

Investment takeaways

• The global economy is on the cusp of a sustainability revolution.
• Trillions of dollars of global wealth will move into the hands of a generation of millennial consumers for whom ESG is a leading investment priority.
• ESG-related failures can have devastating financial consequences for companies and investors.
• We see ESG as a multi-sector, multi-asset class, multi-jurisdictional issue.

¹Environmental, Social and Governance
²Data for the US industry is from US SIF, “Report on US Sustainable, Responsible and Impact Investing Trends 2016”; data for the European industry is from Global Sustainable Investment Alliance, “2016 Global Sustainable Investment Review.”
³2013 World Economic Forum survey of 5,000 millennials in 18 different countries found that they thought the top priority for any business should be “to improve society.”