Environmental, Social, and Governance of Investment

To the Guild of Investment Managers at Farmers’ & Fletchers’ Hall, City of London, Thursday, 17 October 2019

My fellow Alderman and your Master, Robert Hughes-Penney, kindly asked me to provide some opening remarks.  I do wish I could stay longer, but as fellow Livery folk, you’ll understand that an Immediate Past Master of the World Traders needs to attend our Installation Dinner at 19:00 to become an Immediate Past Past Master or an Immediate Immediate Past Master, or some such.

The comedian Jay Leno once quipped, “According to a new UN report, the global warming outlook is much worse than originally predicted. Which is pretty bad when they originally predicted it would destroy the planet.”  Sadly, that quip was from 2007.

Environmental, Social & Governance credentials?  Mine go back to 1977 and environmental research, the first digital maps of the world, the World Conservation Monitoring Centre, London Accord of 2005, Long Finance, Policy Performance Bonds, and more.  While we talk ESG, these days we frequently focus a lot on “E” and not so much on “S&G”.  And “E”, for good reason, often focuses on climate change. 

Now, my first climate change debate was in the City in 1984 with fellow research analysts.  We had a credible thesis from Arrhenius in the 1890’s, a well-known externality, and increasingly compelling science.  That 1984 debate ended where it would end tonight – does society want to pay. 

This month we have Extinction Rebellion.  It’s worth asking, do activism and awareness make any difference?

In the 1967 film, The Graduate, Dustin Hoffman’s character, Benjamin Braddock, is given one word of advice by his father’s friend Mr McGuire, “plastics”.  Over the past two years plastics have been so vilified from David Attenborough on downwards that at a recent plastics industry dinner there was vigorous discussion of changing the brand from “plastics” to “polymers”.  Can you imagine the effect?  We’ll have to redub The Graduate, “one word Benjamin, polymers”.

But activism and awareness don’t usually make great economics.  In 2013 US drivers drove 4% fewer miles per capita.  That wasn’t because the message of the Sierra Club got through.  It was because petrol prices rose by 32% that year.  Society had to pay.

Sadly, complex issues often require complex solutions.  Activism and awareness are not enough.  For example, an extreme through-life-costing shows that you need to use a ceramic mug 1,006 times for it to be better using than 1,006 styrofoam cups.  No chipped mugs, no dropped mugs in 1,006 uses. 

A slightly complex economic issue is carbon emissions.  In Kyoto in 1997 a group of US policy wonks pushed their success trading sulphur dioxide emission permits to reduce ‘acid rain’.  Emissions had been reduced by 50% in 5 years.  Kyoto adopted carbon emission permits.  The City of London Corporation created a shadow market in 1999, adopted by the EU as the Emissions Trading System and launched in April 2005.  But EU nations including the UK issued more permits than their target.  Still, the ETS market worked perfectly.  Supply exceeded demand; prices crashed and languished till this year.  Society didn’t want to pay till this year.

Long Finance’s London Accord, which I co-led, was a cooperative effort, begun in 2005 among 24 investment banks to share investment research to save the planet.  The Accord was well underway before the Stern Review was commissioned.  Our 780-page report was launched in 2007 at Mansion House.  We used a Monte Carlo investment approach to conclude that “there are numerous potential portfolios that can achieve abatement up to about 15Gt along the $40/tonne radial line”, at an incremental cost to society of US$400 billion to US$500 billion per annum.  Yet 12 years later those investments have not been made at the scale required.  Investors are still betting on fossil fuels.  Society doesn’t yet want to pay.

In 2006 Long Finance created the “Burn-It-All” project that initiated “Unburnable Carbon” discussions, later “Stranded Assets”, and that led Andy Haldane, later Mark Carney, to invoke financial instability as a reason to pay attention to ESG.  The instability arises from huge price adjustments to balance sheets.  We have just over 400ppm at the moment.  Current balance sheets have almost full value for fossil fuels up to 1200 ppm.  Scientists say 450ppm to 550ppm really really really is the limit.  If we reprice to 500ppm or so these are enormous write downs.  Investors are still betting on fossil fuels.   Society doesn’t yet want to pay.

We could look at the time-tested IPAT equation – Impact = Population times Affluence times Technology – and explore the role of overpopulation.  We could spend some time on definition and approaches.  Regulators and capital adequacy folk are pushing risk approaches.  The buzz on green bonds is about marketing.  Areas like sukuk are being folded into ‘social’ because they haven’t taken off in their own right.  And folks like me push hard for policy performance bonds tying interest to outcomes, as recently issued by ENEL, Nokia, and Louis Dreyfus.

What might I throw out for discussion today?

The first is probably to consider how many ESG issues are actually about valuing volatility reduction.  I’ve often noted that faced with a distribution a firm can do four things – get out of the distribution, lose the tail end risk (e.g. insurance), improve the benefits (e.g. cut costs or improve marketing), or tighten the distribution around positive results (reduce volatility).  Equally, reducing volatility is related to resilience.  Building better, longer-term infrastructure and encouraging mitigation projects would be one implication.  Valuing volatility reduction favours longer-term renewables over fossil fuels.  Volatility reduction favours an energy storage market.  Volatility reduction favours recycling.

Second, I might point out the interest rate and discount rate conundrum.  12 years ago Stern’s review stated that then current social discount rates didn’t favour longer-term decisions and wanted us to adjust the discount rate down by half a percentage point to avoid climate change – not exactly the way we make investment decisions, but that’s macroeconomics for you.  Following the financial crises, the discount rate has been close to zero, but I haven’t seen us making any better decisions. 

Third, I would suggest a moral dimension we should push more strongly.  Our obligation to promote open markets.  How pathetic that government guarantees are needed in an industry that claims high rewards.  Once we have chosen a market-based approach, as we have in financial services, we must prove to society it’s working.  Jokes about government guarantees or comments about ‘privatising gains, socialising losses’ hurt enormously.  Perfect markets don’t exist. We know the failures, lack of competition, information asymmetry, agency problems, and externalities.

Society has many ways of solving resource allocation issues.  Markets are one choice.  We have a moral obligation to prove to society that the open market model is better than the alternatives, such as command-and-control, taxation, state-control, or a monopoly.  We should police our markets’ ourselves for our own benefit, no LIBORs, PPIs, FX scandals, RBS GRGs, etc.  We knew them but left them for the regulator to discover, and then sat on them to boot.

Finally, crucially we should ask why ESG exists at all?  If markets priced the externalities, then the monetary and financial systems should be producing the right decisions.  We can’t have it both ways – claiming the market is always right then claiming ESG will fix it.  Creating parallel markets with new data, data divorced from financial outcomes, should terrify us.  It tells us the markets aren’t working.  We’re creating what are, in effect, parallel currencies and confusing decisions.  How much is sustainable timber worth to my firm over unsustainable?  Why should I have to price that?  ESG from the outside can rather look like jobs for the financial analytical boys and girls.

During the financial crises in 2009, a BBC news team stopped a young banker on Finsbury Square and asked him to address Adair Turner’s rhetorical question, isn’t banking “socially useless”?  The young fellow was flummoxed, shrugged his shoulders, and slunk away.  How terrible is this – to go to work each day with no social purpose?

I would hope that before me is a group of people who will explain clearly to the BBC news team that Robert has assembled outside why finance is socially useful – facilitating trade & commerce, providing social protection, promoting financial stability.  Finance helps us make much better choices using society’s great decision-making mechanism, the monetary system.  We have a boon with society.  We’ve sold society a dream based on a theory, economics.  To move towards that dream we have to work together building open and competitive financial services markets that price externalities. 

ESG is perhaps a useful stage on a path to sustainability, but equally I would like to ask you to push hard on another question tonight.  “How can we build an even brighter future where ESG is financially useless?”

Thank you.

[And thanks to Alastair King and Elisabeth Mainelli for helpful comments.]