‘Less clarity and lower expectations’ leading to COP27

Morningstar's Kemp says ESG investors must adapt their approach to less favourable conditions this year

As COP26 recedes into history and we look ahead to COP27 later this year, the change in the backdrop to these discussions is striking. The smooth-seeming path following COP26 has become rougher in the face of escalating geopolitical and macroeconomic challenges. Specifically, we are faced with three key challenges if COP27 is to be a success: a change in focus, inflation and tightening monetary conditions.

Although the challenge of climate change has not abated, newer concerns have replaced it in the minds of politicians and the private sector. The most important of these is the apparent breakdown in the security we have enjoyed in Europe since the end of the cold war. Consequently, the attention of politicians is increasingly being dragged from longer range concerns to the immediate challenges of energy and food security. As both energy and food production are major contributors to climate change, it seems likely that this will dampen the resolve of governments to address the contribution to climate change of these sources, preferring instead to address the security of supply.

The second challenge to further progress at COP27 is that inflation is reducing the disposable income of consumers and they are consequently less able to choose more climate friendly options when such a choice results in increased costs. Higher inflation results in consumers struggling to favour long-term benefits at the expense of higher short-term costs, such as replacing their existing ICE car with an electric alternative.

This has the potential to reduce demand for more sustainable options which in turn could lengthen the time it takes for suppliers of more climate friendly alternatives to achieve profitable scale. Without lowering the ‘green premium’ associated with newer climate friendly alternatives, consumption is unlikely to shift quickly enough to meet existing targets. On a more positive note, the rise in energy prices makes alternative energy generation more attractive and consequently shortens the payback period of higher current spending.

Third, the tightening monetary conditions that follows a rise in inflation is likely to increase the cost of capital for companies, lowering excess returns and discouraging investment. As we need significant investment in climate-friendly initiatives, this could further delay progress towards meeting our goals.

Solutions

While the impact of these challenges is uncertain, we move towards COP27 with less clarity and lower expectations than those at the end of COP26. So the question becomes: how can investors respond to the changed environment?

As politicians contend with other issues and consumers are challenged by higher costs, the allocation of capital becomes a more important leaver of changes. As investors, our focus must always be on the long term and so engagement with corporate boards to prepare for transition to a net-zero world becomes more important.

To do this, we need to move beyond simple exclusion criteria and instead become more active owners of the companies in which we invest. Research by Jackie Cook at Morningstar shows there has been a marked increase in the support for shareholder resolutions relating to environmental and social issues.

Not to forget, valuation becomes more important when selecting investments. With the potential for rising cost of capital, compressed margins and lower growth, it is important to not overpay for assets and ensure the valuation at purchase represents an attractive return, ideally with a margin of safety. Such investments are increasingly difficult to find and consequently, investors need to be more selective in their approach.

This requires a more granular approach to investment. When attractive opportunities are scarce, the ability to be highly selective is important. While broad global strategies have delivered very attractive returns over the past few years, this is less likely to be repeated in the near future.

Fortunately, the large number of ESG product launches over the past few years is making it increasingly possible to achieve a similar level of granularity when building an ESG portfolio to a conventional portfolio. Assessing investment opportunities at a more granular level requires a more detailed investment approach and so may require investors to rethink their research and asset allocation structure.

As the path towards meaningful progress in the near term is harder, it is necessary for investors to adapt their approach to less favourable conditions if we are doing to meet our twin objectives of reducing the impact of climate change and empowering investor success.

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Natasha Turner

Natasha is global deputy editor at ESG Clarity, part of the Bonhill Group, and has been a financial journalist for six years. She has been shortlisted for Story of the Year and Investment Journalist of...