Environmental impacts are the new black for investors
Environmental impacts will be weighed up more precisely in the future, and this will be both an opportunity and a threat for businesses. A wise company will win over customers, receive financing on more affordable terms, and ensure its position in investors’ portfolios. Indifference to environmental issues could lead to a gradually increasing systemic risk that may erupt like a financial crisis.
Environmental impacts are the new black not only for consumers but increasingly so for investors. Although the trend in impacts is known in the case of many companies, there are not as yet adequate tools to quantify the rise in costs, increase in risks and potential yield.
Corporate valuation is still often ineffective when it comes to assessing environmental impacts. On one hand, innovative, environmentally focused companies may be undervalued, on the other, price-change risks are not adequately considered in some companies. According to CDSB (Climate Disclosure Standards Board), for example, the integration of environmental impacts into cash flow-based corporate valuation could lead to a significant correction in stock markets. The most critical observers even see resemblances to a financial crisis: a gradually increasing systemic risk that, if it were to erupt, could destroy value and weaken mutual trust between market parties.
Share market has heard only the prelude to the environmental symphony. The integration of environmental impacts into corporate valuations could lead to a significant correction in stock markets.
At a European level, there are ongoing projects that are preparing companies to be more transparent, thereby preventing sudden corrections. One of these is a team established by the G20 nations, the Task Force on Climate-Related Financial Disclosures (TFCD), which issues recommendations on how companies should report financial impacts related to climate change. According to these recommendations, companies should draw up forward-looking scenarios of how climate change will impact their business and financial development. More than 200 companies – with a total market value of about EUR 5 000 billion – have already committed to these recommendations. To add some perspective to this, market capitalization on the Helsinki Stock Exchange is less than 500 billion.
Emissions allowance prices have been fairly low for a number of years, but we need to take a more long-term view when evaluating emission-related costs. The EU is seeking to influence the price of future emission permits by reducing the number of emission allowances available in the market. The EU has also extended its emission reduction targets to cover industries outside the emissions trading sectors, such as transport and construction.
As the intention is to transfer any increased costs all the way along the value chain to consumers, it will not only be companies that feel the impact. Environmental factors can also be seen in everything from corporate credit ratings to equity risk premiums, and thereby affect both the availability and cost of financing. All of these combined will change investment calculations, and steer enterprises towards more environmentally friendly investments.
In the same way that companies are now requiring their suppliers to comply with ethical principles, they can also be required to report on their environmental impacts. Increased transparency throughout the production chain will gradually steer demand towards companies that operate responsibly. A strong focus on sustainable choices will be vital for companies in the long term, and will bring responsibility into the Board room as a tightly integrated component of both strategy and executive remuneration.
In many sectors, such as the engineering, electronics industry and IT, companies provide solutions that can help their customers to reduce emissions. In the IT sector, these impacts can even have a net positive value, that is, the favourable impacts on customers’ business operations can exceed the company’s environmental loading.
Investors’ decisions are always based on future expectations. By the time the extent of these changes has been grasped and reporting is sufficiently standardized, the impacts will already be visible in prices. Which is why investment portfolios should already be gradually shifting their focus in a more sustainable direction. Investors have, with foresight, taken steps in the correct direction. There has been a strong rise in the number of responsibly managed investment products in recent years. Over half of the world’s investment wealth is managed by asset managers that are committed to following the United Nations Principles for Responsible Investment.
Higher emissions allowance prices and cost of capital will steer enterprises towards more environmentally friendly investments
Financial incentives often steer people and companies in the desired direction. When it comes to reducing environmental impacts, societal steering is currently based on factors such as legislation, taxation and EU emissions trading. Financiers are keeping ahead of upcoming changes by targeting their investments increasingly towards low-carbon alternatives. Consumer demand for environmentally responsible products and services has likewise risen.
As consumers, every one of us can demand the environmental labelling of products and services – in the same way that foods and beverages must state their calorific content.
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This blog is a translation of an article published in Tebatti of Talouselämä, a Finnish financial magazine.