With the explosive growth of environmental, social and governance (ESG) investing in recent years, it appears that we may be at or approaching an inflection point. As ESG investing becomes ever more prominent, it may be timely to ask whether, as currently practiced, it considers all issues of material importance to investors.
In this commentary, we suggest that current ESG research, analysis and investing practices pay insufficient attention to one of most important issues of our time: how people, societies and companies will adapt to a changing climate, and what that portends for stock and corporate bond investments.
The elephant in the room
To their credit, the sponsors of several prominent initiatives to promote climate-related disclosure (such as CDP) expressly request information on organizational risks and plans to address them. Accordingly, there is at least some expectation that such disclosures would describe alternatives to business-as-usual conditions and how the reporting entity might respond to them. Perusing a typical annual report or 10-K will show, however, that even today most corporate planning and forward-looking disclosures reflect the assumption of stable business conditions.
(Entities issuing securities — stocks or bonds — in the U.S. that may be purchased by the public must provide regular disclosure of important operating and financial information at defined intervals. These requirements include the issuance of an annual report and accompanying audited summary of key financial information [Form 10-K], as well as quarterly financial reports [Form 10-Q].)
It's time for ESG to consider how people, societies and companies will adapt to a changing climate, and what that portends for stock and corporate bond investments.
This state of corporate reporting and disclosure poses a problem for investors. Science and recent events tell us that environmental, societal and economic conditions will look very different in 20 years than they have in historical memory. Among the increasingly likely effects predicted by climate scientists and analysts are the following:
- "managed retreat" — abandonment of major portions the coastline and other low-lying areas in the United States and countries around the globe;
- potentially severe impacts on water availability, agricultural production, human health, productivity and other fundamental support systems and processes underlying viable societies;
- vast numbers of climate refugees, including in advanced economies; and
- failed nation-states.
In the face of these threats, it is clear that greenhouse gas (GHG) mitigation is necessary (to minimize future climate changes), but not sufficient. Now, and increasingly as these effects compound, adaptation to climate impacts must receive at least commensurate attention, promotion, support and funding to that dedicated to climate change mitigation efforts. (Indeed, this fact has been acknowledged in the 2016 Paris climate agreement.)
Profound changes in climate and severe weather are locked in for the next several centuries and will comprise "the new normal." Given this increasingly clear reality, mitigation is necessary to keep us from moving too far out into uncharted and very dangerous territory. Equally important though, is how well we will adapt to the inevitable changes.
The practice of ESG must adapt
If one accepts that climate change adaptation is vital, the next questions are how to make it happen and where to start. Fortunately, some productive steps have been taken, such as the guidance issued by the Task Force on Climate-Related Financial Disclosure (TCFD) regarding scenario planning. Attention to scenario planning as recommended by the TCFD can facilitate greater focus on the adaptation and resilience challenges faced by organizations and, in turn, inclusion as ESG factors. Careful planning and investment decisions that take account of climate impacts and include infrastructure that will better withstand these impacts needs to become standard business practice. Facility-siting decisions should further account for climate vulnerabilities and the adaptation steps that local governments are taking to address them.
Similarly, a rapidly changing climate requires some rethinking of corporate sourcing. Many organizations will be negatively affected when previously reliable supplies of materials, energy, workers, components, sub-assemblies and other vital inputs are disrupted. Procurement and distribution systems will need to extensively integrate predicted climate impacts and more agile methods as supply chains become increasingly susceptible to climate change impacts.
Thus, adaptation of the supply chain to increase resilience represents an important ESG consideration. Moreover, as the current worldwide COVID-19 pandemic has amply demonstrated, many companies already have over-extended their supply chains and have eliminated redundancies to the point at which they have become insecure and subject to failure, or not resilient enough to withstand additional shocks to the system.
The number and scale of looming climate change impacts likely will appear with an uneven spatial distribution, so it will be essential for larger, multi-site organizations (multinational corporations) to evaluate and strengthen existing stakeholder relationships and perhaps form new ones. This, too, is a form of adaptation worthy of ESG consideration.
These networks and collaborations will be particularly important in the context of the local communities housing company plants, distribution centers, headquarters, major offices and other facilities. Partnerships with other businesses and governments to encourage collective adaptation actions where they leverage complementary capabilities and are cost-effective also will be essential.
At a more general level, the challenges posed by the need for climate change adaptation provide corporate and other organizations with an opportunity to examine important aspects of their current orientation and operations through strategic planning. Performed thoughtfully, such strategic planning efforts can yield a revised or clarified vision and mission; actions indicated through a business, portfolio or asset review; a realigned organizational structure; and an updated understanding of indicated management steps to address business and financial risks.
Companies that accept and play this role effectively will prosper in the years ahead, while those that do not will experience increasingly limited prospects and eventual failure. To spur this necessary transition and, as always, provide asset owners with reliable positive risk-adjusted returns, professional investors must demand that corporate issuers provide evidence that they are actively managing their own adaptation to the new world that we are creating.
This commentary is part of a series on emerging issues from Adaptation Leader.