Patrick Odier, Senior Managing Partner, Lombard Odier, writes exclusively for WEALTH Arabia about why ESG-conscious investment is becoming a necessity
editor's pickSunday 06, January 2019
Are you ready?
At Lombard Odier we believe the world has reached a tipping point. Our world is changing and we have to change with it.
Our current global model is not sustainable, and this challenge goes way beyond the single, albeit very important, issue of climate change. It is one of five megatrends that are set to have an undeniable effect on the world we live in.
Those effects are already being felt. Our population has grown 70 per cent in the last 70 years and will grow by another one billion people over the next decade. We use resources 1.7x faster than the world can replace them every year, and too many people are still excluded from access to capital, basic goods and services, and healthcare.
Climate change is exacerbating all of the above, creating both physical and transition risks, and technology is changing our lives at an extraordinary pace. According to the World Economic Forum, the pace of the digital revolution is such that 65 per cent of children will have jobs that do not even exist yet.
A changing world
These forces will have a transformative effect on our economies. Companies will have to find new ways of doing things. Many will have to change what they produce, find new innovative solutions, and adapt to rapidly changing demands from regulators and consumers. Transition means risk, but it also presents substantial opportunities. Needless to say, companies that are prepared and well positioned for a more sustainable world are more likely to thrive and prosper.
From an investor’s perspective, this also requires change. Investors have to look at companies in a much broader way than before in order to locate sustainable returns over the long term.
Change is coming and it will affect every company and every sector in every corner of the globe. We will have to disrupt many of our systems and processes on a profound scale, fundamentally changing how we do some of the most simple day to day tasks.
Take, for example, transport. Demographic change will lead to higher mobility, migration, urbanisation and a huge increase in the volume of people transport systems have to carry. At the same time, resources are getting scarcer, affecting the cost efficiency of current transport models. Carbon emissions will increasingly need to be reduced and avoided to fight climate change. This is highly likely to mean a significant increase in the cost of carbon in the coming years, a trend which is already becoming apparent. As a result, we need to rethink transportation. It needs to be more scalable, fast, efficient and emission free.
Other sectors face the same challenges, including food systems, education, health care and many more, including how and what we recycle.
It is no longer a choice
We are at a tipping point because there is no longer a choice of whether or not to adapt. The forces driving change are increasingly formidable. The transparency and accountability that comes with more, and more readily available, information is already changing how consumers behave and what they buy. It is also changing how they vote. Consequently, the political agenda is changing too.
A critical policy milestone was recently reached, when global governments came together to both adopt the 17 Sustainable Development Goals, and to sign up to the Paris Agreement to limit global warming to well below two degrees centigrade. These agreements put us irrevocably on the path towards a sustainability revolution. Today, change is not just inevitable. It is highly likely to accelerate.
Even with the rulebook for implementing the Paris Agreement now agreed at COP24 in Poland last month, the current commitments made under the Paris agreement will not be enough to achieve its objectives. Countries will have to implement reform harder and faster than they currently are, and this will start to take hold in the very near future.
The EU’s new Action Plan for Financing Sustainable Development is one example of how far and how fast regulatory change is starting to happen. And, of course, capital markets are not blind to this. There is already a significant shift underway in how money is being put to use in the economy.
Who has to change?
In a complex ecosystem like our global economies, everyone has a part to play in developing a more sustainable system. Companies are responsible for making sure they adapt in a smooth, orderly manner. This will be essential if they want to continue to grow and attract capital. It also means providing more transparency and disclosure to allow investors to make more informed decisions.
Asset managers also have to adapt and innovate. It is essential to find better ways of working out how sustainable companies and countries really are, and where their strengths and weaknesses lie. Asset managers also have a critical role to play in encouraging companies along the road to orderly transition.
Asset owners are also important players. Demand is perhaps the strongest force for change. If asset owners ask the right questions of their managers and the companies they own, and direct more of their capital towards sustainable businesses, their voices quickly build into a roar that is very difficult, if not impossible, for companies to ignore.
Asset owners can do this by defining their long-term beliefs, values and objectives. What level of carbon emissions or water consumption do they want to target? How important are the sustainable development goals? Increasingly, we see asset owners focusing not just on what money is made, but how that money is made. This is a vital ingredient for our future sustainability.
How does change happen?
This process has evolved over the years. Exclusions out of a sense of social responsibility were a popular first step because some things just don’t belong in a portfolio or in the capital markets. At Lombard Odier, we have group-wide exclusions on controversial weapons and essential food commodities.
While exclusions are a very efficient way of expressing investor’s values, they do not necessarily support and drive the change within a sector. There is still always someone on the other side of that trade. The next step is to look at sustainability through the lens of risk mitigation. Considering non-financial Environmental, Social and Governance (ESG) criteria can be used to mitigate risk effectively.
Rather than taking an exclusion approach, we believe it is more impactful and effective to differentiate between the best and worst—essentially promoting the best students in a class and limiting our exposure to those who prove less willing or able to adapt.
Given the scale and pace of the sustainability revolution, we believe it is going to be the biggest driver of investment returns in the future. We are therefore building and improving our processes for identifying the business models that are best placed to benefit as our economies continue to transform.
At Lombard Odier, we have a long and prestigious history of thinking sustainably. This was built into the foundations of our bank, and is a large part of why, 222 years later, we are still going strong. Our independent, partnership structure gives us the flexibility to think in generational terms, not quarter to quarter. We believe this makes us uniquely positioned to generate returns for our client as the Sustainability Revolution continues to unfold.
What are the three pillars?
When it comes to integrating sustainability into portfolios today, we take a three-pillar approach. We believe these pillars are interlinked and interdependent—take one away, and the whole system is much more vulnerable to collapse. Our first pillar assesses the sustainability of the financial model. Can a company continue to generate excess economic returns? Is it likely to maintain its credit quality and solvency?
The second pillar looks at the sustainability of their business practices. How well is the company run in the context of its broader ecosystem of stakeholders? This is where ESG criteria are employed. Data is a really important factor in creating more sustainable outcomes. The more non-financial data, and the more robust it is, the easier it becomes to root out biases in the system, and get a true understanding whether companies are genuinely transitioning to more sustainable business practices.
But sustainability is about so much more than just ESG. This is why our third pillar looks at the sustainability of companies’ business models. As our economies continue to transform, how are sectors likely to benefit? How do they need to change? Can coal continue to compete in a world where the cost of renewables is rapidly decreasing? How will that affect the value of unburned fossil fuel assets that are currently marked to market on the balance sheets of energy companies? What are the energy sources of the future?
We also believe strongly in the importance of active ownership. Stewardship is is a valuable tool to help companies transition in an orderly fashion, to adapt and increase their resilience. Dialogue and engagement can help influence companies into adopting a more sustainable operating model.
When we put all of this together, it becomes easier to see the sustainability revolution for what it is—the biggest driver of investment returns in modern history. It will require us to fundamentally rethink sustainability, rethink investment and, in fact, rethink everything.