Challenges Related to Environmental and Social Factors Encountered by Institutional Investors

Universal Ownership, Externalities, and Responsible Investing

The challenge for universal owners lies in effectively managing risks stemming from these externalities. Costs externalized by one portfolio company can impact the profitability of others, affecting overall returns. For instance, investments in a polluting plastic manufacturer could harm downstream agriculture operations.

According to the Principles for Responsible Investment (PRI), environmental costs can impact portfolios through various avenues like insurance premiums, taxes, and expenses tied to weather-related disasters. Addressing environmental damage often proves more costly than preventing it, underscoring the importance for institutional investors to consider these negative impacts on society and factor them into their decisions.

Material Environmental Issues for an Institutional Investor

Physical Climate Risks

Since the turn of the century, climate change has significantly impacted our physical environment. Global average temperatures continue to climb, with 19 of the warmest years recorded since 2001 (NASA 2019). Erratic weather patterns like intense rainfall, droughts, hurricanes, and increasingly severe wildfires are becoming more prevalent. Coastal flooding due to rising sea levels remains a persistent concern.

As climate change persists, these physical climate risks may intensify further, potentially becoming an established norm for our world. The extent of their impact on economies and investments could be influenced by global responses to climate change in the upcoming decade, potentially mitigating their effects to some degree.

Effects on Tangible Assets

Continued environmental shifts threaten various assets, including real estate and infrastructure. Rising sea levels may affect coastal properties, altering their values and rental potential. Prolonged exposure to extreme heat could hasten the deterioration of transportation networks, prompting frequent replacements and higher costs.

Additionally, more frequent and severe weather events, previously uncommon and uninsured, could dramatically reduce asset values and amplify insurance expenses. Most flood-related losses worldwide lack coverage, intensifying strain on national economies. These increasingly frequent climate-related risks are expected to lower prices and income from high-value real estate, impacting asset valuations long-term. Institutional investors aiming for sustained growth and capital preservation must incorporate these risks into their portfolio strategies.

Transition Risks of Climate

Countries and corporations worldwide are striving to reduce CO2 emissions to comply with the 2015 Paris Climate Agreement’s target of limiting the global temperature rise to within 2 degrees Celsius. Scientists stress the urgency of cutting energy-related CO2 emissions by 25% by 2030 and achieving “net zero” emissions by 2070 to meet this goal.

Initiatives like the European Union’s sustainable finance taxonomy support the shift towards a low-carbon future, aiding investors in assessing the environmental sustainability of economic activities. The necessity for this transition is apparent, given the potential adverse effects of failing to cap global warming at 2 degrees Celsius.

However, the pace of this transition remains uncertain. Rapid shifts could entail emission restrictions, carbon pricing, technological innovations, and changes in consumer behavior, potentially disrupting sectors like energy and automobiles significantly. Forecasts indicate that by 2030, half of the world’s vehicles should be electric to achieve carbon neutrality by 2050.

The PRI’s Inevitable Policy Response (IPR) project predicts climate-related policy risks emerging by 2025, foreseeing a forceful, abrupt, and possibly disorderly policy response due to delayed action. This response could pose significant risks to institutional investor portfolios, underscoring the need for strategies to mitigate climate transition risks.

Prospects in Climate Initiatives

Investors are exploring new investment avenues within climate change-focused companies, aiming to combat and adapt to climate challenges. These prospects span secondary markets, tangible assets, and infrastructure projects like wind and solar farms and smart grids. Notably, the decreasing cost of renewable energy technologies has made them viable competitors against conventional energy methods, such as coal-based power generation.

Material Social Issues for an Institutional Investor

Environmental concerns like climate change and air pollution are well-established and relatively more straightforward to incorporate into financial models. However, social issues such as community relations, occupational health, data security, human rights violations in the supply chain, and inequality pose challenges in quantification and integration. These issues lack concrete metrics for long-term performance evaluation, relying more on qualitative data such as company policies and initiatives. Yet, they hold significant potential to harm a company’s reputation and finances if not effectively managed.

Handling Community Relations and Maintaining The Social License To Operate

Large institutional investors, like sovereign wealth funds and public pension funds, wield substantial influence with their investments, capable of generating positive social impacts like improving infrastructure and healthcare accessibility. Conversely, these investments can also lead to negative consequences such as poor labor practices or mishandling community displacement by the companies they support. EsStrongorporate behavior cultivates positive community relations, a cornerstone for maintaining sustainable, mutually beneficial long-term partnerships.

Consider a hypothetical scenario where a sovereign wealth fund invests in a dam-based hydroelectric power plant in an underdeveloped area. While the project pledges positive environmental outcomes through renewable energy, its social implications are mixed. Despite contributing to rural electrification and regional economic growth, the project’s land acquisition practices necessitate relocating indigenous communities. This sparks protests due to inadequate consultation, unfair land valuations, and forceful removals by local authorities, leading the fund to halt the project due to extensive societal resistance.

This scenario emphasizes the importance of evaluating social risks in investments. Despite the aim of advancing renewable energy in an economically disadvantaged region, the fund faced backlash and reputational harm for neglecting stakeholder interests, particularly those of the affected communities. Effective community relation strategies involve thorough stakeholder consultations, addressing concerns, offering alternative employment, and ensuring fairness in land practices during acquisition and resettlement.

Supply Chain Labor Concerns

In a globalized marketplace, labor issues within supply chains have intensified, primarily driven by the migration of manufacturing to nations like India, Vietnam, and Malaysia. While this move has boosted profits for multinational corporations, it often occurs at the expense of exploited workers, featuring problems like excessive reliance on temporary labor, forced overtime, low wages, and restricted labor rights.

These issues extend across key sectors like technology and garments, implicating significant brands such as Nike, Gap, Apple, and Samsung, facing accusations of labor-related oversights in their supply chains. Such allegations pose risks of significant brand damage, consumer backlash, and potential supply chain disruptions or recall costs.

Addressing these concerns during investment evaluations becomes paramount for sovereign wealth funds (SWFs) invested in these influential apparel and tech companies. The absence of transparency in supply chains and labor management deficiencies can profoundly impact supply chain resilience, especially during global crises like the COVID-19 pandemic. Furthermore, neglecting these factors could risk damaging the reputation of SWFs, potentially associating them with supporting unethical business practices if not appropriately addressed.

The “Just” Transition

Sustainable development involves meeting current needs while securing the ability of future generations to do the same. It covers economic, social, and environmental facets that are interconnected. Moving toward environmentally sustainable economies might lead to challenges like job displacements in sectors such as coal mining, increased energy costs due to sustainable practices, and shifts in commodity prices.

To navigate these challenges, a “just” transition is vital. It aims to balance environmental improvements with minimal negative social impact. This approach advocates for dialogues among workers, industries, and governments, considering diverse geographical, political, cultural, and social factors. While there’s no fixed blueprint, the just transition highlights collaborative efforts across various contexts to address these challenges effectively.

Question

What are some of the most likely environmental concerns impacting institutional investors?

1. Effects on intangible assets only
2. Social climate risks and insurance coverage
3. Physical climate risks and their effects on tangible assets

Solutions

The Correct Answer is C.

It accurately reflects the primary environmental concern outlined in the passage. It highlights the impact of physical climate risks on tangible assets like real estate and infrastructure, which is crucial for institutional investors to consider when evaluating their portfolios in the context of climate change.

A is incorrect. It solely focuses on intangible assets, disregarding the significant impact of physical climate risks on tangible assets like real estate, infrastructure, and other physical properties, which was the primary environmental concern discussed in the passage.

B is incorrect. It introduces a different aspect by mentioning social climate risks and insurance coverage, which were not the primary environmental concerns outlined in the passage. The focus of the discussion in the passage primarily revolved around physical climate risks and their implications for tangible assets rather than social risks or insurance coverage.

Reading 16: Cases in Risk Management – Institutional

Los 16 (b) Discuss environmental and social risks associated with the portfolio strategy of an institutional investor