Along with rapid technological progress, the growing importance of environmental, social and governance (ESG) performance to investors (and ultimately to voters) may well become one of the most important forces shaping the new global economy. Demographic change—including the rise of millennials and rapid population growth in many climate-vulnerable countries—will be another key driver, the Institute of International Finance (IIF) said in a note this week.
While policymakers around the world are seeking ways to channel more private funding towards sustainable development, investment vehicles such as green bonds are still in short supply.
At the same time, demand is rising: following record inflows of over $15bn in October, net flows into ESG-dedicated Exchange Trade Funds (ETFs) have already topped $40bn YTD —up over 65% from the same period in 2018.
While the bulk of these flows still go to equities, innovative new products such as blue bonds and sustainability linked loans have boosted appetite and helped build out the ESG debt universe. But perhaps the biggest driver of demand for sustainable investment has been the policy impetus—notably the European Commission’s Action Plan on Sustainable Finance.
ESG bonds—gradual market development: Amid growing agreement on the materiality of climate-related risks to long-term value creation, asset managers and owners have gradually been incorporating ESG considerations into their investment strategy—for fixed-income as well as equities. This has underpinned a surge in issuance of sustainability-linked products across the credit spectrum. However, the overall ESG bond market remains small—less than 1% of the $110 trillion global bond market.
Real growth will require significant market development, including better corporate disclosure as well as simplification in sustainable investment terminology—all of, which will help ward off “greenwashing.”
As the ESG bond market develops, relative value is likely to become more of a consideration. With the first green bond issued in 2007, and most issuance dating back only to 2015, the market has a very short track record. Moreover, virtually all of this issuance has been during a period when accommodative monetary policy has inflated global asset prices and dampened volatility. Despite early evidence of good risk-return tradeoffs and diversification benefits, markets still price ESG and investment grade bonds similarly (ESG spreads trade in the A+/BBB range of the credit spectrum).
Many central banks are looking more closely at climate-related risks for the financial sector. For example, the BoE has announced that in 2021, it will begin “stress testing” supervised institutions on different climate pathways. More broadly, climate-related risks are increasingly seen as a potential threat to financial stability, and models based on business-as-usual assumptions may fail to capture the far-reaching impact and irreversibility of climate change. The need for data and for commonly accepted methodologies to assess and measure climate risk is a key focus for the IIF Sustainable Finance Working Group.
2020—a climate super year?
As 2020 approaches, many experts across scientific and policy circles suggest next year may be a “climate turning point,” arguing that the Paris Agreement goals of limiting global warming to “well below” 2°C above pre-industrial levels, to strive for 1.5°C, and to reach global net zero emissions by 2050 are realistically feasible only if global emissions peak by 2020.
While “peak carbon” seemed within reach when fossil fuel emissions actually decreased in 2015, these hopes have been dashed as CO2 continues to reach fresh highs.
More sobering still is the concept of carbon budgeting, whereby man-made emissions have totalled some 2200Gt over the past few centuries: scientists estimate that the planet can only absorb an additional 420Gt for global warming to remain below 1.5°C with at least a 66% probability.
Even in the improbable event that the world manages to stabilize emissions in 2020, without reductions from current levels the likelihood of achieving 1.5°C would fall to 50% in 10 years and to zero 20 years from now.
Indeed, the global economy is decidedly off-track: none of the 2020 milestones across energy, infrastructure, transport, land use, industry, and finance to achieve Paris goals (and SDGs by 2030) have been met. Among the few bright spots are public investment in climate action, shipping sector emissions, and renewable energy. Policymakers will thus have their work cut out for them in a supercharged schedule beginning with COP25 in Madrid next month. The 2020 agenda features an ocean summit and the UN’s 75th anniversary, along with work to reset targets for the Paris Agreement, the UN Convention on Biological Diversity, and various environmental SDGs at the High-level Political Forum on Sustainable Development.