Gareth Sutcliffe and Holger Schalk look at the impact of ESG regulation, and different approaches to implementation
Interpretations of sustainable investment differ, and investors behave along a spectrum of investment approaches. While traditional investment often does not involve any real consideration for sustainability practices or societal impacts, responsible investment is concerned with avoiding the downside risks associated with sustainability factors. You then have the sub-asset class of sustainable investment, which is about adapting progressive sustainability techniques in your investment portfolio with a view to adding value and outperforming a traditional investment portfolio. Impact investing, on the other hand, aims to address specific societal challenges. Some of these types of investments provide a risk-adjusted return that can compete with or beat traditional investments, but others offer a lesser return – you are essentially making an investment for the greater good of society.
Whatever your precise definition of sustainable investing, three core factors are likely to play a key part in investment decision-making – environmental, social and governance (ESG) (Figure 1).
What are insurers doing?
Many insurers have stopped underwriting and investing in coal companies. This is not without challenge, even for early adopters that are passionate about sustainable investment. While some are taking these decisions because of convictions that supersede purely financial considerations, most are engaged in sustainable investment because of the improved risk-adjusted outcomes. Divestment from polluting industries such as coal may be a factor, although a more important consideration is the full integration of sustainable investment principles throughout policies, processes and portfolios.
The industry is about to be hit by a raft of regulations, driven by EU commitments made under the Paris Accord of 2015 and by the European Commission’s 10-point action plan, which has aggressive timelines for implementation. Two of these 10 points are particularly significant: the classification system for sustainable investments, and the incorporation of sustainability into financial advice and prudential requirements. This means insurers must understand the ESG preferences of their customers, and will need a way to identify their beliefs and put them into an ESG category. More importantly, the Commission says that, in future, insurers must offer customers products that fit their ESG preferences – and they will be subject to mis-selling risk if they fail to do so.
According to the European Insurance and Occupational Pensions Authority, there are financial risks associated with sustainability. Insurers should therefore already be managing these in their investment strategy through the Prudent Person Principle, and on the risk management side through their Own Risk and Solvency Assessment. The Prudential Regulation Authority has also stated that it expects insurers to be modelling and managing physical, transitional and liability risks.
Physical risks may concern exposure to climate change events or natural disasters, and the subsequent risk of damage or loss to an insurer’s assets.
Transitional risk is when an asset suffers a loss of value, possibly caused either by regulatory change or disruptive technological advancement. For example, a global ban on the use of coal at some point in the future could result in the value of mining company shares suddenly falling to zero and becoming a stranded asset.
Liability risks will arise from parties seeking compensation for losses incurred due to the physical and transition risks associated with climate change. Legal liability for losses and damages associated with these risks could be transferred to the insurer through some types of policies.
Sustainable investing, sustainable profits?
With sustainable investing being a relatively recent phenomenon, the historical data available for analysing its performance is far more limited compared with that for other investment themes. On balance, the evidence does suggest either a neutral impact from having a sustainable investment-tilted portfolio, or a moderate risk-adjusted long-term benefit.
More compelling evidence can be found by differentiating between individual ESG components. The strongest evidence is for the impact of governance on investment performance. Most asset managers have shown a commitment to embedding the governance principle into their policies, as a company with good governance, a long-term horizon and good corporate social responsibility is likely to be better managed and add more value over time.
As the focus on ESG factors is a recent trend, the link between environment and social factors and investment performance is less clear cut. That being said, environmental scientists, regulators and politicians are increasingly pointing to the real risks associated with climate change, suggesting a tipping point may have been reached in which companies that do manage this risk are more likely to achieve a better outcome.
Exclude, engage or tilt
There are three options for implementing a sustainable investment portfolio: exclude, engage or tilt. Exclusion means not investing in certain assets, such as munitions, cluster bombs and landmines. These are sometimes excluded on moral grounds and, from an investment point of view, are so insignificant in size that investment performance is unaffected. While there is significant evidence to suggest that excluding stocks will detract from value in the long run, this is increasingly being challenged, and the issue is unresolved.
Tobacco stocks, for example, have tended to outperform indices in the past, but this has become less clear in recent times and there is no indication that they will continue to do so. In industries that may qualify for exclusion from an ESG-focused portfolio, some companies have started to invest in alternative products and services. This complicates the issue of exclusion and raises the question of whether it is more productive to engage with these firms and their move towards more sustainable business models. Oil companies, for example, are some of the biggest investors in renewables. Engaging with them would enable an insurer to use their ownership to push for change within the company. Exclusion, on the other hand, should perhaps be left as a last resort when engagement fails to deliver the necessary results.
A tilt signifies ‘leaning’ towards good ESG risk management through portfolio construction. Individual names or shares need not be excluded but can be underweighted, either due to a current ESG score or a trend in the score.
Adapting portfolios to climate risk
A recent study from Smurfit Business School showed that only 43 companies worldwide reported 100% of their greenhouse gas emissions. Another 23 companies reported at least 95% of the same emissions, while the remaining companies reported less. Consequently, the ability to monitor the investment portfolio with regard to environmental impact remains an issue.
In the past, a lack of interest and scrutiny has made it possible for ESG risks to remain hidden. Today, the steady growth of ESG investing has brought sector risks to the surface and impacted asset prices. The big challenge for governments, industries and individual companies will be to successfully adapt to a new environment that favours smarter, cleaner and healthier products and services by rebuilding and reshaping the economy in a more sustainable way. Whole sectors will inevitably be affected, from greenhouse gas-intensive industries to the automotive sector.
Regardless of a company’s belief in sustainable investment, few question the escalating threat presented by climate risk. At the very least, insurers will need to incorporate climate change effects into their investment and underwriting strategies. Insurers will also need to be prepared for changing customer demand, as this may happen quickly and shift the landscape dramatically.
Gareth Sutcliffe is head of insurance investment at Willis Towers Watson
Holger Schalk is a director of insurance consulting and investments at Willis Towers Watson