We desperately need to embed science in sustainability investing
This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum./
Author: Francesco Curto, Ex-Global Head, Research, DWS; Ex-Head, Cash Return on Capital Invested (CROCI) Investment Strategy and Valuation Group, Deutsche Bank AG
- How can the financial sector really make capital have an environmentally and socially sustainable positive impact on our planet and humanity?
- Disclosure and accounting rules need to go beyond financial materiality towards integrating full environmental and social costs of business.
- We need to bring scientists into the debate on how to embed science and the economic impact capital has in corporate financial statements.
In December, I happened to be in Montreal, Canada at the same time as the United Nations (UN) conference on Biodiversity, COP15. As I was taking a stroll, I literally walked into a peaceful protest taking place downtown. The protest was against the UN conference.
In the previous days, several other protests had also taken place. The protestors’ argument was that an agreement to protect biodiversity would give the impression that the issue was being addressed, but such an impression was not backed up by reality. The illusion of progress could make things worse.
At around the same time, a research paper, “The End of ESG”, was published. In the paper, Alex Edmans, Finance Professor at the London Business School, argues that: “ESG is both extremely important and nothing special. It’s extremely important because it’s critical to long term value… Thus, ESG doesn’t need a specialized term… It’s investing… We want great companies, not just companies that are great at ESG.”
If you are confused, you are not alone. And it is not easy to make sense of it.
Impact of capital
Clarity starts from focusing on the concept of “capital”. As investors, we play an important role in capital allocation. Such financial capital will be used by management to run daily operations, which has an impact on the environment and society. Our analysis suggests that the economic life of such operating capital for the non-financial sector is 14 years, with a remaining life of 7 years. The life of invested capital can vary much going from five years for IT equipment to as high as 40 years for some infrastructure investments.
Such capital does have an impact on the environment and society, from water pollution to modern slavery and the climate crisis.
In Alex Edman’s view, I see the thinking of Adam Smith, who through his famous book “The Wealth of Nations” described how free markets can incentivize individuals, acting in their own self-interest, to produce what is societally necessary. This idea was further elaborated by Milton Friedman and his doctrine that an entity’s greatest responsibility lies in the satisfaction of the shareholders.
The problem with this view is that, as Professor Sir Partha Dasgupta, author of the UK government-commissioned report “The Economics of Biodiversity”, convincingly shows, individual self-interest and profitability is not resulting in socially optimal outcomes. So, yes, in a world that focuses strictly on financial return, then incorporating ESG risks and opportunities into a competitive analysis of a stock in the market should not be seen as anything special. Indeed, EU regulations require investors to consider ESG risks and opportunities in decision-making. ’Extra’ financial data should be part of normal investor practice and it should be agile, forward-looking and based on a clear understanding of the stock price impact of the operational risk, rather than on the operational risk itself. For those who believe that ESG is a risk management tool, it should stay that way.
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