According to recent research, investors should
anticipate that green assets will under perform brown assets. Investors tend to
invest in green assets and divest their stakes in brown holdings. The demand
for green assets increases their market price while diminishing the value of
future returns. Green assets are a 'climate hedge' as they will perform better
than brown assets in the face of adverse climate change impacts, and investors
tend to attribute more value to this hedging ability. When evaluating potential
green investments versus brown investments, companies anticipate higher returns
from green investments by measuring the greenness of an investment using the
Morgan Stanley Capital International indices on environmental ratings.
Eventually, when the returns fall below the cost of capital, brown investments
tend to outperform green holdings. Further, research findings imply that
greener assets have a lower cost of capital with all other parameters remaining
equal, and therefore companies should use a lower cost of capital when
evaluating potential green investments when comparing them with brown holdings,
creating an incentive for investors to hold a portfolio with increased
investments in green holdings.
Long-term climate strategies include shifting
from fossil fuel consumption to clean electricity, clean fuels and electrification
of end-uses is viewed as the most efficient and economical way to reduce
emissions in power, transportation and construction sectors. In sectors that
are deemed as hard-to-abate sectors such as industries and heavy-duty transportation
that include aviation and shipping. It would be pertinent to quote an example
of green investments in producing sustainable aviation fuel (SAF). Technological advancement in production of SAF, a low-carbon alternative to traditional jet
fuel made from crude oil has accelerated investments in the technology aided by
incentives from state and federal governments of the US and EU. A consortium including the United Airlines has
started a $100 million venture capital fund on Tuesday to invest in the
technology. Aircraft manufacturer, Boeing has announced that it as doubling its
use of sustainable fuel this year. Yet, as on date, no flights are powered by sustainable
fuel because of the cost factor which makes it three times as expensive as
conventional fuel and it seems difficult to overcome the considerable cost
differential that exist between conventional fuel and SAF owing to the
production pathways for SAF.
Investment levels in the production of electro-fuels or
power-to-liquids have been insufficient due to high production costs thereby
creating a negative feedback loop among investors. The demand for SAF needs to
be consistent with the certainty for future supply of the product and eliminating
the risk factor surrounding its
production pathways. Presently, the lack
of real large-scale demand for SAF has stymied the deployment of the product at
a global level.
Policy development by the International Civil
Aviation Organization (ICAO) has brought in a three-phase program known as the
Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) that
aims to stabilize international aviation emissions at 2020 levels by 2035. It
is stated that a mandatory participation by all countries starting 2027 could create
new demands for SAF globally. It is estimated that low-cost pathway for production
of SAF could reach price parity with conventional jet fuels in 2027. Additional
incentives and/or tax credits can render costlier production pathways to become
cost-competitive as has been brought in under The Inflation Reduction Act of
the USA. Investments in producing
sustainable CO2 via
point-source capture or direct air-capture (DAC) and green hydrogen (H2)
can help in producing clean fuels. Scientists believe that only SAF technology has
the potential for unbounded production.
A European Corporate Governance Institute working
paper on finance focused on a "natural experiment in responsible
investment" conducted by the world's largest public pension fund, Japan's
Government Pension Investment Fund (GPIF). In 2018, the GPIF gave its largest
portfolio manager a compensation-based mandate to enhance the ESG performance
of portfolio companies. The authors concluded that "engagement by the asset
manager has led to improvements in certain ESG scores for mid- and large cap
companies." The mandate was distinct from the asset management contract
already in place to invest in and manage equity securities. The incentive of
remuneration for stewardship services above and beyond a standard asset
management fee motivates passive managers of assets to increase the value of
active stocks, creating financial incentives to improve a company’s ESG scores
and consequently increasing equity investments in such companies.
To
understand if ESG criteria have been met by companies, it is essential to be
aware of the calls for stringent norms for scrutiny, regulation, and reform of practices followed by ESG rating agencies that wield a substantial influence
over market fluctuations and retail investors. It is recommended that
regulatory agencies prohibit rating agencies' direct outreach to businesses in
order to reduce their influence and prevent an imbalance in favour of those who
pay them for consulting and insurance services. These agencies require
universal norms for ESG compliance by companies based on standards such as
resource efficiency, waste management, ecological harm, and disclosure of the
amount of 'natural capital' inputs to their businesses. Profits from the
practise of sustainable business processes should not be the only metric used
to declare ESG compliance. For an accurate assessment of ESG compliance, the
negative environmental impacts of business processes that tend to affect the
environment should be used to offset profits. The objectives of rating agencies
should not be based on a company's market capitalization or financial
significance. It should aid in enhancing corporate performance, thereby
contributing to sustainability and the circular economy. The methodology
employed by rating agencies to collect and aggregate relevant data has been
criticised by financial analysts as lacking transparency. It is simple to
attract investments using ESG ratings on sustainability, but the absence of
uniformity and harmonised benchmarks for compliance assessments can divert
funds to projects and companies that engage in greenwashing.
In 2021, the International Organisation of
Securities Commissions urged global regulators to investigate the veracity of
claims made by various ESG data providers regarding environmental and social
governance. In response, the Securities and Exchange Board of India (SEBI)
mandated that all ESG rating agencies register with the regulator in order to
prevent conflicts of interest and increase transparency in rating ESG
compliances by corporations. It is important for large-scale investors and
institutional investors to compare the outcomes of ESG compliance by companies
that impact several industries and sectors to get an overall view to guide
their future investments. Several ESG data providers sell volumes of data
online, which means that the data available on their website has been verified
both quantitatively and qualitatively. One such website, for example, is
Statista, which provides information from individual nations pertaining to
various sectors for a price.
References:
1.
Pástor,
R. F. Stambaugh, and L. A. Taylor (2022). Examining green yields. 146(2)
Journal of Financial Economics: 403-424.
2.
Pástor,
R. F. Stambaugh, and L. A. Taylor (2021). Balanced investments in sustainability.
142(2) Journal of Financial Economics: 550-571.
3.
Berg,
F., Koelbel, J. F., & Rigobon, R. (2022). The divergence of ESG ratings has
led to widespread confusion. Finance Review, 26(6), 1315-1344.
4.
Berg,
F., Koelbel, J. F., Pavlova, A., & Rigobon, R. (2022). ESG ambiguity and
stock returns: Addressing the issue of noise (No. w30562). Bureau of Economic
Research, National.
5.
Go
to https://www.esgthereport.com
6.
Go
to https://www.statista.com
7.
Go
to https://www.sasb.com.
8.
Go
to https://www.globalreporting.org.
9.
Inputs
from Financial Times and The New York Times