Volume 2, Issue 4 - October 2007. Financial Services
Asset managers exist to make money. They have in their care the savings and pensions of millions of people and consider it their duty to maximise the financial returns of those investments to their shareholders.
Biodiversity conservation does not make anybody any much money — or at least, not on the scale to register as important among the trillions of dollars traded daily on the world’s financial markets. As long as this is the case, there will be no incentive for asset managers to consider biodiversity when making investment decisions, and therefore little pressure on companies from their shareholders to change their practices. From the perspective of the biodiversity conservation community, this should represent a problem. Many sectors, and certain sectors in particular, have an enormous negative impact on biodiversity. Others benefit hugely from ecosystem services — but without realising it or paying for them.
However, the picture is not entirely bleak. First, there are stirrings of interest among the asset management community. Secondly, there is a small but growing body of examples in which biodiversity-related issues can be directly linked to share prices. Thirdly, some companies are seeing biodiversity-related opportunities for making profits. Finally, there is the potential for a series of actions by governments and others to make biodiversity far more material to companies, and therefore to their shareholders.
What do asset managers think about biodiversity? The vast majority of individual fund managers will not be familiar with the concept of biodiversity. But ten years ago, most of them ignored climate change — if they had heard of it at all. Five years ago, many fund managers would have heard about it, but very few believed it to be relevant to their investment decisions. Today, it is not possible for a fund manager to value a European utilities company without understanding how it might be penalised by, or benefit from, the Emissions Trading Scheme. News of movements in the price of carbon will cause fund managers to buy or sell affected companies.
At the turn of the millennium, a small number of fund managers had in fact started to think about climate change. The genesis of this was not the portfolio managers themselves, but the SRI teams that existed in about half a dozen London investment houses. Similarly, biodiversity is starting to register on the radar screens of fund managers. Two of those SRI teams, F&C Asset Management and Insight Investment have published research reports identifying the investment risks associated with biodiversity (1).
Apart from those stirrings in the SRI community, there is every reason to believe that biodiversity will follow the path of climate change as an issue that asset managers need to understand when making investment decisions in certain sectors.
Most importantly, the work done by companies themselves over the past five years has revealed a great deal about the nature of biodiversity risk. Extractive companies, in particular, have repeatedly cited biodiversity in risk assessments to investors, such as 401K declarations and Operating & Financial Reviews (OFR) in annual reports. To date, there has been no clear evidence that good biodiversity management has given a competitive advantage, or that poor biodiversity management has led to revenue loss. However, extractive companies, unlike the majority of their shareholders, are used to planning for 30-50 year scenarios, and their move towards better biodiversity risk management indicates a long-term view of where the materiality of the biodiversity debate is heading — particularly the ability of companies to access and exploit land and marine areas. Three other sectors that have begun to make progress — often in response to consumer, regulatory and media pressure, rather than that of investors — are the Equator Principles banks, utilities companies and sections of the agro-industry.
Moreover, there are two major differences from seven years ago, when climate change began to creep onto the agenda, which suggest that investment awareness of biodiversity might move faster. First, there has been a significant increase in the number of brokers and investors that claim to analyse ESG (a term that has started to replace SRI) risks — due in part to two initiatives, the UN’s Principles for Responsible Investment (2), and the Enhanced Analytics Initiative (3). They are actively looking for ESG risks and opportunities in a way that was previously only happening among the small community of SRI investors. Secondly, because of climate change, there is a much greater awareness of business opportunities that are related to the environment. New industries have entered stock markets — such as biofuel companies — and investors need to understand the regulatory and consumer drivers behind their business models in order to decide how to invest.
Among the research that has been emerging in the past year from the brokerage houses that provide investment analysis to fund managers have been some clear references to biodiversity and ecosystem services, for the first time. Again, this has often sprung from research looking primarily at the impacts of climate change. Some research notes have shown a very full understanding of the complex links between, for example, climate change, the cost of water, the provision of other ecosystem services and the potential impact on company valuations. The most specific research has been about Australia, where investment analysts are beginning to understand the enormous potential affect of environmental change on the agricultural and related industries (4).
Finally, there is the emerging body of tangible examples where mis-calculating biodiversity risks has had a negative impact on the share price. Ultimately, that is what makes the majority of the investment community sit up and take notice.
The impact on share price To understand the share price impact of biodiversity, it is first necessary to understand the nature of ESG risks, and how they affect share prices.
Although ESG risks at times have a direct effect on share price, it is unusual to be able to trace a direct cause and effect. This is for three reasons. First, the immediate financial value of an ESG risk is usually negligible in the context of the market capitalisation of a large company. For example, a one-off fine of USD 100-200m would be considered as relatively immaterial in a company with a market cap of several billion dollars, as long as that company was otherwise doing well. Secondly, the impact of the risk or a negative event may be felt by the company in the long-term or in intangible ways — which the markets seldom reflect in valuations. Thirdly, there is so much ‘noise’ in the valuation and movement of a particular share price that it is difficult to disaggregate a positive or negative ESG event from all the other daily influences on a large company’s share price — which will include both the company’s own performance, how the markets are viewing the prospects of the sector as a whole, and how well the company’s competitors are doing.
However, financial analysts have become more sophisticated in understanding ESG risks and analysing how they may affect valuations. Some of the leading work in this area has been undertaken by Goldman Sachs. This does not seek to establish a causal relationship between ESG risks and share price, but examines the correlation between good ESG management and high cash returns.
Chart 1 shows Goldman Sachs analysis of the share price at BP between December 2004 and September 2006, and the correlation with a series of ESG incidents at the company. Having started the period trading at a premium to its peers, the company proceeded to underperform relative to its peers and, more significantly, temporarily break the connection between the price of oil and the share price — an unusual circumstance for a major oil company, in which the oil price is usually the single largest factor in the share price. Goldman Sachs’ conclusion was that “ESG issues can cause share volatility: recent events at BP have shown how ongoing ESG issues can directly affect a company’s share price”.
The BP case, and the Goldman Sachs analysis, demonstrates that when the evidence is sufficiently compelling, ESG events will have an effect on the share price. This reinforces the need for fund managers to understand them. But can the same be said of biodiversity specifically, or is it still an issue that will not be sufficiently material to affect a share price?
The case of Associated British Ports (
chart 2) clearly demonstrates that biodiversity-related issues can affect the share price. The company had an expansion strategy that involved developing a new port facility at Dibden Bay on the UK’s south coast. It was an area of high biodiversity value, and had three types of protected area status. However, the company pressed ahead with its plans, presumably believing that it could make the case that the need for more shipping and transport infrastructure on the south coast outweighed the need for protected areas. In the event, permission was turned down by the Department of Transport. Unusually, in its ruling, the Department of Transport specifically cited ‘environmental impact on…internationally protected sites’ as its rationale. The share price immediately dropped by 12%. The company did not recover the lost ground in its share price until the subject of bid speculation and was eventually taken into private ownership.
What does the ABP case actually tell us? There are two important lessons. First, that the company itself mis-calculated the biodiversity risks it was facing. Secondly, that investors did not understand the nature of the risks facing the company. An investor understanding the biodiversity risks might fairly have concluded that it was necessary to sell the company’s shares before the Department of Transport’s decision or, earlier in the process, engaged the company’s management in well-informed discussion about whether it was pursuing the correct strategy. Investment analysts at the brokers might also have spotted the risk embedded in the strategy and issued a ‘sell’ recommendation before the government’s decision.
Where next? In most cases, biodiversity and ecosystem services are not sufficiently material for investment analysts to consider them when valuing a company for investment or making the decision to buy or sell. However, the picture is changing, due in part to a greater awareness of environmental impacts and opportunities related to climate change, and in part to the greater awareness of government, regulators, civil society and the media about biodiversity loss and the concept of ecosystem services. The actions identified above that governments could take would make biodiversity become more material more quickly to the financial markets. Irrespective of what mechanisms government may chose to implement, as natural resources become more scarce, and ecosystems no longer deliver the services that companies have come to rely on, the effects will be felt in the financial markets. We have not reached the point yet, but in future the interests of investors, companies and conservationists will become more closely aligned. Governments could provide the framework for this, and in doing so can regulate it. Is this an investor calling for more regulation? It is indeed: but only for good regulation, that understands that companies will need to continue making money, and that means they need to have access to natural resources, be rewarded by the markets for effective biodiversity management, and benefit from biodiversity-related business opportunities. Governments can set the rules — and, if they want investors to consider biodiversity when making investment decisions, it is time for the rules to be set.
What could make a difference? The cases above suggest that, in certain circumstances, ESG issues, including biodiversity, substantially affect a company’s share price. This strengthens the case for investment analysts to understand better the risks and opportunities related to ESG events. Although such case studies for biodiversity specifically are rare, three actions by governments could substantially affect the materiality of biodiversity and therefore how it will be considered by investors.
Procurement & certification — The most obvious, but perhaps the most difficult, is in the area of government procurement. If governments were to commit to buying only from sources certified as biodiversity-friendly, then there would be a revolution in supply. This could stretch from meals provided in schools and hospitals to aggregates used for road-building — and from hydrocarbons used in government vehicles to building materials for government offices. In fact, the UK government has already moved in this direction through its timber-sourcing policies (5). Fundamentally, the buying power of governments is sufficiently large that it could be used to generate the ‘missing link’ in the market — rewarding companies for good performance relative to biodiversity, and punishing those that ignore it.
Fines — Most governments have a system in place to fine companies for environmental mismanagement. However, the level of fines is immaterial to a large company – such that it will be ignored by investors and will not register even the smallest blip in the share price. Regulators need to have, and exercise, the power to issue large fines for negative biodiversity-related impacts if they want financial markets to take biodiversity risks more seriously. This would not necessarily be favoured by investors, as there is a high risk of political manipulation in areas where the rule of law is weak.
Ecosystem services — The most interesting development would be for governments to stimulate trading in ecosystem services — just as a mixture of government and voluntary action has created trading in climate change-related credits. This is the kind of mechanism the financial markets understand and like. People can make money from it. It would require a shake-up in the way most conservationists view biodiversity: valuing species and habitats according to their contribution to ecosystem services and human well-being rather than according to abundance or diversity or the degree of threat they face. In other words, a biodiversity ‘hotspot’ in a remote area may provide a ‘cultural service’, but be less economically ‘valuable’ than a relatively common habitat type in a river basin that enhances water supply and purity for a large human population. Governments – through a Conference of Parties – would need to decide what relative weights to give such services, and the debates might pit conservation purists against hard-line free marketers. However, it is another mechanism for internalising external costs. Companies that are dependent on ecosystem services would have to pay for them — and those that want to damage them would need to buy enough credits to do so. Some first steps have been taken by off-set arrangements and through the Clean Development Mechanism. A thesis could be written — no doubt many have and many will — on the viability of trading ecosystem services, and the different mechanisms that could be used. Suffice it to say that many sceptics felt a cap and trade system would not work for carbon dioxide emissions, and some question how effective the current systems are; but they put environmental debates into the language and mechanisms of trade, and that is what investors understand best.
is Director, Governance & Sustainable Investment and Sagarika Chatterjee
Sagarika Chatterjee is Senior Analyst,
F&C Asset Management.
(5)
http://www.sustainable-development.gov.uk/government/estates/#sustainableprocurement (1) See
http://www.fandc.com/new/aboutus/Default.aspx?id=75986 and
www.insightinvestment.com/responsibility/investor_responsibility_home.asp (2)
http://www.unpri.org (3)
http://www.enhancedanalytics.com (4) See, for example, ‘Climate Impacts, Adaptation & Vulnerability: water, coasts, ecosystems and agriculture require early adaptation’ Citigroup, 12 June 2007; and ‘Food & Beverages Sector: worsening drought = worsening earnings outlook’, JP Morgan, 21 September 2007.
