Three megatrends reflecting each aspect of the environmental, social and governance (ESG) spectrum are shaping the sustainable investing world.
Climate change remains the biggest sustainability challenge facing mankind, causing a seismic shift in business models. Rising inequality means looking at countries from the top-down perspective, particularly for bond investors, while cybersecurity provides both a bottom-up opportunity and risk.
The University of Cambridge Institute for Sustainability Leadership tried to measure the theoretical impact of three scenarios for combatting global warming.1 The most benign scenario consists of a rapid shift from a fossil-fueled world economy to low-carbon, which would require tremendous investment in new infrastructure. The shift would be costly and produce a short period of high volatility and slow growth.
On October 8, a special report by the United Nations Intergovernmental Panel on Climate Change warned that the target of limiting global warming to 1.5 degrees Celsius above pre-industrial levels by 2100 would probably be reached by 2030, leaving only 12 years from now to combat it.2 The report warns of a large difference on the impact on the life on the planet between a 1.5°C and a 2.0°C scenario.
Unfortunately, a more plausible scenario seems to be a world in which past trends essentially continue, with temperatures rising to 2.0-2.5°C above pre-industrial levels by 2100. The world would succeed in slowly reducing its dependency on fossil fuel, but it would take longer for the positive benefits of the new low-carbon economy to make themselves felt.
A third scenario would involve prioritizing growth to the detriment of climate change risks. Initially, economic growth would depend quite heavily on fossil fuels. But market confidence on the future performance of the economy would gradually worsen due to environmental degradation, water stress and increasing resource constraints.
The Cambridge study modelled the impact of these scenarios on four types of portfolios: conservative (low risk), balanced, aggressive (high risk) and fixed income-only. In the first two scenarios, the worst-performing sector in developed markets would be real estate, followed by basic materials, construction and industrial manufacturing. The best-performing sectors would be transport, agriculture and consumer retail. Unsurprisingly, the long-term impact of the third scenario on the expected returns of the most risky portfolio is highest, because it has a larger exposure to equities, whereas the fixed income-only portfolio performs best.
A report by the International Monetary Fund stated that while global inequality between countries has fallen in the past three decades, it has risen sharply within countries.3 It said 53% of countries have seen an increase in income inequality over this period, with the rise particularly pronounced in advanced economies (especially the US), but also in some large emerging markets such as China, Russia and India.4
Six drivers appear to be responsible. Globalization is increasing the supply of cheap labor through the integration of emerging markets into the global economy, which has displaced low-income jobs in advanced economies. Technological advances have increased the demand for skilled labor at the expense of low-skilled workers everywhere, while migration has increased the supply of labor in advanced economies. And declining unionization has considerably diminished the bargaining power of workers, reinforcing pressure on wages.
For the wealthy, the share of the economic pie flowing into corporate profits has increased, benefitting higher-income earners, as a larger share of their income is profit-based. Meanwhile, expansionary monetary policy has led to asset price inflation, which increases wealth inequality by boosting the price of equities and housing, which are typically owned by richer households.
For investors, countries with rising inequality face the potential for social unrest, and have inferior sovereign credit quality. Inequality can lead to subdued economic prospects, more volatile (and lower) investment returns, and a reduced number of attractive investment opportunities. A structured approach to incorporating country-specific ESG information in investment processes could therefore help inform investment decisions.
Society is becoming increasingly digitalized and connected, which has led to rising cybercrime, producing some worrying figures. Research by cybersecurity firm Symantec shows that the number of ransomware attacks rose by 36% in 2017, while one in 123 emails is believed to be infected by malware. In the same year, 6.5% of internet users were victims of identity fraud, losing USD 16 billion, according to Javelin Strategy & Research.
While the size of the global market in cybersecurity is difficult to estimate due to the proliferation of new products and services from hundreds of new market entrants, reputable market forecasters Gartner and IDC both put the current size at around USD 80-90 billion, and set to exceed USD 100 billion by 2019.
The bright side to all this is that it is providing ample opportunities for solution providers to start successful businesses. However, competition is fierce and success is not guaranteed, so investors need to take a highly active approach in this area. Active engagement on the topic of cybersecurity by investors can also play a vital role in helping companies minimize the threat of cyberattack.
In conclusion, climate change, inequality and cybersecurity are just three examples of the many megatrends currently rapidly changing the world around us. Demographic developments, the dark side of urbanization and polarization in the political sphere are a few more megatrends identified by the World Economic Forum in 2018.
It is the joint responsibility of governments, companies and investors worldwide to safeguard a sustainable future for ourselves and for generations to come. These trends show that sustainability is no longer an isolated investment theme, but a phenomenon with many faces, and its habitat is not limited to a handful of industries and sectors, or even a specific region.
1 Unhedgeable risk: How climate change sentiment impacts investment (CISL, 2015)
2 UNIPCC report 2018 http://www.ipcc.ch/report/sr15/
3 IMF Fiscal Monitor: Tackling Inequality, October 2017
4 IMF World Inequality Report 2018