Integrating Social and Environmental Performance, an Informed Decision for Investors

Allocating financial resources to economically, socially & environmentally (ESG) performing strategies is not only a collective necessity, but also an informed decision for investors!

Indeed, whether from a macro-economic point of view or at the level of each investor, the abundance of liquidity makes it both possible and reasonable to reinforce and favor investments financing for example the energy transition or enabling to rebalance value chains and to increasingly take into account ESG criteria.

An Unprecedented Level of Liquidity on Capital Markets

It is no secret that last decade monetary environment has led to an unprecedented level of liquidity in the markets. And at interest rate levels that have been hitting bottom records year after year, with negative-rate bonds issued multiplying in 2019: 30-year bonds for the German government, or even 5 to 10 year bonds for certain large investment-grade companies considered as solid enough to deserve this treatment. An amount of $17,000 billion invested in negative-rate investment lines was thus reached during 2019.

Without a doubt, there are better things to do, and in particular to imagine a better use of these colossal means in view of the social and environmental challenges that await us!

For many years now, a significant proportion of investors has been expecting interest rates to start rising again within a few months’ time. Indeed, the negative rates and unconventional measures (quantitative easing and the repurchase of government and corporate bonds by central banks) implemented by central banks have not led to a real resumption of interest rates & growth, nor of inflation. The recent rise in long-term interest rates since the end of the summer 2019 may be the light at the end of the tunnel, but nothing is less certain.

Admittedly, these policies were adopted during financial turmoil to avoid a financial and economic slump that would have led to a much more violent crisis than the difficulties encountered in recent years.

But the effects of these monetary policies are manifold, and to some extent to be waried of.

A Monetary Context Pushing for Asset Value Inflation Decorrelated from Operational Performances

First of all, we are witnessing an increasing decorrelation between the levels of liquidity in the markets and the actual level of economic activity.

But there is also another effect, which is well documented in business press: as the pricing of financial assets is determined by comparing their level of risk with the ‘risk-free rate’, represented (in theory) by the bonds of the more solid states, the lower these rates fall, the lower the expected return on the assets to which they are compared. This automatically results in an increase in the value of these assets, even if the spreads (the difference between yields expected and those generated by risk-free assets) have also increased.

This increase in value can be very significant in the current context, leading to record valuation levels.

To illustrate this principle, let us take the example of an office building in a European major city’s Central Business District, whose capitalization rate (i.e. the ratio between the rent earned and the price of the asset) would have fallen from a 4.5% gross yield ten years ago to 3% today – a relatively realistic example even based on a pessimistic assumption of a stable rent. From this decrease in the capitalization ate (from 4.5% to 3%) and all other things being equal, the result is a 50% increase in the value of the building given as an example…

This mechanism applies to most other asset classes, pulling up stock market indices (cf highest historical S&P level), “EBITDA multiples” used for valuing companies (e.g. SME valuation index) in private equity, and lowering the return expectations of start-ups (and hence increasing their valuations) in venture capital funds. This trend is also driving the development of business models based on access to abundant liquidity – and therefore almost free money – the relevance of which is sometimes difficult to demonstrate (see the case of Wework and its particularly nebulous financial transparency for example: coworking global leader IPO went from a target valuation of 60 billion to 10 billion dollars within a few Week … before being cancelled and replaced by a last minute rescue by Softbank, its main shareholder).

This inflation of asset values – and suspicion of bubbles – without any real correspondence or correlation with activity levels – and consequently wage levels – is also one of the main drivers of social inequalities.

Yet we cannot but notice that inequalities crack our societies, from the demonstrations of the yellow jackets in France to those that pushed the COP25 from Chile to Spain. And these inequalities are about wealth, much more so than income: when asset prices soar, those with little or no assets have no access to this enrichment. It hardly seems tenable.

Investment Opportunities Offered by the 2030 UN Sustainable Development Goals

However, there is a consensus among political and economic decision-makers that the Sustainable Development Goals and their financing are a collective imperative, in view of the environmental and social, but also democratic, challenges we face.

We also have reason to hope that we will be able to act regarding these challenges that we collectively face, whether they are environmental, social or economic: by way of illustration, the Millennium Goals set within the framework of the United Nations were aimed at eradicating extreme poverty: if this goal has not been achieved, the percentage of people living in extreme poverty in the world has fallen significantly and this effort must be continued.

However, from intentions to commitments, from commitments to decisions, from decisions to results, there are just as many steps to be taken. And it will inevitably be necessary to rely on the long-term objective interests of the various actors concerned to make these achievements possible.

In all Macroeconomic Scenarios, Investment and Asset Allocation Policies Must Integrate Extra-Financial Criteria

How to translate these major principles, these collective imperatives, to decisions made at the level of each player, and each investment policy as far as investors are concerned? It is needed for this to analyze the update  of investment policies, and in particular of asset allocation policies, as illustrated by the increasing consideration of extra-financial environmental and social ESG criteria in investment choices and strategies.

The necessary rebalancing resulting from the monetary context referred to above, particularly in terms of social inequalities and the financing of the energy transition, should be read in the light of two major economic scenarii: a return to more “usual” levels of growth and rates vs. a Japanese-style “forever no yield” scenario.

In both cases, a reallocation of asset allocation policies towards strategies that take into account social and environmental performance is necessary to avoid the risks of possible bubble effects on financial assets!

  • Either the recent rise in long-term interest rates continues, probably slowly, and inflation and growth will eventually resume and lead to a rise in rates. In view of the mechanisms described above, this will mean a deterioration in asset values compared with current valuations. In this case, non-financial risks will weigh more and more significantly. Indeed, apart from the digital revolution already happening, climate, environmental and social issues are the most likely to reshuffle the cards in terms of operational dynamics on the corporate side and of appreciation of the risk/return trade-off on the investor side. In this case, controlling these extra-financial risks will be one of the only means of reducing the impact of the general rise in interest rates on the value of assets, by reducing the volatility of the assets managed or held.
  • Or we can continue to navigate the long tunnel of low interest rates, and it will be increasingly difficult to come up with investment policies that generate even minimal returns in relation to the capital risks taken. For life insurance, for example, this will result in a further decline in the share of guaranteed-capital investments and a further decline in returns. Let us take an example of the impact of ESG criteria on the income generated: to take the example of the office property mentioned above, the impact of a significant increase in carbon valuation and therefore in energy prices on the net income generated by an office building (cost of energy, attractiveness for tenants, etc.) will be less significant if the building has undergone an energy performant refurbishment that is compatible with the carbon trajectory of the Paris agreements. Otherwise, lower rent values and increase in the risk premium will necessarily lead to a deterioration in the value of the asset. On the corporate side, the ability to solidify operating models will be key.

Conclusion: Protecting the Value and Potential of Assets by Strengthening ESG Criteria

In conclusion, the rebalancing of asset allocation policies towards strategies that are economically, socially and environmentally efficient and compatible with contributing to the achievement of the Sustainable Development Objectives is imperative to protect the value of assets and find new sources of return.

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20+ years of experience in investment & asset management.
Raphael Hara works on relationships between finance and sustainability, in particular through the development and management of impact investment funds and projects.

2 thoughts on “Integrating Social and Environmental Performance, an Informed Decision for Investors

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