Widely discussed in the industry circles in the preceding months, this major regulatory change has been received by many industry players as "yet another regulatory hassle" that would only increase the regulatory compliance pressure on the asset management industry.
A recent study by PwC Market Research Centre
showed that 77% of institutional investors intend to stop purchasing non-ESG products within the next 24 months. On the other side, only 14% of European managers intend to stop launching non-ESG funds within the near future
. The gap is even more dramatic when private investors are factored in: according to a 2019 Morgan Stanley report
, 95% of millennials, who will at some point inherit an estimated $30 trillion of wealth from baby boomers
, are interested in sustainable investing.
The world has changed, and so have the investors' preferences. New "light-green" and "dark-green" products are being launched at an increasing speed to keep up with the growing investor demand. Yet it is the reluctance of assets managers to let go of their native "brown" strategies that is a strong warning signal that the industry as a whole is in major disconnect with the reality. Systemic failure
The key failure of the current financial system is caused by the prevailing risk & return models, which serve as the system's cornerstones, yet are fundamentally, and dangerously, incomplete. Take the model known as "capital asset pricing model", or CAPM, introduced by Sharpe in mid-60s, which is still widely used today by professional investors. Designed to calculate an acceptable level of return for a given level of risk, the model fails to fully incorporate the entirety of applicable risks, on one side, and does not account for non-financial returns, on the other.
In practice, that means that social and environmental risks (that is, risks of pushing the "social foundations" and "planetary boundaries" of the "doughnut" economics by Kate Raworth
), are largely disregarded in the standard investment analysis. Underestimating those risks leads to "false positive" profitability of conventional economic activities (e.g. fossil fuels, plastic production, extensive demolition practices in the construction industry) that actually destroy value, should we take a larger and more long-term perspective. While delivering short-term financial return to investors, such investments disproportionately harm the world's least developed areas, less affluent social groups — and inevitably backfire on the global environment, putting the entire population of the planet in danger.
On the return side of the asset pricing model, attempts have been made to design an add-on "gamma-factor" to account for the positive impact generated by the activity being analyzed. However, this practice is yet far from common, while the mainstream model is ignorant of the positive non-financial returns. Limiting return considerations to financial returns, which tend to be extremely short-term, linked to annual accounting cycles and related KPIs, means under-funding of potentially lucrative business ventures (financially, but also environmentally and socially so), and leaves us with sub-optimal pace of sustainable economic progress.
Lack of long-term vision and the failure of the system to price in the sustainability risks creates a false sense of security and profitability of many investment strategies, which are ultimately destroying value for investors. Conventional energy bubble
In their February 2021 report on the energy sector
, ReThinkX visionaries Adam Dorr and Tony Seba warn about the trillion-dollar bubble that has been forming over the past decade in conventional energy assets:
"A large and rapidly-expanding global financial bubble now exists around conventional coal, gas, nuclear, and hydro power energy assets. This bubble has in part been created by mainstream energy analyses that have, for the last decade, significantly underestimated the levelized cost of electricity (LCOE) from conventional power plants because they assume these plants will be able to successfully sell the same quantity of electricity each year from now through 2040 and beyond".
This assumption, as the authors of this insightful study demonstrate, is fundamentally wrong. The capacity factor of conventional energy producers has been dropping since 2010 and will fall dramatically over the next years due to energy market disruption caused by alternative technologies. In the UK alone, the capacity factor of coal producing plants has fallen from 58% in 2013 to just 8% by 2019 - still, such capacity factors are assumed constant at up to 85% for the entire life of prospective coal plants by multiple analyses produced by reputable sources, including the International Energy Agency and the World Bank.
Carbon neutrality can be achieved quicker and cheaper than expected, claim Dorr and Seba: not only solar and wind power have already reached cost parity — the conventional energy technologies are simply no longer competitive, as the "mainstream analyses underestimate the per-kilowatt-hour cost of coal, gas, nuclear and hydro power of up to a factor of 4
A key implication for the asset management industry is that conventional energy assets today are severely, dangerously mispriced. We have seen credit ratings mispricing subprime mortgage assets in a very similar way — that led to the infamous housing bubble. In their article "Macroeconomic impact of stranded fossil fuel assets
", Mercure et al. confirm "the existence of a carbon bubble that, if not deflated early, could lead to a discounted global wealth loss of US$1–4 trillion, a loss comparable to the 2008 financial crisis
Flawed assumptions in valuation models lead to a significant risk of stranded assets. Last year, facing lower demand for oil both in the short and long term, BP wrote down $17,5 billion "in the decision to not exploit some existing resources"
. As much as $20 trillion of assets on today's balance sheets could turn out to be worthless, warns the Bank of England
— that's one quarter of the global GDP.
Obviously, to get exposed to that risk one does not have to be invested only and directly in the conventional energy; a number of industries (i.e. fishing) exhibit similar patterns of mispricing based on unrealistic assumptions, and many others are subject to indirect exposure to fossil fuels, including the banking sector — see, for instance, the total fossil fuel financing by year
(in the years that following the adoption of the Paris agreement) by the world's leading banks: