Investors have a duty to shape a sustainable future

By Peter Michaelis and Steve Waygood, Aviva Investors

Investment is about the future. How the future turns out determines the returns on investments and the volatility of these returns. But, in turn, the pattern of investments (where capital is allocated) itself helps to determine the type of future we get.

Therefore, in order to make the right decisions for the clients within the Sustainable Future funds which we run, we need to form a plausible view of what a sustainable economy looks like and to determine what our role should be in allocating capital to enable it.

This is why we commissioned Forum to produce Sustainable economy in 2040: a roadmap for capital markets. The report articulates the problem very clearly in its ‘framework for a sustainable economy’, describing what we need from our economy: “A resilient, sustainable economy that maximizes quality of life for all, so that people can develop their full potential and lead productive, creative lives within environmental limits”; the inescapable environmental limits; necessary social conditions; and the characteristics of such an economy. It then provides clear pictures of what that economy would look like for certain sectors.

As responsible investors, we acknowledge that the capital markets currently allocate capital in a way that undermines sustainable development. Forum for the Future’s work demonstrates that an estimated 776 million adults lack basic literacy skills, 2.5 billion people worldwide still do not have access to sanitation and 285 million people already suffer from diabetes. We are also approaching the limits to which the amount of land surface can be converted to cropland, and the fact that human processes convert more nitrogen into reactive forms than the combined effects from all the Earth’s terrestrial processes gives a real sense of the scale of our combined activity.

Individually, these problems are deeply concerning indicators about the status and stability of our economic development. Collectively, they are profoundly worrying signs that our economy is on an unsustainable footing. We are deeply concerned that threat to financial stability could originate from our misuse of natural and social capital.

We believe that it is within our collective ability to deal with these problems. These problems do not arise from the lack of financial capital, as we have the financial firepower to deal with them now. They arise from the misallocation of capital. Indeed, the capital markets and the entrepreneurship and innovation that they fund can be the driving force behind this 2040 Vision of a globally green and just economy. For example, in dealing with the climate change problem, green bonds can be developed that will raise a substantial proportion of the additional €2.9 trillion of capital required to build low-carbon infrastructure in Europe between now and 2020.

Why are the markets not currently allocating capital in a way that promotes a sustainable economy? We believe that the key problems are that investors do not integrate sustainable development issues into their valuation work, or into the messages that they transmit to the people that run the companies for them. There are many reasons for this, but two stand out: (i) short-termism – for which the capital markets can be fairly criticised; and (ii) market failure – which is a lack of action by global governments and policy-makers to make the sustainable development issues actually matter to corporate cash flows. The difference between short-termism and market failure is that the former is a failure of the predictive power of investors – while the latter is a failure of governments to ensure that companies have to pay the full cost of their social and environmental externalities.

As a result of government’s failure to internalise these costs into a company’s profit and loss statement, the capital market does not incorporate companies’ full social and environmental costs. It would be irrational for investors to incorporate companies’ full social and environmental externalities into company valuation as they do not affect earnings or costs. This is why we asked Forum for the Future to consider what recommendations it wanted to make to policy-makers as well as investors.

It is clear that in order for sustainable development to matter to markets, we need much more action by all. Long-term responsible investors understand that the financial implications of unsustainable development on pension portfolios could be catastrophic. Such investors have a duty to intervene and help shape the debate.

We believe the report gives rise to a great many challenges for investors. For our part, we make no claim to be adopting them now. We see the report as a guide giving us a bearing for our investment compass: which sectors are likely to grow in the transition to a more sustainable economy and will reward capital allocated to them; and which areas are best avoided.

Peter Michaelis and Steve Waygood are Head of SRI and Head of Sustainability Research and Engagement at Aviva Investors. This is an edited version of their foreword to Sustainable economy in 2040: a roadmap for capital markets.