December-January 2014


LakeAn outcrop of socially responsible investment, natural capital accounting requires a new language to value the things in nature that make life worth living, finds Fiona Rintoul. You don’t often attend a conference as a financial journalist and end up in a session about peat bogs. But such was the lie of the land at the recent World Forum on Natural Capital in Edinburgh: integrated reporting one minute, peat bogs (admittedly I was in the wrong room) the next. This illustrates the breadth of the topic and some of its difficulties. What is a peat bog worth? Supposing I could tell you, how would that help you to make better investment decisions? As things stand, a peat bog isn’t worth that much. That’s partly because the way we value them and other natural resources, such as trees and water, does not take account of their contribution to ecosystem services. These, in the words of Scottish National Heritage (SNH) which has developed a Natural Capital Asset Index for Scotland, “are the benefits provided by nature (natural capital) that contribute to making human life both possible and worth living”. Since natural capital has not been ascribed a market value – although, as the SNH definition shows, it could hardly be more valuable – companies have traditionally exploited it quickly and comprehensively. And investors have traditionally applauded them for so doing. But, according to Neil Brown, socially responsible investment (SRI) fund manager at Alliance Trust Investments, change is afoot and for two reasons. First, we live in an information age where we can find out about and respond to what companies are doing as never before. Second, environmental impacts are starting to bite in hard-to-ignore ways: resource scarcity, ecosystem failure and social impacts. If this is starting to sound like SRI all over again, it is and it isn’t. “It’s under the same umbrella but it’s an extension,” says Mike Wilkins, managing director, infrastructure finance ratings at ratings agency Standard & Poor’s (S&P), who is working on analytical tools to assess the impact of environmental risk on corporate credit quality. Natural capital accounting goes beyond SRI. It’s about incorporating the benefits provided by ecosystem services, and the risks associated with abusing those services, into mainstream financial analysis. This process, often called integrated analysis, involves looking at the world in a different way that takes account of natural capital at every stage, including GDP calculations. “It should be of interest to any investor but it’s driven more by SRI clients,” says Brown. “We want to appeal to as wide an audience as possible. It’s on us as part of the industry to explain these things in terms that are of interest to the wider market.” Looking at the world in this new way requires a new language of resource, according to Lois Tarbet, a former technical director at the International Integrated Reporting Council (IIRC) and working group member. “Because of the history of financial reporting standards, resource is treated as meaning money,” she says. “Capital does not just include financial capital.” This new language is partly about putting a monetary value on things that have not been valued in that way before. Forests, for example, might not be valued simply by how much you can get for the timber but also by the positive contribution they can make to the ecosystem. But the new language is not just about that. When you are talking about something that “makes human life possible and worth living”, a monetary value only takes you so far. “Monetary valuation is one of the things that needs to happen,” says Miriam van Gool, senior consultant at Ecovalue. “Financial institutions can start with transparency and understanding the impact of their portfolio on the natural world.” Or to put it as Terra Finiti, a corporate sustainability consultancy, does in an amusing video on its website: “Ecosystem prices might tell us what we would get if we sold all of our Mum’s stuff, but it wouldn’t buy us a new Mother Earth.” A new language of resource may be some way off, but there is an increasing flow of new vocabulary out there in the market. Organisations such as Trucost and True Price have developed or are developing ways of measuring environmental and social impacts. A February 2013 report on integrated analysis from the Principles for Responsible Investment (PRI) initiative provides examples of how integrated analysis can be applied in the five areas of economic analysis, industry analysis, company strategy, financial reports and valuation tools. In December 2013, the IIRC released a framework designed to accelerate the adoption of integrated reporting across the world. However, knowing how integrated analysis can be applied and actually applying it are two different things. “It’s early days,” says Wilkins. “It’s going to take a bit of time for the concepts to bed in. Part of that is to establish clearly how material natural capital is to investment decision-making.” In a bid to establish materiality, S&P has produced two case studies: one on what a carbon-constrained future could mean for oil companies’ creditworthiness and one on how drought and floods in the east of England could impact business. The results of the first study, for which S&P worked with Carbon Tracker, show a deterioration in the financial risk profiles of smaller companies that could lead to negative outlook revisions and then downgrades between 2014 and 2017. The effect on the majors is more muted, and S&P projects that “they would likely remain consistent with metrics we consider commensurate with their respective ratings until 2016-2017”. The timescale for the impact on smaller companies is important because it is soon. Often environmental impacts look forward 20 to 30 years, bringing the business up against the perennial problem of short-termism. “Most investors don’t find it easy to focus that far ahead,” says Wilkins. And, indeed, an April 2013 report from fund manager Schroders entitled Broken models? Economics and ecosystem services, which explores how chief economists at some of the world’s largest investment banks are integrating changes to ecosystem services into their economic forecasts, finds short-termism to be one of the main problems. “One of the most common reasons cited for lack of integration was the different time horizons over which these impacts would be felt (for example, five to ten years) and the differing but invariably far shorter focus of their clients,” says the report, which was prepared in collaboration with Alliance Trust and Newton Investment Management. There’s no easy solution. But it brings us nicely back to Brown’s point that many environmental impacts are biting now, making them harder to ignore. “Some issues just are long-term, but there are enough that are impacting on different companies now,” he says. “Climate change might be long-term thing, but society’s response to it might not be. These things need to be brought into notes like anything else.” That HSBC Global Research released a report, Natural capital: identifying implications for economies, in November 2013, which talks about the costs of inaction, demonstrates that the large investment banks are waking up and smelling the coffee on this issue. The report, says Brown, is important because it’s likely to be read, coming from such a large institution. It concludes: “There is no silver bullet template for capturing and analysing natural capital factors, which can be rolled out across countries and industries. However, there is a consistent methodology to assess and analyse the issues that can be applied across countries, namely – identify the contribution, assess how well the natural capital factor is managed, identify future risk and assess the potential economic impact.” It also echoes the clarion call for new data, metrics and methodology made at the World Forum on Natural Capital. And that is kind of where natural capital is now. Investors and analysts are waking up to its importance – or at least some are – but having woken up, they need tools to do the work. “We don’t have the metrics we need,” says Brown. “We don’t have the data, and we’re very cautious about asking for new data from companies. What we want is better data.” Creating those new metrics will not be straightforward and requires an exceptionally clear head. Metrics for metrics’ sake helps no one. “We need to develop metrics based on what we intend to do with them,” observes Tarbet. However, creating viable new metrics is definitely going to be less tricky than creating a new planet. “These things will wax and wane in the public consciousness,” says Brown, “but they need to be resolved.” And if they are not resolved from within the finance industry, they may be resolved from without. “We’re not going to call for regulation,” says Wilkins. “But it may be unlikely that investors will react in the absence of regulation.” ©2014 funds europe

Executive Interviews

INTERVIEW: Put your money where your mouth is

Jun 10, 2016

At Kempen Capital Management, they believe portfolio managers should invest in their own funds. David Stevenson talks to Lars Dijkstra, CIO of the €42 billion manager.

EXECUTIVE INTERVIEW: ‘Volatility is the name of the game’

May 13, 2016

Axa Investment Managers chief executive officer, Andrea Rossi, talks to David Stevenson about bringing all his firm’s subsidiaries under one name and the opportunities that a difficult market...


ROUNDTABLE: Beyond the hype

Oct 13, 2016

The use of smart beta investing continues to grow. Our panel, made up of both providers and users, discusses what the strategy actually means, how it should be used and the kind of pitfalls that may arise when using this innovative investment technique.

MIFID II ROUNDTABLE: Following the direction of travel

Sep 07, 2016

Fund management firms Aberdeen and HSBC Global meet with specialist providers to speak about how the industry is evolving towards MiFID II.