Shifting Gears from ESG 1.0 to Transition Finance

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The recent developments in global politics and regulatory/banking alignments away from ESG themes are a most visible and obvious trend in a phenomenon that has been years in the making.

Financial institutions, investors, and the general public have been exposed to what can well be called “ESG 1.0”, where narratives that have little in common (Environment, Social Justice and the, seemingly unconnected, Governance) are bundled into a single concept, and measured, often in loosely defined and unvalidated methodologies, with single-point metrics, for the purposes of facilitating trading (often algorithmic trading)  and providing scorecard-like grades to corporates and governments.

The ESG investing strategies typically focus on one specific KPI or metric to base assessments, be this ESG ratings (“green vs. brown” portfolio theory), Pure Emissions (Weighted Average Carbon Intensity, WACI), Implied Temperature Rise (ITR), or Science Based Target Initiative alignment (SBTI).

These approaches are used, and have some merit, to build equities and bond portfolios, where the goal is to create algorithmic exclusion/inclusion principles, and trade on relatively short-term returns from the stock markets.

None of these approaches have successfully passed the smell test on actually correlating good grades/values with positive outcomes for investors, and are now likely on the way of the Dodo, marching towards extinction and irrelevance.

The failure of these overly simplified, naïve metrics and approaches is based on poor understanding of economics, complex non-linear systems, and behavioral-based actions and reactions.

This misalignment with reality is epitomized by the “Just Stop Oil” activist approach, which focused on protesting banks and the financial system in visible and confrontational manners, with the stated goal to stop them from providing financial services to the O&G industry.

This approach failed completely to address the painfully obvious fact that such a strategy, if it were to ever succeed, would have not have resulted in the reduction a single barrel of oil being produced and used, as the industry would simply have moved to Private Credit or other alternative sources of financing, and passed these costs onto the finished product, and thus the consumer base.

The use of unsound metrics and approaches doesn’t however mean that Climate Change is not a real problem that the world is facing, and that a transition to alternative, zero-emissions, energy sources is not an imperative (after all, oil is a finite resource which needs to be replaced at some point, if we don’t want to be sent back to a pre-industrial society once it runs out).     

The warming climate, coupled at times with very bad policy decisions (such as stopping bush clearing and forest thinning in California over the last decades), has been top of the news in recent times, and is increasingly striking at the heart of the Financial Markets, via the Insurance and Reinsurance risk transmission channels.

Figure 1 below gives us as clear a clear-eyed view as possible about the increasing frequency of very severe Climate-Related disasters between 1980 and 2023 [these are CPI adjusted figures, which remove any discussion on inflationary effects as driving the exponential growth in the rolling 10-year window numbers]. 

Figure 1 – Billion-dollar natural disasters (CPI adjusted) in the USA from 1980-2023 (Source: National Oceanic and Atmospheric Administration/Haver Analytics)

Table 1 – Aggregated Billion-Dollar disasters for the USA (1980-2023) and change at the end of the period (Source: National Oceanic and Atmospheric Administration/Haver Analytics)

Figure 2 – An aerial view of damage caused by the passage of Hurricane Otis in Acapulco, Mexico, on October 28, 2023  - Rodrigo Oropeza / AFP / Getty

[source: https://www.theatlantic.com/photo/2023/10/photos-acapulco-aftermath-hurricane-otis/675835/ ]

In addition to the increased damage from Acute and Chronic Physical Risk, we are also seeing shifts in long-term weather and precipitation patterns, which have impacts on agriculture that go far beyond the commonly discussed topics.

Figure 3 - Of the 10 million square miles (26 million square kilometers) of northern vegetated lands, 34 to 41 percent showed increases in plant growth (green and blue),  over 1983-2013.   Credit: NASA's Goddard Space Flight Center Scientific Visualization Studio