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ESG and inflation: An inconvenient truth?

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This is a sponsored article from Federated Hermes.

When it comes to ESG investing, we need to talk about the inflationary elephant in the room says Martin Todd, portfolio manager for Sustainable Global Equity at Federated Hermes.

ESG investing is marching into the mainstream, but COP26 exposed a landscape of fragmented opinions and simmering discord on a global scale. Here, we argue that if sustainability is to win over its sceptics and reach escape velocity, investors, governments, corporates and consumers can no longer ignore what we believe to be the most important elephant in the room.

Against the backdrop of this shift towards a more sustainable way of living, the world is grappling with rising prices. As a result, the two biggest market themes for the year ahead are, right now, on a collision course.

Markets have mostly tiptoed around discussions linking ESG and inflation, largely because the topic is as polarising as it is inconvenient. It polarises because there are two schools of thought at play: the first suggests that adopting ESG or sustainable practices in business is a fundamentally inflationary act. The second school of thought argues that doing nothing to address issues such as climate change is, ultimately, even more inflationary.

The inconvenient part of the situation lies in the fact that – in truth – both schools of thought are correct.

Let’s take carbon emissions as our first example. Decarbonisation can be inflationary in two ways and both, ultimately, boil down to a question of supply:

  1. Even though, in many countries, the cost of renewable energy is fast coming down, renewables remain – overall and for now – more expensive that fossil fuel. This is fundamentally due to a lack of supply, but is exacerbated by new levels of demand created by widespread electrification in areas such as EVs.
  2. As governments place more restrictions on both fossil fuel development and nuclear power – thus constraining supply – pricing for fossil fuels and for the renewable sources poised to replace them inevitably moves higher.

In a real-world example of this dynamic, in early December 2021, Shell announced its withdrawal from the development of a new oilfield in the North Sea.1 The move, hailed as positive for the climate, will reduce fossil fuel supply and so drive up costs. Meanwhile, demand for renewable alternatives will also rise, triggering an inflationary double whammy.

Real life; real costs

This is a relatively simple energy-related example, but the same issues are bubbling under the surface of the whole corporate sector. A clothing manufacturer may be under societal and regulatory pressure to use more sustainably sourced material – but to do so comes at a cost. Converting a piece of agricultural land from producing traditional cotton to producing organic (i.e. more sustainable) cotton is resource-intensive and takes time. It’s hard to incentivise a farmer to do this without providing financial support. Put bluntly, if the world wants producers to transition to more ESG-aware practices, then the world must pay for it: yes, hello inflation!

In the sentence above, transition is the key word. At the heart of the equation is the time horizon: Now and in the short-term we can expect inflationary pressures to increase. But as innovation and economies of scale come into play, ongoing costs will gradually come down and green solutions will become cheaper. In other words, short-term investment must be weighed against more-enduring, long-term gain.

Still, asking corporates to incur costs in the short term to reap benefits in an unknowable future remains a hard sell. Fossil fuels and plastics are simply cheaper and more efficient right now. Change, in any direction, creates resistance and costs money; and those costs will ultimately land with the end consumer.

The recent rise in energy bills globally, for example, is not solely a symptom of COVID-19 and supply chain disruptions, but also the ramification of changing sources of energy and reduced availability of natural gas and oil.

Another widely felt impact will be on the aviation industry. Higher taxes and the possible requirement for airlines in some countries to use a percentage of sustainable aviation fuel will likely drive up costs across the sector. As these are passed onto the consumers, a sharp rise in the cost of air travel could price out the average family who may find foreign holidays less affordable than before.

Such cost increases will not affect the world’s wealthy, but instead middle to lower income households. As more governments introduce these kinds of industry-specific regulations, questions about patterns of consumer impact and the pricing-out of the less affluent will need to be addressed globally.

Those who advocate a more sustainable way of living have a responsibility to bear this in mind – and to ensure that families and individuals are part of the conversation about the short-term impact on living costs.

Link through: https://www.hermes-investment.com/sg/insight/equities/esg-and-inflation-an-inconvenient-truth/

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

1FT.com: ‘Shell pulls out of North Sea oil project’, 3 December 2021.

For professional investors only. This is a marketing communication. The views and opinions contained herein are those of Martin Todd, Portfolio Manager, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”).

This is a sponsored article from Federated Hermes.

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