In April 2012, Jeremy Grantham delivered a speech to attendees of The Prince of Wales’ Business & Sustainability Programme at the University of Cambridge. Grantham is the ‘G’ in GMO LLC, the Boston-headquartered investment management firm which famously foretold the bursting of the tech bubble, at the turn of this century. So sure were they that markets were wrong, GMO lost 60% of their book of business over two and half years, as unconvinced investors took their money elsewhere to follow the herd. As you can imagine, post the burst, lots of these assets returned. As reputation-building as this was, the University of Cambridge had not invited Jeremy to speak about it. Instead, it was in his capacity as co-founder, alongside his wife, of the Grantham Foundation for the Protection of the Environment. His chosen topic was living on a finite planet, which examined humankind’s exploitation of natural resources. To conclude his address, he summarised by asking the students to imagine the Devil making a deal with a farmer.
The Devil and the farmer
In the words of Grantham, the Devil approaches an arable farmer and offers him a contract for 40 years, saying, “I will triple your profits, but in return you will lose 1% of your soil.” In reality, this is the actual impact modern farming makes on soil; about 1% is lost, which is c.10–100 times faster than it can be replaced naturally. Organic farming does replace it, but this theoretical contract is being negotiated with a high volume, capitalist farmer, who signs on the basis the tripling of profits is significantly more consequential than any hit to productivity lost through soil erosion, over the 40 year term. When the contract renews, all the farms in the neighbourhood sign for another 40 years – it’s an easy decision again – and then for a third, a fourth and a fifth. However, as the chart illustrates, 200 years on there is no soil and no food can be produced.
The devil’s deal represent cumulative soil and productivity loss. Scales
Soil depth (inches), farm productivity (% of original level) Source: Jeremy Grantham Whilst the farmers may die rich – they still die, whether this be through starvation or as victims of the hungry mob that come looking for food.
This is a simplistic model which ignores a number of variables, however, nearly 10 years on, the point being made by Grantham still holds true. Indeed, one could argue it has been amplified many times over by the ramifications of the pandemic we are currently living through. The pursuit of profit without an expense being applied, relating to the cost of natural capital used, instils a corporate behaviour (let’s assume the farmer is a limited company) which is unsustainable over the long term.
Nature to become a metric in the measure of economic success
‘Our economies, livelihoods and wellbeing all depend on our most precious asset: nature. We are part of nature, not separate from it.’
These are the opening lines of The Dasgupta Review on The Economics of Biodiversity, published by HM Treasury in February this year. It argues nature needs to enter economic and finance decision-making in the same way buildings, machines, roads and skills do. This requires changing our measures of economic success. The universally used metric – Gross Domestic Product (GDP) – does not account for the depreciation of assets, including the natural environment. In its current form – so argues the report – GDP is based on a faulty application of economics, because it measures the flow of money, not the stock of national assets. Introducing natural capital into accounting systems is seen as a critical step to promoting sustainable growth and development.
Building on the implications of this report has come the high profile launch, in June, of the Task Force for Nature Related Financial Disclosures (TNFD). This will consult with a variety of stakeholders to create uniform, but voluntary, disclosures to help corporates, investors, lenders and insurance underwriters manage nature-related risks – such as new legal liabilities and the systemic loss of soil fertility described earlier.
Our collective failure so far to understand that nature underpins our global economic system, will increasingly lead to financial losses. More than half of the world’s economic output – US$44tn of economic value generation – is moderately, or highly, dependent on nature, according to estimates by the World Economic Forum. Nature is the bedrock for economic growth but nature cannot send invoices for services rendered. The high dependency of the global economy on nature means biodiversity loss represents significant risk to corporate and financial stability.
In order to ensure humanity does not breach the safety limits of the planetary boundaries, we need a fundamental shift in mind-set, transforming our relationship with nature. From government policies related to procurement, taxation, trade and regulation; to the way businesses and financial institutions make decisions on investment, risk and disclosure – it is vital that we hardwire into our economic system the value of nature in a profound way.
In this context, the TNFD builds on the work of the Task Force on Climate-related Financial Disclosures (TCFD). This climate-focused framework covers a subset of nature-related risks, but only through a climate lens. The TCFD’s framework excludes other nature-related risks, and the TNFD will augment the structure and foundation of the TCFD, harnessing synergies to avoid repetition. Over time, the objective is to see these two frameworks as complementary.
Implications for portfolios
In the State of Finance for Nature Report, published by the United Nations Environment Programme earlier this year, they estimated c.USD 133 billion/year currently flows into Nature-based Solutions (NbS), with public funds making up 86 per cent and private finance just 14 per cent. This spans biodiversity offsets, sustainable supply chains, private equity impact investment and smaller amounts from philanthropic and private foundations. The total volume of finance flowing into nature is considerably smaller than the flow of climate finance.
Looking to the future, the UN estimate investment in NbS ought to at least triple, in real terms, by 2030 and increase four-fold by 2050, if the world is to meet its climate change, biodiversity and land degradation targets. This acceleration would equate to cumulative total investment of up to USD 8.1 trillion, and a future annual investment rate of USD 536 billion.
Why does such an enormous investment gap exist? As always, it is complicated, but part of the issue is NbS have simply not attracted anywhere near the same publicity as climate-based solutions. Part of the answer is to make natural capital a mainstream asset class. In a recent HSBC presentation we attended, during the 4-day Sustainable Investment Festival (run by Investment Week), they argued Nature provides ample opportunities for investment, offering returns from income, capital gains and upside from carbon credits. With a low correlation to other asset classes, it also provides a diversification benefit, or even a hedging tool, for portfolios. However, the supply of investable solutions is in its infancy and fund management product development teams need to focus their energy on this area.
Another key aspect is the risk this poses to earnings and profitability. If companies are required to account for the cost of nature in balance sheets and the pricing of their products and services, this will inevitably lead to falling equity valuations for many. Today, the market is simply not factoring this in. For example, when we purchase shampoo in the supermarket we are currently not paying for the cost of water, carbon emissions or the impact on biodiversity incurred during its production. This needs to change.
To be fair – not all companies are waiting to be told what to do. One example is Kering (owners of Gucci, Saint Laurent, Bottega Veneta, Balenciaga, Alexander McQueen and Brioni) who we would describe as trailblazers in this space. It might surprise some of you to know this leadership has come from the luxury sector, which once had a very poor reputation for sustainability. Much has changed. Today, Kering – a company owned across our Responsible Real Return and Responsible Growth portfolios – publishes an EP&L (Environmental Profit & Loss), being an innovative tool to quantify and value the environmental impact of all its activities. This measures carbon emissions, water consumption, air and water pollution, land use, and waste production along the entire supply chain, thereby making the various environmental impacts of the Group’s activities visible, quantifiable, and comparable. These impacts are then converted into monetary values to quantify the use of natural resources. Kering can thus use the EP&L to guide its sustainability strategy, improve its processes and supply sources, and choose the best-adapted technologies. Kering has shared this methodology with companies in the luxury industry and other sectors.
If more companies could follow their lead then, using urban slang, it’s all Gucci.
Please do contact us with any questions.
