Old world, new world?

As a consumer, I am as entranced by the latest shiny piece of technological gadgetry as the next person. Markets are too, judging from the performance of tech stocks this year. But we need to realise that “old world” sectors and firms will be equally important in the sustainability transition. So don’t dismiss last week’s mining sector manoeuvres – focused around a major proposed takeover – as irrelevant to environmental progress. As always, everything economic is interconnected. Copper is the linking factor between “old world” and “new world”: miners want to guarantee a strong future position in producing this essential component (cars, wiring etc.) of the energy transition.

In this edition we look at three important, non-shiny “old world” transition problems: insurance, commodities, and how established firms are reassessing environmental targets. But one thing is clear. Yet again I am reminded of a song by a favourite singer/songwriter, Avishai Cohen. As he puts it in his Song of Hope, “our own responsibility relies on our ability”. If we are to fulfil our responsibility to deliver prosperity, we must enhance our ability to manage sustainable change.

Under debate: Environmental change and insurance

Insurance is an “old world” industry that we often take for granted. But climate change has created an urgent need to change how this sector operates.

Petra Hielkema, the chair of the European Union’s insurance regulator, EIOPA, recently emphasized the urgency for Europe of bolstering defences against climate risks. Rising economic damage from these events, she warned, could make some areas effectively uninsurable.

The data suggests this may already be happening. According to EIOPA, the EU recorded EUR50bn in losses from natural catastrophes annually in both 2021 and 2022, more than triple the average annual losses of the previous decade. Only 25% of those losses was covered by insurance. Separate data from Aon shows that global economic losses from natural disasters in 2022 were USD313bn (EUR292bn), of which only USD132bn was insured: a similar “protection gap”.

This is a problem of our own making, and one we can solve. Reinsurance, in particular, has a long and successful history of incorporating new factors in decision-making processes, particularly in risk management, exposure management, and pricing.

The impact of environmental change on insurance availability or cost is already having an impact on property valuations. My colleague Daniel Sacco points to Real Estate Investment Trusts (REITs) as providing an early indication of what is going on. The FTSE EPRA/Nareit Developed Europe Index, for example, is starting to be impacted by flood concerns in countries such as Germany and Italy. In Asia-Pacific, the S&P Asia Pacific REIT Index is being held back by a decline in markets exposed to increasing typhoon activity, particularly in coastal areas.

One immediate response to escalating insurance losses is for insurers to simply stop insuring certain areas: note the decision by major U.S. insurers to halt policy sales in wildfire-prone areas in California.

Daniel points out that finding a more sustainable long-term solution will require action on multiple fronts, both conceptual and practical. On the conceptual side, we need to reassess traditional insurance models, which rely heavily on long-term historical data and are thus becoming less reliable as climate patterns shift. We can also increase the resilience of properties through stronger building codes and risk mitigation measures. (States like Florida offer discounts on insurance premiums to homeowners who fortify their homes against hurricanes; California now mandates insurance discounts for properties that implement fire-proofing measures.) New financial products such as catastrophe bonds and resilience bonds may make it easier to find the funds needed for recovery and rebuilding after disasters.

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Investor perspective: equity prices and commodities

The global economy and capital markets remain fundamentally dependent on basic resources/commodities in a variety of ways. Many investors think first (and understandably) about the impact of fossil-fuel prices. But resource dependency affects many other sectors too: Consider the enormous amounts of water necessary to produce semiconductors.

We tend to take resource abundancy for granted, albeit with some temporary soul-searching (usually around energy). And, it is true, higher resource prices have not stopped gains in asset prices. In a discussion with my colleague Afif Chowdhury, he noted that over the last decade there has been a positive correlation (0.19) between global equity prices (MSCI World) and commodity prices (as measured by the Bloomberg Commodity Index). This correlation rises considerably (0.5 – 0.7) for highly resource-dependent sectors such as Materials and Energy.

But suppose that the global economy is shifting from a long period of perceived resource abundancy to a new period of increasing scarcity. Resources of some key commodities will be unevenly divided and sometimes difficult to access. This could be particularly critical in the energy transition to net zero. According to the IEA, demand for critical minerals could more than triple by 2030. All this will be happening at a time when more and more people are aspiring for greater prosperity.

More than half of the market value of listed companies on 19 major stock exchanges is exposed to financial risk through high or moderate dependence on nature, according to recent research from PwC and illustrated by the chart below. In a resource-scarce world, the historical correlation between global equity prices and commodity prices could even reverse, with the negative impact mainly focused on companies with weak resource management strategies, e.g. in Europe, where much of the dependence on nature is in large industries, including retail and consumer goods, food, beverages and tobacco.

What is the takeaway for investors and markets? I don’t think investors should rely on an implicit positive correlation between higher commodity prices and equity markets. Instead, the focus should shift to idiosyncratic risk, and individual companies’ capacity for efficient and sustainable use of resources. In other words, don’t assume prices will be driven by relative abundancy – look instead at how companies can cope with scarcity.

Our view: is reassessing environmental targets always a bad thing?

Globally, we see a discussion about country-level backsliding on sustainability/transition targets and that this is now taken as a fact of life. But individual firms have been reassessing their individual targets too – pushing back timelines or lowering target levels. This appears a clear negative development – in that they are stepping back from prior commitments. But is this always a bad thing?

It is possible to see a silver lining in this particular cloud. Reassessment of targets might show that firms are seriously considering what these targets mean. And what we observe in the market is that the focus is moving from broad statements to deeper thought about what they mean for corporates’ future economic viability. Major firms, for example in the consumer goods sector, have admitted that some consumer goods environmental targets (e.g. on plastic packaging use) were often set without a full appreciation of what achieving them might require.

Greater realism is always to be welcomed. But how can we be sure that targets are being pushed back really because of a reassessment of what is possible – rather than simply by a (concealed) belief by firms that not keeping to targets will make them more economically competitive? Any short-term gains for firms here are likely to be more than offset by increasing long-term risks. If we have learnt one thing from recent debate, it is that sustainability is economically rational. If a company reduces its resource intensity it can also reduce its costs and dependencies. How? Through technological development, which then can deliver growth. In short: postpone targets at your peril.