Inflation has been the economic story of 2022. Leaping to a 40-year high has made food and energy unaffordable for many and put us on the verge of recession. But this could be a bigger concern for institutional investors seeking to decarbonise their portfolios.
The invasion of Ukraine and economies still suffering from the impact of Covid have pushed up the cost of living, on top of that making the world greener and reducing inequality is another driver of inflation. In short, greening the world could potentially lead to what has become known as “greenflation”.
This has implications for pension schemes and insurers who have committed to building sustainable portfolios amid a supply-demand imbalance which has pushed up the price of assets with a high ESG profile.
Madeleine King, co-head of global investment grade research at Legal & General Investment Management (LGIM), believes that greenflation is a problem for which there is no short-term fix. “It is definitely an issue and there are many aspects to it,” she says. “Certain commodities being in short supply is not going to be alleviated anytime soon. Arguably, it is only going to get more difficult.”
And some aspects of greenflation stand at the door of investors themselves. “You have a certain pool of green assets to invest in and a growing pool of investors who want to invest in them. It is a basic supply and demand problem – with more people wanting to invest than there are assets to invest in,” King says. “So naturally, the prices of those assets have been driven up. The value of something considered purely green is arguably inflated.”
This raises problematic questions about the market and how it works in terms of ESG investing, King says. “The market environment around ESG incentivises everyone to be invested in pretty much the same positions. Which is never a healthy environment. A regulatory system – with slightly unrealistic ESG standards – and a climate that encourages everybody to put the same trade on is ultimately not a healthy one for the financial markets,” she says.
It is a concern shared by Désirée Lucchese, an ESG data and UN Sustainable Development Goals expert. “Capital flows and heightened interest in ESG funds have caused an increase in valuations of highly coveted stocks,” she says. “These flows have not been adequately matched by availability of underlying investable assets. For years, green bond issuance of externally reviewed, certified or verified bonds have also been over-subscribed.”
Lucchese, therefore, declares greenflation a negative scenario. “We are undergoing the greatest inflationary storm of all times; we are talking about escalating inflation with a bite,” she says. This will see greenflation combined with climateflation, which is where food crops and key commodities fail to reach market, and fossilflation where energy supply-demand comes under pressure. “These inflationary shocks mean that they will unexpectedly add to current and future price pressures,” she says.
But Alex Bernhardt, global head of sustainability research at BNP Paribas, presents a different picture. “Greenflation is a transitory problem,” he says. “The long-term effect of the transition to a greener, more sustainable economy that is less depending on fossil fuels is deflationary. Renewable energies over the longer term are going to be much more deflationary given they do not require ongoing fuel input costs.
“The challenge in the short term as we transition to a future greener economy is there are inflationary pressures that could arise on inflation from higher fossil fuel prices and higher prices in commodity markets needed to support the energy transition like copper and lithium,” Bernhardt adds. “It will be particularly challenging if we do not invest adequately at the same time in building the green infrastructure necessary to replace fossil fuels. So it is important in the transition that all the people around the top tables responsible for this are aligned to that goal.”
Eric Nietsch, head of ESG Asia at Manulife Investment Management, also has the short-term implications of greenflation in mind. “Inflation of any kind is a problem for investors, especially fixed income investors. When it comes to greenflation, we have to think about whether the transition is contributing to inflation.”
Here Nietsch cites some data that asserts a short-term greenflation picture, and a less stressful picture at that. “If we look at the value of commodities that are consumed globally, that has increased to $15trn (£12.2trn) from about $7tn (£5.7trn) during the past year, due to the Ukraine shock. That’s about 7% of global GDP.
“If we were to compare that to a $50 carbon price being applied across all commodities globally, Citi estimates that would be about $2.5trn (£2trn). So that potential level of greenflation is only a third of the level of inflation from the Russian/Ukraine shock. It is likely even less than that – because that $2.5trn can be spread over time compared to the inflationary pressures that have happened with a single year.”
Such numbers suggest a greenflation situation is not as problematic. “It is manageable. There is a time horizon aspect to it,” Nietsch says. “If we try to think about greenflation and take a step back to look at the bigger picture, the implications of reducing greenhouse gasses by 2050 are massive.
“And many estimates state that it will require up to $5trn (£4trn) of investment annually – so it’s probably not an under- statement to say that this will reshape the global economy. “That could create inflationary pressure, especially during the next 10 years when there is the capex going into new infrastructure,” Nietsch adds. “But once that infrastructure is built, it will probably be deflationary after about 2030.”
And any inflation in the meantime is something that could be kept under control, Nietsch says. “And even though it might be a little inflationary over the next decade, it is likely to be at a level that is pretty manageable. If we put that in the context of the annual investment that will be required for the transition, which creates a huge amount of investment opportunity for asset managers to participate in,” he says.
Peter Mennie, global head of ESG integration at Manulife Investment Management, highlights a different angle to the greenflation scenario. “From a political perspective greenflation is a challenge. It obviously is important if we are going to successfully address climate change to retain popular support for the risks that faces.”
And with the picture evolving over the coming years, Mennie admits that investment managers have a role to play in showing investors where the best places to invest will be, as greenflation takes some form of hold, even temporarily.
“In the ESG investment spectrum you have everything from ESG integration all the way through to impact products,” Mennie says. “The onus is on us as investment managers to be as transparent as we can about the products and when they are likely to outperform and underperform. So when the asset owner is making their asset allocation decisions they understand that backdrop and how, and what, will work,” he says.
To the many potential problems presented by greenflation one should also present a counterfactual of what life would be like if we did not take the transition road, Nietsch says. “The World Economic Forum estimates that climate change could lower global GDP by 11% in a 2-degrees scenario by 2050 and up to 18% in a 3.2-degrees scenario relative to a world without climate change. And that would be even higher in Asia,” he says.
“So that could end up being either deflationary or inflationary depending on whether it materialises as a supply or demand shock. But we can agree that either way, the priority should be on avoiding that level of economic loss in the first place,” Nietsch adds.
Whatever the likely worse-case scenario, greenflation inevitably presents a challenging picture for investors. Bernhardt has some interesting advice on how investors can make the most of the situation. “You can play the commodity angle, invest in commodity producers, ideally the most sustainable ones, or more interestingly, invest in low carbon solution providers,” he says.
“Increasingly more companies are developing new technologies to address decarbonisation challenges. And investors are providing capital for these companies to do things to scale. Embracing sustainable investment processes is the best thing to do to address greenflation causes in the real economy and related portfolio effects,” he adds. “What we are seeing in our portfolios in the investment landscape is that the energy transition presents a whole host of risks and opportunities, and as asset managers we can strive to avoid those risks and take advantage of those opportunities.”
King says though concerns about greenflation could present a rethink of LGIM’s approach to ESG. “We may have to rethink if every fund needs to be 100% sustainable. I would argue, not every one of our clients wants that. Some will, and that’s fine.”
On investor trends in a greenflation environment, Lucchese offers some recommendations. “When we focus on greenflation, long-term investors certainly need to pay attention to how macro-trends are translating into local market dynamics and who the leaders are going to be out of robust strategic positioning in the short and medium term,” she says.
King says a problem for investors is they are bound by ESG regulation, which, of course, could be creating greater greenflation problems. “Looking at this from the position of an investor, I would argue that the way regulation is positioned and moving right now is only going to make matters worse,” she says. “Everyone is incentivised to chase the same small number of super green companies to invest in. And the demand for more to be as green as they can be is growing.”
It raises questions for pension funds as well, says Lauren Wilkinson, senior policy researcher at the Pensions Policy Institute. “While greenflation is unlikely to cause pension investment strategies to backtrack on ESG progress, rising costs and limited supply of the raw materials needed for the creation of renewable technologies are likely to further complicate decisions about how best to allocate investment in order to meet targets and mitigate risks,” she says.
King challenges such conventional ESG investment thinking. “You do not need every company to be perfectly green and tick the taxonomy box today. But you need everyone to improve and transition across the climate path. It is here where we should be concentrating – on those with the biggest scope for change.”
This leads to a more compromised and less idealistic ESG approach to avoid the problems posed by greenflation: with investors currently chasing the same green investments. “I think in the UK there is time for the green definitions to be a lot more practical than the EU taxonomy,” King says.
“Hopefully in the UK we can get the regulation to be a little less restrictive,” she says. “There needs to be some compromise if we are to construct sensible portfolios for our clients. You do not just want to let anything into an ESG fund. You want to have standards. But you do not want those standards to be so high that nobody wants to launch an ESG fund.”
The piling into green investments, which in turn is boosting greenflation is also having a worrying impact on returns. “From an investor point of view the returns you can expect to generate from purely green assets is typically much lower than it was in the past,” King says.
A point highlighted by Lucchese. “We are in for a sobering adjustment of market returns expectations and business transformation,” she says. These are worrying sentiments for investors.”
But Lucchese adds that it is not all doom and gloom. “Darkness is defined by light, after all, and there is an upside to this: a new economics story.” On this reading, greenflation, in all its various outlooks, may well be worth it in the long run.