Untangling the polycrisis

12 Oct 2022 | Plus, auto companies get creative with Scope 3 accounting.

View from the top

🌐 High on the agenda at IMF and World Bank annual meetings this week: The escalating global ‘polycrisis’. Faced with the unenviable responsibility of untangling “causally entangled” social, environmental, and economic crises, finance ministers are getting serious about the financial cost of ‘extra-financial’ disruption. The IMF tackles the macroeconomic impact of decarbonisation in its World Economic Outlook and adjunct blog, attaching figures to the lost output and additional inflation created by the transition—which, while very real, are dwarfed by the price of inaction. Battered by revelations that it provided $15B to fossil fuel projects, the World Bank is under pressure to step into a “revamped” or “reinvented” role with a wider lens on the systemic risks now wreaking havoc on the world economy. Expect more focus on the price tag of climate change and biodiversity loss at COP27, as policymakers move closer to climate-related capital requirements for banks.

⚔️ Who wins the ESG culture war? There are three ways to invest, writes Matt Levine: (1) Invest just to make money; (2) Invest to promote your values (and you’re a Democrat); (3) Invest to promote your values (and you’re a Republican). Proponents of (3) argue that (2) undercuts (1), though anti-ESG law is now accused of “endangering financial stability” by encouraging firms to sacrifice risk management to appease state governments. Long-suffering BlackRock, however, is still in the crosshairs. Having withdrawn a reported $1B from the $10T investor, Republicans must take their business elsewhere. South Carolina state treasurer Curtis Loftis tells the FT his concerns led him to Federated Hermes, a self-described “global leader in responsible investment,” which doesn’t sound very anti-woke. Still, it was a ‘platinum sponsor’ of the anti-ESG State Financial Officers Foundation—which counts Loftis among its members—until Dutch pension clients turned the screw last month. So there’s that.

⚖️ It’s hard to please everyone. Let’s say you (an asset manager) have a priority (risk-adjusted returns) but cater to a client base (asset owners) with additional priorities (values). If your clients are aligned, great! If they’re ideologically opposed, however, your global strategy meetings just got a lot longer. Get comfortable. Morningstar finds asset managers are divided along ideologic and geographic lines: European investors want a disclosure framework that includes double materiality and mandatory Scope 3 emission; their US peers do not. It gets complicated for an industry in the throes of consolidation. Federated Hermes, for instance, is the union of one UK and one US firm, each with a set of principles moulded by its respective market. You can merge companies and cultures, but how do global firms meet diverging regional demands? Ironically, both ‘values investing’ and M&A are born of the same challenge: How to scale international distribution in spite of fee pressure. Talk about polycrisis.

Car companies get creative

This week, finance leaders in Washington begin the breezy task of fixing the world economy. IMF and World Bank meetings happen every year and through every downturn. This time, however, the challenges are more complex. Besieged by geopolitical, environmental, and social crises, the economy is exposed to a chaos of “causally entangled” financial and ‘extra-financial’ risk.

Look beyond the “hurly burly” of market volatility, says The Economist, and long-term fundamentals suggest we’re on the precipice of a macroeconomic transformation. Prepare to see influence shift from monetary to fiscal policy, as governments boost spending on a suite of factors that have a less direct, but no less significant, bearing on financial markets.

“The biggest mistakes in economics are failures of imagination that reflect an assumption that today’s regime will last for ever. It never does. Change is coming. Get ready.”

Climate change and energy security are chief among them. The US Inflation Reduction Act (IRA) was just the beginning.

Companies must get creative

For companies able to capitalise on the flood of new investment, structural change yields big opportunities. Many others are exposed to transition risk, defined by the BoE as “big shifts in asset values or higher costs of doing business.”

At the extreme, stranded assets push ‘old economy’ industries into terminal decline, while ‘new economy’ companies with first-mover advantage seize market dominance. Falling somewhere in between, however, most companies exposed must adjust to a new share price and cost of capital. Cue creative accounting, currently on dazzling display with emissions disclosures.

Gearing up for Dieselgate 2.0

Mandatory Scope 3 reporting reaches Europe in January 2023, at which point asset managers will begin feeling pressure to decarbonise their portfolios.

In a new report, campaign group Transport & Environment (T&E) finds mandatory Scope 3 reporting represents a “ticking carbon bomb” for investors in car companies. At present, the auto industry reports fewer than 50% of the lifetime or indirect emissions for which it’s responsible, “misleading investors” by drastically underestimating the fuel consumption and travelling distance of its vehicles.

Given 98% of auto industry emissions fall under Scope 3, those oversights have some pretty big ramifications when disclosures become compulsory. T&E warns of valuation shocks and selloffs.

Investors need “reliable” corporate disclosures. Instead, says T&E, they get data lacking in “quantity, quality and comparability.” This is a persistent problem for Scope 3 assessments. Product impact data is harder to evaluate, and far easier to manipulate, than the company-level equivalent.

One problem is that global automakers are “using the flexibility” of different reporting frameworks to select the most favourable numbers. Climate risk may be universal, but interpretations are—for now—regional.

If you can’t beat it, short it

Here’s a different scenario. Carson Block, founder of hedge fund Muddy Waters, recently spoke to FT Moral Money about his newest shorting target: solar power provider Sunrun, accused of overstating customer conversion.

Block claims “misleading” and “aggressive” accounting methods are widespread in a US residential solar sector recently buoyed by IRA stimulus. Not surprisingly, one perpetuates the other. Hefty tax credit sales boost Sunrun’s bottom line; the policy tailwind, its share price.

“Misleading practices are widespread in the US residential solar sector, Block claims, blaming an obsession with rapid growth at the expense of standards.”

Both ‘clean’ and ‘dirty’ companies are vulnerable to the type of creative accounting that catalyses price shocks. For short sellers with access to comprehensive product data, they represent a profitable opportunity via which to hold companies to account.

Sustainability reporting requirements won’t stop at emissions. The mounting food crisis portends what could happen if biodiversity loss spirals, which will, in likelihood, accelerate government and investor focus on resource use. If and when companies are required to address both pre-production material and post-production carbon footprints, it won’t just be combustion engine vehicles in the spotlight.

Toyota positive/negative contribution to 17 SDGs, weighted by revenue (Util data)
Tesla positive/negative contribution to 17 SDGs, weighted by revenue (Util data)