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Ella Williamson: Welcome to Sustainable Intelligence, where we discuss all things sustainability for the private markets. I am Ella Williamson and I’m so excited to be joined today by Dr. Julie Anderson, Director of the Master of Science in Sustainability Management at the American University’s Kogod School of Business.
Julie has over 25 years of global asset management experience and is a leading expert in ESG and sustainability strategy. We’re diving into the risks investors face when sustainability regulations are rolled back, from mispriced risk to capital misallocation, and what this all means for long-term value.
Julie, could I ask you to start by giving us the big picture? What are some of the most notable examples of sustainability regulations being weakened or delayed in recent times.
Julie Anderson: So first of all, thanks for having me on the show. It’s a pleasure, and I think it is important to start from that big picture.
So, as most people know, major regulatory retreats are happening across all jurisdictions globally, from the SEC climate rule modifications or elimination to the EU’s Omnibus change, stop the clock directive, you name it. We’re seeing what appears to be a regulatory retreat. What I think is happening here is that we’re creating a period of global fragmentation versus what we were hoping for, which was global harmonization. But I do wanna stress here that these regulatory delays aren’t eliminating sustainability imperatives. What they’re doing instead is creating a more differentiated market that gives space for rewarding, sophisticated analysis, and in the end, hopefully, creates an opportunity to generate alpha or excess return.
So, as difficult and disconcerting as this is because the climate crisis is real, I personally believe that the pause is appropriate at this point in time and it’s going to open up opportunities for both companies and investors.
Williamson: Thanks for that, Julie. And if we look at this regulatory backtrack, what kind of signals does it send to investors? How does it impact their confidence or risk assessment?
Anderson: Right. So I think let’s first talk about, you know, there’s two key actors in this. The first one are companies and without regulation, companies are gonna have to make strategic decisions about whether they proceed with comprehensive sustainability initiatives or take a more wait and see approach.
And because of this choice that companies face, the other actor is of course the investors. And we’re gonna see both information gaps and a dispersion or bifurcation between sustainability leaders and laggards. And that’s gonna become more pronounced. So as a result, we are going to have to use more sophisticated analytics—investors will have to.
So when we think about what does the backtracking, what signal does it send to investors? I think number one, regulatory uncertainty increases market inefficiency, as I mentioned this growing gap. But the counterfactual to that, or the most important thing to remember is that market inefficiency is precisely where investment opportunity lies, especially for large, sophisticated investors. And that’s where I believe we’re gonna see, again, this competitive advantage from the investor side based upon the investor. So in this case, even though we’re talking about the signals from backtracking, I’d like to focus on the opportunities that this opens up for investors. So again, information asymmetry between sophisticated investors with robust, analytical tools versus what we would call retail investors are those that have to rely on standardized disclosures.
Regulatory backtracking may create a perception that sustainability is less material or important than previously signaled, and this will likely affect retail investors causing them to pull back. However, large asset owners or large investors, pensions and insurance companies are going to continue to stress investing more sustainably.”
Julie Anderson
Professor of Management, Kogod School of Business
Anderson: And this is where they will have both a competitive advantage to creating value or finding value in their investment portfolios. But they also will have an increasing voice in still demanding for disclosures of sustainability related data.
Williamson: In terms of what you said there and the need being stronger than ever for sophisticated data and analytics, that’s what we’re all about here at Novata. So it’s great to hear you phrasing this as an opportunity. If I could ask you to look at the potential long-term financial consequences of this reduced regulatory pressure, looking at say, carbon intensive assets, stranded assets, or systemic risk exposure, what would you say is gonna happen there?
Anderson: Again, starting from the big picture, I think it’s important to stress that delayed regulation doesn’t mean delayed consequences. It means more abrupt market corrections when these risks eventually materialize. And this is going to translate into market volatility. So, when we talk about these long-term financial consequences, we are focusing on risk and importantly, financial materiality. So, in my mind, this delay may reduce the prospects of what we were hoping for, which is an orderly transition. In simple terms, if carbon intensive assets experience sudden devaluations when policies inevitably tighten in the future, we could see a lot of market disruption. So there’s sort of a calm before the storm. It’s providing a false sense of calm or a relief to market participants right now. We don’t have to sell all of our carbon intensive assets and buy only green assets. It’s more of an even-keeled sense that we can invest for the transition, but when that regulation catches up, we will eventually see risks being faced by carbon intensive industries.
So what does that mean, if climate action leads to more disorderly transitions in the future—delayed climate action, I should say, leads to more disorderly transitions in the future—we are gonna see higher economic costs. So this of course leads into financial materiality, which is most important for investors. And we know that it’s pretty universally accepted, anyway, that sustainability risks can become financially material through a variety of channels, whether it’s operational costs, capital expenditures, the cost of capital. But I wanted to stress a little bit that financial materiality of non-financial data or climate-related data is still very difficult to quantify. I would argue that the industry and investors at large are still trying to get their head around how exactly are these? We know the channels I just mentioned operational costs, capital expenditures, asset valuations. But how do they manifest that? How can we put that into models? And I think first it’s important to remember that the financially material risks of climate change play out very slowly over time. Five to 10 years or more.
So they’re very difficult to translate through into quarterly performance or annual data. And the second issue that I think is important to discuss is that a lot of the strategies that we’re hoping businesses implement to mitigate their emissions or to prepare for climate changes, physical risks, will manifest themselves as loss avoided.
And this is very hard to quantify. So it’s an interesting concept that, again, we’re delaying the regulation, and that’s gonna cause future consequences and how can investors put that in their models today? So I would say that the consequence for investors is increased complexity and performance asymmetry. Because sustainability risk that a company is managing well may not show up in dramatic outperformance during normal periods, but it’s expected to demonstrate significant relative outperformance during stress events. So until we have those stress events in the future, we won’t be able to quantify just how well those companies that have prepared for these events are resilient in terms of market pricing.
Williamson: Absolutely, I think your point there about getting ahead now is so important because the stresses that are to come down the line could impact your business in a multitude of ways. And if we could shift to looking at frameworks, how do you see voluntary versus mandatory frameworks playing into all of this and what investors choose to align to?
Anderson: So this is where my comments may be a bit controversial, because the voluntary reporting landscape isn’t perfect. Of course, we know that it suffers from certain inefficiencies and inconsistencies, so to speak. But it does offer flexibility and innovation that can complement mandatory frameworks. So I really want to stress that the most effective system combines mandatory minimum standards with voluntary frameworks because those voluntary frameworks I believe enable leadership and innovation. So, in other words, asking companies to voluntarily disclose or rewards companies for those that meaningfully address material sustainability issues, right? So there are times when investors may actually show greater comfort with principles-based voluntary frameworks because these allow company leaders to demonstrate their responsiveness to these emerging issues.
One of the important things here is that we are witnessing in very rapid timeframe a corollary to the evolution of gap accounting. So gap accounting is what gave us our financial reporting structure. And it took years to develop, decades to develop and to get everyone on board. But even with that gap accounting, which is very standardized and consistent, and all companies get their data assured and investors are very used to analyzing them, I think it’s important to remember that, if you have a room of investors all analyzing the exact same gap accounting reporting, there will still be some investors that go away and say, this is a strong buy. And there will be other investors that go away and say, strong sell. And so my point here is that the structured regulatory data or those frameworks are an important baseline and a starting point, but they never provide the full picture.
So having some level of voluntary reporting allows companies to explain exactly the risks they’re facing or the opportunities that they are trying to capitalize, and you may, as an investor, actually get richer data or richer insights as to the long-term sustainability of that company through the voluntary disclosed data versus a standardized, simplified data form.
Williamson: Fascinating. I think two points that really resonated with me there were number one, the seeing voluntary frameworks as actually an opportunity for innovation. And then the other part, likening it to gap accounting and how long it took for gap accounting to get to where it is today, but still there being different views based on how different investors interpret that data. So thank you so much for those insights. How should certain investors respond when the regulatory environment becomes more uncertain? And are there any tools or strategies that you’ve seen can help them stay ahead?
Anderson: So, we’ve touched on this a little bit, but now is the time to stress it. What will be the investment edge that investors can capitalize on in this uncertain environment? And as we shift from access to standardized sustainability data towards noisy unstandardized information, investors are going to have to rely upon sophisticated analysis that can extract signals from that unstructured data. It’s great because this, of course, focuses on things like AI. Sophisticated investors are already developing advanced analytics and using alternative data sources to supplement their traditional investing approaches. And this will increasingly be the dividing line between an investor’s competitive advantage versus others. So again, it does benefit larger investors that have these in-house capabilities to analyze unstructured data.
But I also wanted to point out very importantly that, just like gap accounting isn’t the end-all, AI, artificial intelligence and data analysis also isn’t. I think the other consequence that we’re gonna see here is that direct company engagement is going to continue to be critical.
We’ve always had the concept of stewardship as asset owners and investors that we need to engage with our investee companies, but I think it’s going to evolve and deepen from that traditional stewardship role to one of more in-depth due diligence because investors are gonna have to seek information beyond public disclosures. And that means engaging with these companies and asking critical questions.”
Julie Anderson
Professor of Management, Kogod School of Business
Anderson: And, I think that’s important. I think that this pause in regulation is allowing that to occur. It’s allowing large institutional investors to communicate with their investee companies and tell them very critically what they’re expecting from them with regard to how they’re managing their sustainability-related challenges. And it’s allowing companies to hear that, internalize it and begin the journey. Whereas just being forced into standardized reporting seemed to be more of a compliance issue and an upfront cost. So I actually think that this is going to give more room for productive engagements with companies. And here again from an investment perspective, large asset managers or investors that create their own internal taxonomies or create proprietary assessment methodologies, can become strategic differentiators from them.
And I can’t stress this enough, lack of information or asymmetric information is really what investors love. All investors want to have an edge over their competitors and say, I have a unique ability to extract value from the marketplace, and they wanna create frameworks and do that and stress test it and back test it and prove that they’re able to find value.
So I do wanna stress also that for a very long period of time, there was this shift from active management to passive and everyone thought, oh, you can just replicate a benchmark and be fine. And now this complicated addition of non-financial factors that could have a financial impact is giving new life to active management. And that engagement with investee companies and really trying to determine which companies are doing the right things for their long-term viability.
Williamson: The way you phrase that in terms of seeing this regulatory rollback as an opportunity to free up time for investors to find their edge, I absolutely love and I hope everyone goes away from listening today and invests time and actually finding what their edge is in this current climate.
So looking ahead, what role do you think investors can play in advocating for stronger sustainability standards and why might that be in their financial interest in the long term?
Anderson: Yeah. So big picture, I would also like to bring back the concept of values versus value because this is a big, has been a big debate, within the sustainable investing community. Are we investing for personal values when we should be, as fiduciaries, investing for value? So I wanna stress that advocating for better sustainability standards isn’t just about values. We need to shift the focus increasingly toward value. And in this case, I don’t exclusively mean economic profits. I think that’s important. Value has a broader concept here than just returns and profitability. So, when we pivot the conversation from values to value, we’re focusing on creating more sustainable companies, more profitable, more competitive, more value add, because they are managing their climate risks and opportunities better. So achieving these more sustainable companies will create three things. First, more efficient markets for investors. Second, reduced costs for producers and consumers. And lastly, it will reduce systemic risks for investors. Again, we talked about this idea that even though we’re delaying some of these climate-related regulatory frameworks, we are not delaying the fact that this is a crisis that we all face. So we need to create companies and push our companies that we’re investing in to create sustainability or climate-related strategies to reduce that systemic risk for everyone. So it’s about market risk, it’s about more efficiency and reduced costs and market efficiency. Eventually, the freedom of information is what creates market efficiency for investors.
So again, a lot of what we’ve learned in this journey of sustainable investing is that how we define things matters as you and I both know, neither one of us have said the word ESG because that term has it, it was forced to evolve. And I would say the same thing here. The old discussion between values-based investing and value investing purely for economic prospects needs to evolve. What is the value that we are creating for everyone in the future? And it’s multifaceted.
Williamson: Thank you so much for that, Julie. I think the difference between value and values is such an important one here. And I wondered to end on if you could give everyone listening one piece of advice to navigate the next 12 to 18 months, what would you say?
Anderson: I would say, look for opportunities. This is a massive period of change. I say regularly that this is a mega trend, which means it’s both global and persistent. So it’s not going away. And I think when we have a massive disruptive event, such as climate change, and the need to change how we are doing business is an incredible opportunity. I remember being a young investor and sort of reflecting that, wow, we’re still analyzing stock investing and bonds the way that they were doing in the forties, fifties, sixties, like our approach to investing was, I would say stagnant. It was stuck in a rut and we were still trying to use the same tools to extract value.
And I really think that looking more holistically at non-financial challenges that will challenge companies in the future really is invigorating and gives us a new way to engage with companies and to develop companies that will be resilient and that will provide benefit, broad benefit to society as they produce products for us, but also do so in a responsible way and create healthy environments.
So I just, I view this entirely as a once in a lifetime opportunity to watch how investing is going to be changed forever. And my dream is that we no longer have the concept of sustainable investing versus traditional investing, that it becomes business as usual.
Williamson: It sounds like this is such an opportunity to give investing a new lease of life, which it’s needed for a long time and ultimately it’s a way to push forward. My four key takeaways that you’ve shared with us today. Number one, there are so many opportunities that come out of this regulatory backtrack, so make the most of this time that you now have. Use that data now, collect it now to get ahead and make sure you focus on the material issues. Ensure that you stay agile, and finally, this is a new era and a new age for sustainable investing and investing in general.
Such powerful points. So thank you for sharing those with us and all our listeners. Julie, thank you again for joining us. It’s been absolutely wonderful having you on. Until next time, let’s keep building sustainable intelligence together. Find out more at novata.com.