How does an unsustainable investment become a bad investment?

Investors are increasingly incorporating sustainability-related information into their assessments of the attractiveness of investments. But how exactly do sustainability-related risks (and benefits) manifest in the prices of assets we invest in?

At To the pound we think there are two ways that this happens.

1. The market punishes a company or a country for having bad sustainability characteristics, directly driving stock prices lower or bond yields higher
2. The actual physical cost of the sustainability-related risk ‘crystallises’, such that the company or country has to pay for the cost out of their own pocket. This could happen either in the event of the sustainability emergency, or intentionally because of the company or country choosing to spend money to prevent the emergency happening.

For corporate entities, both are likely. The former is likely to be the short-term transmission from sustainability to stock price, while the latter is slower-moving and longer term.

For countries/governments, we don’t think the first type will happen in strong form most of the time. There is more noise than signal in the relationship between sustainability and government bond yields. Therefore we shouldn’t expect direct translation of sustainability costs into bond yields. Sustainability-related factors do appear correlated with measures of country credit risk, so bond markets are likely reflecting sustainability characteristics in their lending decisions, but we think that a market-driven impetus of ‘bad’ sustainability leading to higher bond yields is not at play, at least for now.

The second type of transmission from sustainability to stock prices or bond yields can happen for three main reasons:

1. Voluntary: The company or government recognises that a sustainability-related cost is unsustainable and takes action to rectify it. Example: Israel recognised its water crisis and moved to develop new water technology, including mass desalination to return to water surplus.
2. Forced: A regulatory body forces companies to act, or a supranational body such as the UN forces a government to take action. Example: The Paris climate accords have forced countries to invest in clean energy
3. Emergency: The sustainability risk becomes acute, and the cost is crystallised in an emergency / uncontrolled fashion.

The assumption (or hope, from a sustainability perspective) is that companies and governments will do one of the first two, i.e., they will take action.