Natural Capital Investment Strategies
Risk, Return and Nature
Asset managers create a unique investment policy statement (IPS) for every institutional and high net worth client (HNW). Such an IPS fully describes all material issues affecting the objectives and constraints placed on the investment thesis by the institutional investors and their HNW clients.
A model IPS statement includes two objectives, which are “risk” and “return”. These two objectives are then informed by five constraints. The five constraints are “time horizon”, “taxes”, “liquidity”, “legal”, and “unique”. These two objectives and five constraints form the acronym RRTTLLU.
Natural capital comes from ideas related to economic capital and human capital. Natural capital includes stocks measuring qualities and quantities of air, land, water, and biodiversity and the flows of ecosystem services and goods from these stocks into the future. Examples of natural capital include water quality and quantity inputs into potable water distribution systems, how biodiversity improves pollination in agricultural supply chains, how land-use can improve real estate values, and how better air quality improves human health.
In an investment policy statement, natural capital stocks and flows can be integrated into each component of the RRTTLLU model. This integration allows asset managers to include natural capital criteria in their investment management strategies. Although it is not the industry standard, asset managers with a proclivity to incorporate natural capital into portfolio decisions are finding resources to do so.
One example is the Natural Capital Protocol that is currently being developed by The Natural Capital Coalition (NCC). This protocol will provide a unified methodology for stakeholders in businesses across the world to quantify the impacts they have and the extent to which they are dependent on the natural environment, its finite natural resources and functioning ecosystems.
Company and industry specific language in this protocol will inform executive managers within these companies on major decisions endogenous to the firm. Equally important to asset managers, the protocol will also be incorporated into analysts’ assessment of risks and resulting company recommendations.
Once the RRTTLLU model is complete, the information within is then synthesized and used to structure a portfolio catered to that particular investor. The intention is to first determine the relevant characteristics of each company and industry and then construct the portfolio to minimize risk for an agreed upon level of desired return or maximize the return for an acceptable degree of risk. Sounds great, right? Yet what if these same asset managers fail to incorporate an entire taxonomy of objectives and constraints – the taxonomy of capital market movement due to the change in natural capital stocks and flows?
Markowitz’ Modern Portfolio Theory shows that investors should be compensated with higher returns for taking on higher risk. Asset managers understand the risks posed by competitors, changing customer needs, and the capital markets. Therefore, asset manager diversify their portfolios and mitigate unsystematic risk by investing across different companies, industries and asset classes.
But how do asset managers quantify the impacts on risk and return objectives, and time horizon, taxes, liquidity, legal, and unique constraints posed by natural capital stocks and flows? Salient example of this quantification of natural capital into portfolio management is how asset managers are pricing climate risk into portfolio management. Since climate risk is a known and material financial risk, asset managers now often include in their pricing of publicly traded companies their analysis of risk and return associated with both emissions reduction technologies and high-emitting extractives.
For example, companies in the renewable energy industry and the coal-mining industry now see their share prices effected by these natural capital inputs. Likewise, US public utilities that rely on coal for new generation may experience punitive outcomes from exposure to the pending EPA Clean Power Plan from June 2 of this year discouraging coal-fired plants.
Similarly, The University of Cambridge cited one raw material extraction company that was recently the subject of a negative NGO video campaign viewed by 78,500 people within an hour of being published? How do asset managers determine the calculus for lost market share and commensurate revenue shortfall from this form of reputational damage?
Finally, how do asset managers monetize the impacts on natural capital for a particular company or sector? In November of 2011, PUMA voluntarily accounted for the environmental costs of its operations at $190 million or 70% of its profits, certainly a metric most would deem relevant and financially material.
Presently, the HNW or institutional client, unfortunately in retrospect, may find that an investment was entirely inappropriate from a risk/reward perspective once the financially material parameters associated with natural capital stocks and flows are factored in.
Multinational companies are inevitably moving toward adoption of an integrated form of accounting which includes both financial and non-financial costs. However, until such time as this is fully standardized and published for all investors to analyze, asset managers can exercise their fiduciary duties with their clients by integrating natural capital measures into their investment policy statements through each portfolio’s RRTTLLU framework and its associated risk and return objectives.