| Federated Hermes Limited (2024)

ESG investing continues to march into the mainstream, but COP26 exposed a landscape of fragmented opinions and simmering discord on a global scale. Here, we argue that if sustainability is to win over its sceptics and reach escape velocity, investors, governments, corporates and consumers can no longer ignore what we believe to be the most important elephant in the room.

Against the backdrop of this shift towards a more sustainable way of living, the world is grappling with rising prices. As a result, the two biggest market themes for the year ahead are, right now, on a collision course.

Markets have mostly tiptoed around discussions linking ESG and inflation, largely because the topic is as polarising as it’s inconvenient. It polarises because there are two schools of thought at play: the first suggests that adopting ESG or sustainable practices in business is a fundamentally inflationary act. The second school of thought argues that doing nothing to address issues such as climate change is, ultimately, even more inflationary.

The inconvenient part of the situation lies in the fact that – in truth – both schools of thought are correct.

Let’s take carbon emissions as our first example. Decarbonisation can be inflationary in two ways and both, ultimately, boil down to a question of supply:

1. Even though, in many countries, the cost of renewable energy is fast coming down, renewables remain – overall and for now – more expensive that fossil fuel. This is fundamentally due to a lack of supply but is exacerbated by new levels of demand created by widespread electrification in areas such as EVs.
2. As governments place more restrictions on both fossil fuel development and nuclear power – thus constraining supply – pricing for fossil fuels and for the renewable sources poised to replace them inevitably moves higher.

In a real-world example of this dynamic, in early December 2021, Shell announced its withdrawal from the development of a new oilfield in the North Sea.1The move, hailed as positive for the climate, will reduce fossil fuel supply and so drive up costs. Meanwhile, demand for renewable alternatives will also rise, triggering an inflationary double whammy.

This is a relatively simple energy-related example, but the same issues are bubbling under the surface of the whole corporate sector. A clothing manufacturer may be under societal and regulatory pressure to use more sustainably sourced material – but to do so comes at a cost. Converting a piece of agricultural land from producing traditional cotton to producing organic (i.e. more sustainable) cotton is resource-intensive and takes time. It’s hard to incentivise a farmer to do this without providing financial support. Put bluntly, if the world wants producers to transition to more ESG-aware practices, then the world must pay for it: yes, hello inflation!

In the sentence above, transition is the key word. At the heart of the equation is the time horizon: Now and in the short-term we can expect inflationary pressures to increase. But as innovation and economies of scale come into play, ongoing costs will gradually come down and the cost of green solutions will fall. In other words, short-term investment must be weighed against more-enduring, long-term gain.

Still, asking corporates to incur costs in the short-term to reap benefits in an unknowable future remains a hard sell. Fossil fuels and plastics are simply cheaper and more efficient right now. Change, in any direction, creates resistance and costs money; and those costs will ultimately land with the end consumer.

The recent rise in energy bills globally, for example, is not solely a symptom of Covid and supply chain disruptions but also the ramification of changing sources of energy and reduced availability of natural gas and oil.

Another widely felt impact will be on the aviation industry. Higher taxes and the possible requirement for airlines in some countries to use a percentage of sustainable aviation fuel will likely drive up costs across the sector. As these are passed onto the consumers, a sharp rise in the cost of air travel could price out the average family who may find foreign holidays less affordable than before.

Such cost increases will not impact the world’s wealthy, but instead middle to lower income households. As more governments introduce these kinds of industry-specific regulations, questions about patterns of consumer impact and the pricing-out of the less-well off will need to be addressed globally.

Those who advocate for a more sustainable way of living have a responsibility to bear this in mind – and to ensure that families and individuals are part of the conversation about the short-term impact on living costs.