SDGs and Inflation

System-Level Thinking Required of Responsible Investors

With many investors now targeting the UN Sustainable Development Goals to guide their impact strategies, it is becoming increasingly important for investors to consider the interconnectedness of sustainability issues to contribute to shaping real-world sustainability outcomes.

Addressing the system-level risk of climate change, for example, creates inflationary pressures through internalization of negative externalities. The system-level risk of widening income inequality and declining labour income share, if left unaddressed, will combine with rising inflation to further reduce households' purchasing power and hence well-being. If this happens, net zero momentum could be lost, and anti-ESG and anti-SDG sentiment could increase and spread globally.

To avoid such a malign outcome, responsible investors need to adopt system-level thinking with a macro-socioeconomic perspective, focusing on the interconnectedness of the financial system, the environment, and the social system.

Cost-push shocks caused by internalization of negative externalities

The term "greenflation," which combines "green" meaning decarbonization and "inflation" meaning rising prices, has become widely known. As investment in fossil fuels has been curbed, demand for natural gas, which can have lower greenhouse gas emissions than coal, has increased, causing energy prices to rise. Prices have also risen for a variety of metals and commodities, including copper and lithium, which are needed to drive renewable energy growth.

The cost-push shocks of such decarbonization occur in the process of internalization of negative externalities by companies. The spread of corporate management engaged in sustainability issues has led to the internalization of negative externalities in areas besides decarbonization. For example, improvements in human rights in the supply chain and the deforestation-free movement have made it more difficult to source previously available cheap labour and raw materials. New mine developments are also taking longer to come online due to concerns about the environment, local residents, and miners' human rights

To increase the sustainability of corporate management, it is necessary to maintain, preserve, and enhance nonfinancial capital, such as natural capital and human capital, and this comes at a reasonable cost. These costs are passed on in no small measure in market prices. For example, compared to internal combustion engine vehicles, which damage natural capital through greenhouse gas emissions, EVs, which damage natural capital to a lesser extent, are generally more expensive to produce. The airline industry has offered green fares to passengers who want to offset their carbon footprint by using more expensive SAF (Sustainable Aviation Fuel): consumers pay a premium and offset their flight shame. In addition to natural capital, the costs of human rights considerations and investments in human capital (e.g., training costs) are gradually being passed on in the prices of products and services.

Environmental and social sustainability underpin the business foundations of all companies around the world, and if it is undermined – if the SDGs are not achieved – market returns will deteriorate on a global scale.

Institutional investor actions to achieve the SDGs

The impact of cost-push shocks associated with the internalization of negative externalities is likely to become more widespread in the future as society moves further toward achieving the SDGs.

The SDGs were adopted by the UN General Assembly in 2015 as global goals to be achieved by 2030, and 2023 was just the turnaround point, but a mid-term wrap-up of SDG achievement shows that less than 20% of the SDG targets are on track to be achieved globally by 2030, and more than 80% of the targets have made little or no progress or have experienced backsliding. Therefore, the global community will have to accelerate its actions at a considerable pace if the targets are to be achieved by the target date. Indeed, institutional investors are expected to gear up to achieve the SDGs in the future. For example, PRI's survey of signatories conducted in late 2022 and early 2023 clearly confirms this direction. Investors are expected to intensify their efforts to encourage portfolio companies to reduce negative impacts as well as create positive impacts through stewardship activities. In the process, the magnitude and impact of cost-push shocks will become more pervasive.

Fiduciary duties and addressing system-level risks

Why is achieving the SDGs so important to institutional investors?

It is now clear around the world that beneficiaries and clients are increasingly showing a preference for sustainability and SDG achievement, not just financial returns. In Japan, for example, according to a survey conducted last year by Nippon Life Insurance for its policyholders, 65% of policyholders expect Nippon Life Insurance to consider the achievement of the SDGs as well as financial returns when it comes to asset management. Another 14% of policyholders expect the company to prioritize the achievement of the SDGs regardless of financial returns.

In addition, even for beneficiaries who are only interested in financial returns, the achievement of the SDGs is actually very important from a long-term perspective. Environmental and social sustainability underpin the business foundations of all companies around the world, and if it is undermined – if the SDGs are not achieved – market returns will deteriorate on a global scale. If this happens, institutional investors will not be able to fulfill their fiduciary duties. No matter how well diversified their investments are, they will not be immune to the impact of system-level risks, such as global warming or biodiversity loss, that threaten the business foundations of all companies.

For this reason, the UK Stewardship Code encourages institutional investors to address system-level risk. The PRI has developed guidelines for Active Ownership 2.0, a stewardship initiative to limit system-level risks, and collaborative engagement among investors is expanding.

Declining labour income share and widening income inequality

As noted above, the pursuit of the SDGs is inflationary. So, if beneficiaries want investors to contribute to the achievement of the SDGs, will they accept the resulting inflation? That depends on wages

Even if the people and society want to achieve the SDGs, it would be difficult for them to accept a consequence in which only prices rise without wages increasing. In the first place, if price increases are not met with wage gains (i.e., household purchasing power does not improve), consumer demand for more expensive goods and services that take sustainability into account will not increase, and as a result, the SDGs will not be achieved.

In relation to the purchasing power of households, it is noteworthy that the labour income share has been declining for a long period of time on a global basis. In other words, the growth of real wages for workers has been low relative to the growth of labour productivity, accelerating the concentration of wealth among shareholders and others and increasing income inequality. This is not sustainable. Such income inequality is significantly undermining the productivity of the economy as a whole. In other words, the declining trend in the labour income share and the widening of income inequality is itself a system-level risk.

While addressing the system-level risk of climate change creates inflationary pressures through internalization of negative externalities, another system-level risk of widening income inequality and declining labour income share, if left unaddressed, will combine with rising inflation to further reduce households' purchasing power and thus well-being. If this happens, net zero momentum could be lost, and anti-ESG and anti-SDG sentiment could spread globally. To avoid such a situation, it is increasingly important to consider the interconnectedness of sustainability issues.

The current goal of society and the context for capital markets to contend with is the shift from an emphasis on shareholder profits to an emphasis on the overall interests of various stakeholders, which will naturally lead to an increase in the labour income share and the elimination of income inequality. For stakeholder capitalism to take root in capital markets, responsible investors need to comprehensively evaluate various sustainability issues surrounding their portfolio companies and their business partners. In the supply chain, for example, it is important to not only reduce CO2 emissions but also consider human rights and ensure fair wage levels (on an inflation adjusted basis). In fact, the European Sustainability Reporting Standard (ESRS) requires companies to disclose information on working conditions, including fair wages, human capital investments (training and capacity building), and human rights, not only for their own operations but also for their impacts throughout the value chain.

What is clear is that responsible investors will be required to adopt "system-level thinking" based on the interconnectedness of the financial system, the environment, and the social system, with a macro-socioeconomic perspective in mind. This is essential if investors are to contribute to shaping sustainability outcomes in the real world.