Hidden investment themes with impact

INTRODUCTION

Of all the impact topics considered by investors, climate change has become the most dominant. In the rollercoaster ride of 2020, equity investments in the climate change mitigation theme skyrocketed. Investments in electric vehicles, green utilities, hydrogen pure-plays and manufacturers of solar panels and wind turbines also saw tremendous price action.

Examples are Tesla's share price, which increased by 740% in 2020, but also the S&P clean energy index, which saw an increase of 141% after being relatively flat for the preceding four years. This was not a complete surprise. The number of climate-related natural catastrophes has risen in recent years, with storms, flooding, droughts and forest fires providing a sobering reminder that the physical risks of global warming are already materialising. Over the past three years, climate-related damage has exceeded $650bn, representing 28bps of global GDP. Climate change is no longer seen as being beyond the relevant time horizon of corporates or asset managers.

In other words: investing in climate change is “hot” and both valuations and volatility have increased in this market subset. All this can be rationalised of course: more government regulations on climate change, more investor visibility and less visibility in subsidies, quantitative easing and the markets makes it hard to say whether these stocks are overvalued or whether the volatility and the price action is the irrational inflation of the “green bubble”, or rational investment as the world is changing. What is more interesting, however, is to look beyond climate change for other impactful themes. Returns in the long run and exposure to these alternative themes could now provide investment opportunities that might not be available in the future because of the risks and opportunities having been fully priced in.

According to the Social and Economic Council of the Netherlands' report entitled ”Seizing opportunities and managing risks, the relationship between the SDGs and IRBC”, financial institutions can act as a lever by using their position as shareholders. The best way of doing this is to set up a robust due diligence framework to monitor companies' adherence to best practices. Shareholders could then ask questions about and suggest best practices. Dutch institutional investors that are aware of the themes due to receive increased scrutiny from regulators – given the evident difficulties those investors face in implementing the IRBC framework – will structure policy documents accordingly and ascertain whether investment and engagement strategies reflect the coming risks and opportunities as regards ESG.

Themes which will be increasingly important in the coming years and which are directly and indirectly investable and trackable to companies' supply changes will be environmentally related. No poverty, decent work and reduced inequalities are all important sustainable development goals (SDGs), but without sustainable environmental conditions, any effort to help end inequality or poverty will be in vein.

Current climatic conditions and other planetary systems are deteriorating but are still enabling societies to prosper. However, the environmental conditions for prosperity are at risk due to climate change, forest clearance, resource depletion etc. Thus, even though the OECD lists a number of other topics that are just as important for investors, nurturing sustainable environmental conditions is key and will have relevance not only to governments and businesses but also to society at large.

Sustainable Development Goals

^{Source: https://blog.igem.org/}

Alternative investable themes will be described below and are solutions to the top risks reported by the World Economic Forum in its most recent risk report. Apart from climate change, weapons of mass destruction and infectious diseases, the report lists biodiversity loss and natural resources as the top risks facing humanity. The themes water management, circularity and biodiversity will accordingly receive greater attention in the coming years, in line with a transition towards a more sustainable model.

Global risk landscape

^{Source: http://www3.weforum.org.}

WATER MANAGEMENT

Demand for water is projected to exceed supply by 40% by 2030 if global water consumption continues to grow at its current rate. Population growth and economic development are increasing the amount of water required for irrigation, industry and domestic purposes. This was a reason for the UN to include an SDG specifically related to water (SDG #6). This theme is clearly important from an impact perspective, as water availability is a basic human need. It is also crucial to production processes. Although climate change affects water availability, water management solutions can provide investors with investment opportunities in an area which is poised to become increasingly important in the medium to long term. The world bank estimates that GDP will fall 6% by 2050 as competition for water resources intensifies. And companies are already feeling the impact of water risks as, in 2018 alone, they sustained financial hits totalling $ 28.5 billion in this regard, according to the international non-profit organization CDP that helps companies and cities disclose their environmental impact.

Compared to investments in climate change solutions, companies that focus on water management have not seen such astronomical share price increases. Looking specifically at valuations as a proxy for performance in this theme, the MSCI Global Sustainable Water Index is trading at a discount compared to MSCI World. At the end of December, the P/E ratio for the former hovered at around 24 compared to 28 for the latter.

P/E-ratio Water index versus World index

^{Source: MSCI}

Given the assumption of worsening water shortages with supply exceeding demand over the next few decades, this discount is likely to narrow in the long run (even though the water index is heavily tilted towards utilities with an historically lower PE), particularly since the water services industry (e.g. wastewater treatment companies, or companies that develop smart metering systems for water infrastructure) is expected to grow globally at around 4-6% a year (source: GWI Global Water Market 2015). However, companies that do not have their water-risk exposure in order will face increased scrutiny. Droughts may also impact companies, given tightened government regulations.

One only has to look at the example of the Coca-Cola bottling plant which, in 2014, was ordered to close in northern India after local farmers blamed it for using too much water, thus creating a headache for the world's biggest soft-drinks maker in one of its most important markets. The plant was one of the company's smaller ones, so Coca-Cola did not suffer excessive losses. However, the problems continued. In 2017, traders in the south Indian state of Tamil Nadu, whose population exceeds that of the UK, boycotted big brands and replaced them with locally produced soft drinks. The reason for the boycott was again the big brands' excessive use of water. Even though some companies may have valid arguments for their use of water, they are not immune from suffering water-related impacts no matter how little blame attaches to them in that regard.

Water management as an opportunity

Over $1 trillion needs to be spent each year between now and 2030 to provide an effective global water infrastructure (source: OECD 2005/Morgan Stanley). Companies that generate revenue from providing water to customers, treating wastewater and making water technology available will probably grow 4%-6% per annum. Added to this is the knowledge that P/E levels are depressed, and growth and investments are needed. This means that investors have the opportunity to capitalise on this theme now. Water will become scarcer and investments need to be ramped up in order to meet the demand for water. This does not necessarily mean that investors will need to be positioned more cyclically or defensively, as most opportunities will arise from industrials and utilities from which investors will be able to select a balanced basket.

Weary of problems with water scarcity, front-runners in water utilities sectors are well positioned to meet the additional demand. This is backed up by the water technology companies, which provide both water utilities companies and their customers with the technology and products to monitor water use, increase efficiency and do everything else in-between.

Water management risks

As with investments in Coca-Cola in India and coal-powered power plants, stranded assets and increased costs are now the main risks for companies and for investors. We all know about assets being stranded due to climate change, but water depletion is equally likely to create similar problems. Power plants are mostly water-cooled, but perhaps more interesting is that a lot of water is used in chip manufacturing. Demand for chips is booming but supplying chips can become an issue when production plants use considerable quantities of water in areas of increasing water scarcity. Electronics manufacturers in general are at risk when chips are not available, or their supply is impacted due to water shortages. Companies should have their water risks under control and policies in place at their production sites where the risks are clear, but they also should be monitoring their suppliers' sites and examine the entire chain for potential problems. Poorly managed production sites or supply chains create avoidable costs. For investors, preventing avoidable water management costs should be the aim of due diligence and engagement.

CIRCULARITY

The United Nations (UN) forecasts that there will be another 1 billion people living on the planet by 2030, with 60% of the global population living in cities. Together, these trends will put incremental pressure on natural resources unless the link between economic growth and consumption trends can be broken. Improving resource efficiency, developing a circular economy and minimizing pollution are all essential for the 12th SDG (responsible consumption and production) to be achieved. Specifically, circularity is one of the themes that, interestingly enough, has been in the public eye for some time but hasn’t really been in the spotlight of investors.

This could be because circularity is a broad theme and it is difficult to pinpoint which specific sub-sector or industry group actively touches on this theme. Another factor is that, because it is such a broad theme, it is not easy to measure, unlike in the case of a CO₂ footprint for example. Nevertheless, circularity provides investment opportunities for companies and investors. For instance, circularity would boost the Dutch economy by EUR 7 billion and create 50 thousand jobs, with 25% fewer imports of primary resources (source: TNO). This could be an incentive for investors to increase their exposure to this theme or, of course, a reason to focus on businesses circularity in their production processes or supply chains using a due diligence framework for their policies.

Circularity as an opportunity

The responsible management of waste has the dual benefit of reducing both the negative environmental impact and the need for extracting excessive primary resources. Companies can contribute to the circular economy through their products and service provision to other businesses or to consumers. Companies such as Umicore, a Belgian firm that is trying to make a profit out of recycling used batteries, is making electric vehicles even more environmentally friendly. Businesses that are moving away from “take-make-dispose” production and consumption model and pursuing circular business models are set to be winners in the process of structural changes ahead. Innovation leaders such as Ball Corp, which produces aluminium packaging for food and beverages, are also applying circular economy principles to differentiate their product range. Given that aluminium is exceptionally well suited to recycling purposes, Ball Corp is looking at ways to use it for other non-traditional purposes as well. For instance, using aluminium recyclable cups instead of plastic ones at football stadiums or parties. Forward-looking investors can benefit from this largely untapped growth story by allocating capital to business models aligned to circular economy principles or to the enablers of this transition. This is a subset of companies spread across several sectors. Investors should also be on the lookout in the industrials sectors as well as in utilities, where there are opportunities for companies active in waste disposal and re-use.

Circularity risk reduction

In addition to focusing on just pure-play circular economy players, investors should be alert to companies integrating circularity into their value chains. Apart from the economic benefits that pure plays derive from resource depletion, companies that are currently increasing their focus on implementing circularity in their production methods and their supply chain will be better prepared for potential resource depletion and government intervention. Although the perceived focus of governments is currently on climate change, they are also increasingly aware that the adaptation to a circular economy is just as important. The Dutch government aims to be a circular economy by 2050, i.e. an economy without waste in which everything runs on reusable raw materials. Companies that do not keep up will be regarded laggards and pay higher prices for their input costs as well as incur higher risks of losing their material input and thus their customers. One example of this was SSAB's failed attempt to acquire TATA steel. Given the estimated cost of upgrading the production plants to be more in line with SSAB’s sustainability targets and circular economic policy, the deal fell through, thus jeopardising thousands of jobs.

BIODIVERSITY

Biodiversity refers to the variety and variability of life on Earth and is typically a measure of the variation at the genetic, species and ecosystem levels. It is critical for sustaining human populations globally. The OECD estimates that ecosystem services provide societal benefits worth USD 125-140 trillion per annum, representing over one-and-a-half times global GDP. Examples of such benefits include meeting growing food demands, regulating air quality, providing biomedical resources and insights and maintaining water security.

Various drivers have caused biodiversity to be lost at a faster rate than ever observed in history. The most notable of these are land use change, partly driven by urbanization, the spread of invasive species due to globalization, worsening pollution, direct exploitation of natural resources, and climate change.

Biodiversity loss is having a profound impact on the economy. Biodiversity provides protection from adverse weather events and physical risks. For instance, wetlands prevented USD 650 million in damage during hurricane Sandy in 2019. The UN estimates that the global economy will lose USD 23 trillion by 2050 as a result of land degradation. Without biodiversity protection, a significant number of supply chains will be broken, resulting in a lack of cocoa for chocolate, for example, but also impacting tea and coffee harvests. Basically, all production from natural resources, including agriculture and fishing, will be impaired if biodiversity fails.

Biodiversity, climate change & water in PRI reporting

^{Source: PRI.}

Biodiversity as an opportunity

Looking at the preservation of biodiversity as an opportunity requires some creativity. Apart from climate change, agriculture poses one of the biggest risks to biodiversity, meaning that opportunities to boost biodiversity will be centred around the agricultural sector. Specifically, the available opportunities are to be found in reducing intensive agriculture, which demands substantial fertiliser use and leaves deposits of nitrogen and phosphorus in ground water. Vertical farming companies, or businesses that provide lighting or other tools and equipment for use in less intensive agriculture, will reap the benefits of the increasing focus on biodiversity.

Biodiversity as a risk

Agriculture is a sector in which pesticides and fertilisers have had and continue to have a profound impact on biodiversity. However, more and more companies are aware of this issue. Unilever, for instance, has implemented a Biodiversity Action Plan and set itself the 2020 Net Zero Deforestation Goal, the aim being to ensure the long-term sustainability of the agricultural systems it sources from. This will actually create opportunities. For example, biodiversity is a source of material benefit to agribusiness because of the lower operating costs involved. This is due to the reduced input of crop production products and climate resilience, as healthy soils are better suited to coping with droughts and floods. The agricultural yield is also higher in terms of value because consumers increasingly tend to favour organic and sustainably sourced foods.

Investors can already assess how companies are reducing the risks of biodiversity loss and they can gauge potential opportunities provided by more efficient production processes by looking at companies' policies as well as at supply chains of corporates that depend on agricultural products. There is a regulatory risk, however: companies in the timber, mining and oil and cattle production industries are being forced to mitigate impacts on forestry and nature in order to avoid statutory liability for spills and deforestation

Nature loss, risk and implications for investors

^{Source: PRI, Investor Action On Biodiversity: Discussion Paper (08/2020)}

CONCLUSION

Even though climate change is a hot topic and will continue to be so for the foreseeable future, investors still need to diversify and prepare for new challenges that will be just as important. Investors would do well to study other impact themes and benefit from subjects that are now overshadowed by the theme of climate but are just as important. Investors should now be looking at laggards and engage with the issues or face catastrophic returns. Water, circularity and biodiversity are three themes that will command increasing intention from the international community and investors at large in the years to come. Fortunately, data providers have already been preparing for water disclosures for some time. Until recently their focus was on companies' CO₂ footprints, but data on water is now becoming widely available and will improve in the coming years.

Data on circularity and biodiversity is less mature, and whereas data on recycled waste is available, company reporting needs to improve. Data on biodiversity is hardest to come by, as it focuses mainly on policies and managing exposure to risks. However, this will also see improvement as reporting frameworks begin to be standardised. Opportunities are to be found in investments that have an active tilt to or specifically target impact themes. Creating exposure now will set investors up for enhanced returns in the long run. As for risk reduction, asset owners should look to asset managers that incorporate a strict due diligence framework and impact themes in their selection process. Excluding worst performers will reduce ESG risks and, with proper management, will only marginally increase financial risks such as reflected by tracking error.