Everything’s gone green

One way 

Despite the pushback against environmental, social and governance (ESG) investing in some parts of the world and the disappointing recent performance of sustainability-focused investment strategies, there is no going back. Society has accepted that economic growth cannot continue unabated. The risk to life from irreversible climate change and the degradation of natural habitats is too great. Economic activity needs to become more sustainable. We see this already in the evolution of regulation and the changes – present and future – to business plans. This is only going one way and even the potential re-election of Donald Trump to the US Presidency will not totally derail progress. Renewable energy is cheaper, better energy efficiency supports the bottom line, and companies see the value in meeting customer demand for shorter supply chains, more sustainable materials, and healthier food. Being sustainable makes sense economically as its focuses on reducing external costs.

It is easy to understand the fatigue around sustainability, especially in the finance sector given the increased regulatory burden of recent years. But that does not change a secular trend. We have spent the last couple of months talking to clients in the UK wealth management space, and a sustainable investment option is accounting for an increasing share of the wealth wallet. Younger investors demand a more sustainable approach, just as pension funds and insurance companies do. This week, we had a discussion with an investment consultant about the option of using a global green bond index to replace part of a traditional global aggregate bond benchmark. To me it is wrong to think of ESG or sustainability as something separate to mainstream investing. It is mainstream now because the world is on a path that involves adapting economic activity, so it has a less negative impact on the planet. That provides huge investment opportunities. Along with the development of generative AI, the greening of the world economy is the most important long-term investment narrative of the age.

Active management opportunities 

What sustainability and AI have in common is that both are trends here to stay and are disruptive to businesses. In turn this means that operating models need to change, there needs to be investment, and there will be companies that benefit more than others because of company management recognising the need to change and implement it efficiently. From the investment perspective one can quibble about ESG fatigue and the lessening of political support for the transition, or that the market value of technology companies displays bubble-type valuations. Whatever. It would be hard to convince me that in 10 or 15 years’ time, the world will not be materially closer to achieving net zero or that AI will not be present in much of what we do and consume daily. As a result, the opportunities for active investment management are huge.

Have you got a sustainability plan?  

Increasingly companies are developing their own sustainability frameworks. In general, this involves targeting greater use of renewable energy, improving energy efficiency, shifting to cleaner transportation, reducing the impact on the environment through cutting waste, improving recycling, and using more sustainable packaging. Many industrial companies need to focus on more efficient water usage and eliminating pollution in their processes. New real estate developments are based on the concept of smart buildings while legacy stock is being retrofitted to become more energy efficient. And of course, there is the social dimension, particularly in the Global South where unabated industrialisation and commodity production is generating negative impacts on communities.

Increasingly, sustainability plans are outlined in annual reports and form a major part of the dialogue that companies have with their customers, their suppliers, regulators, and investors. Plans are detailed and monitored, with targets and key performance indicators. In the sphere of achieving net zero, companies can get accreditation based on scientific methodologies for their carbon reduction plans. This helps get access to capital to finance those plans. It is symbiotic. Companies need to adapt, to remain competitive more than anything (sustainability should lead to efficiency), and investors need and want to invest in sustainable business models to protect their capital and future returns.

Follow the money 

It is interesting to follow the green money. For example, when a company raises debt finance through issuing a green bond, the bond’s sustainability credentials are assured by a green bond framework and third-party opinion. For many fixed income investors, it is the impact instrument of choice as the proceeds are used to finance assets that support the company achieving greater sustainability in its business model. That money is spent on either refinancing existing assets or funding new investment in technologies and services that help meet the sustainability goals. So, some or all the proceeds, raised by the issue of a green bond becomes revenue for goods or services providers. Every dollar spent to shift to more renewable energy, to improve energy efficiency or reduce pollution and waste is spent on something – equipment, digitalisation, service provider jobs. Often it is innovative technology, so the suppliers are market leaders and, hopefully, can achieve strong growth in sales as take-up of their goods and services increases as more and more companies invest to meet their sustainability goals. The equity investment opportunities are clear, hence the proliferation of impact equity funds focused on themes such as clean energy and biodiversity protection.

Green bonds 

You do not have to be an environmentalist to see the economics of this and the investment opportunities. Bond investors benefit from having an interest-paying asset that behaves very much like all other fixed income assets. The ICE Green Bond index – with a face value of $1.6trn (compared to $377m just four years ago), has a current yield to maturity of 4.0% in US dollars, a duration of 6.6 years and a composite credit rating of A1. It is a growing, high-grade credit asset class with the benefit of the invested capital doing good. The return profile has been close to that of a broad global investment-grade credit benchmark – underperforming a little over five years because of the longer duration but matching the total return performance of global credit over the bond market recovery of the last year.

New stuff 

Green bonds give investors exposure to the transition and returns from businesses that are investing to become greener. But for growth we need to look to where the money raised is being spent and what companies are benefitting in terms of sales. The equity market provides the growth opportunities. The industry has packaged this as ‘impact’ investing – investing in companies that are themselves operating sustainably and having a positive impact on environment or social issues, expressed through the link to a United Nations Sustainable Development Goals, or providing goods and services that enable others to reach those goals. If you have access to the 17 February edition of The Economist, read the article on the electrification of industrial processes and the new technologies being developed to generate high-temperature heat in order to decarbonise sectors such as steel making, cement and chemical production. While much is still in the early stage, there will be huge potential public equity opportunities in years to come as these technologies are scaled up.

Don’t underestimate progress 

It will take a long time to reach net zero. It is not even clear that reaching net zero will prevent global temperatures rising by more than 1.5 degrees. But the world will try, and the roadmap is clear. It requires structural change and, if anything, progress is more likely to accelerate than be derailed for good reasons (technology becomes cheaper thus making transition economically more attractive) or bad reasons (policy needs to react to climatic events by accelerating the imposition of carbon taxes, for example). One of the external advisors to the AXA IM Investment Institute, Nigel Topping, has consistently argued the point that progress – in terms of cost and productivity of new green technology – will be exponential.

As the transition evolves, the green bond market will grow, become more diversified in terms of number and types of issuers, and a ‘greenium’ may even become a more material and permanent characteristic (the greenium is the lower cost of capital for issuers of green bonds relative to regular corporate bonds). A larger green bond market means more investment in sustainable assets which means greater revenues to support the equity of companies providing the technology, equipment and services required. The great news is that investors can benefit from both the growth in fixed income and equity opportunities. A green growth and income strategy if you like.

Repeat the mantra 

None of this is new of course. There is already a well-established sustainable investment industry and firms like AXA IM have put sustainability at the heart of what they do. Our aim is to achieve substantial reductions in carbon emissions coming from the companies we invest in over the coming years. We have a focused biodiversity strategy that invests in activities that have a positive impact on the environment. Every investment decision we make is looked at through both the prism of expected financial returns and the sustainability angle. We are well into the era of sustainable investing. But there is nothing wrong with shouting about it now and again because there is a lot more to do - and values have been under attack since the pandemic and the elevation of global security and energy concerns.

The secularity of the transition to a more sustainable future, with a focus on limiting climate change and protecting the environment, suggests more capital will be devoted explicitly to sustainable investment in the coming years. That creates investment opportunities in the whole financial supply chain related to greening the economy. Explicit sustainable investment strategies will become more mainstream and implicitly, investment decisions in general will incorporate both financial and sustainability criteria. I would argue this has already impacted positively on the quality of investable assets. The decision to invest in a corporate bond has always relied on credit ratings that assess the financial strength and repayment ability of the issuer. Now we also look at the ESG risks and the sustainability profile. That additional governance of the investment decision should mean better quality and more robust credit portfolios. Yet another reason, given where we are in the cycle and in the path towards a greener future, why corporate credit is a key asset class. Even if credit investors do not invest in green bonds, I would wager that their credit portfolios today have a better sustainability profile than was the case five or 10 years ago.

Performance should reward sustainable investing 

Many investors are concerned about the performance of ESG-related assets. This is fair given that equity portfolios which underweighted the energy sector, for example, would have significantly underperformed in 2022. That energy shock was a one-off, driven by Russia’s invasion of Ukraine and the disruption to natural gas supplies that came in its wake. However, the response has been to accelerate the take-up of renewable energy. I read this week that Spain has almost achieved a 100% share of renewables in its energy generation. Germany has improved energy efficiency, being forced to wean itself off Russian-supplied gas. The point is that the market evolves to account for shocks and price developments - and these have reinforced the case for renewable energy production (and thus the demand for the components of the supply chain).

The philosophical case is clear. Companies shifting their business model to a more sustainable one will benefit over the long term. They will achieve lower energy costs, have more efficient processes and be less subject to punitive regulation. On the demand side customers will express a preference for goods and services that have a sustainable provenance. Investors are already displaying a preference for providing capital on better terms for sustainable assets. Investors need to take a long-term view as many of the activities around sustainability are in their infancy and there is still a lot of technology to be developed and to come to market. 

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 29 February 2024). Past performance should not be seen as a guide to future returns.