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How to invest in the ‘E’ of ESG
The ‘environmental’ pillar offers many investment opportunities across a wide array of themes
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A case study of the Fiji government’s plan to issue a sovereign blue bond in 2022
Environmental policy in action
The opportunities created by the energy transition
The future is bright for clean energy
How investment groups determine the environmental issues related to companies
Jessica Ground, global head of ESG at Capital Group, on why the environment is such a focus for investors right now
The broad impact of climate change
A just transition
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a guide to exploring esg: ENVIRONMENTAL
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To many investors, the ‘E’ of ESG – the environment – means one thing: the move away from a reliance on fossil fuels such as oil and gas. There is no doubt this transition from historical ways of generating energy to a more balanced mix that includes renewable sources is very exciting and offers numerous investment opportunities. For Capital Group, one of the world’s largest active fund managers, addressing environmental issues is integral to the research and investment process. However, Capital Group’s analysts have identified energy transition as a theme that requires patience from investors. The move towards a low-carbon future will be a slow evolution rather than a revolution. Those companies positioned to benefit from it may make attractive long-term investments.
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global aum in sustainable funds in Q1 2021
$2trn
Energy transition as a theme requires patience from investors. The move towards a low-carbon future will be a slow evolution rather than a revolution
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year-on-year increase, as at july 2021
17.8%
sustainable funds net inflows , Q1 2021
$185.3bn
This includes energy companies that are balancing declining fossil fuel-based earnings with growing renewable investments such as Denmark-based Ørsted, the largest developer of offshore wind farms in the world. The company was once a traditional utility business dominated by oil- and coal-powered plants, but over several decades it has reinvented itself to become a leading renewable energy company. Electric vehicles are another area with rich investment potential associated with the transition. Capital Group’s analysts and portfolio managers have identified that the move towards lower- or zero-emission vehicles will require significant research and development (R&D) spending. This means auto parts companies with a greater focus on R&D may grow faster than the industry average. The proportion of a company’s spending that is directed towards R&D can be a signal that identifies opportunities. This is a key indicator as to which organisations are prepared for the possibility of increasingly restrictive emissions standards.
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The move towards lower- or zero-emission vehicles will require significant R&D spending. This means auto parts companies with a greater focus on R&D may grow faster than the industry average
But there is more to investing in the ‘E’ of ESG than just the transition aspect. In fact, the environment encompasses an array of themes from the obvious – such as electric vehicles and battery storage – to less well-known areas like the circular economy, waste management and smart cities. Smart cities, for instance, offer solutions for reducing power consumption ranging from more energy-efficient buildings to office lifts that require less energy. A circular economy is one in which no waste is created – everything is reused and recycled in a circular way. For investors with shorter investment horizons than those required by the transition theme, waste management could be an attractive investment opportunity over the short to medium term. Waste management organisations, which provide collection and optical sorting systems to food and recycling businesses, could benefit from trends such as rising urbanisation rates and increased consumption. The ‘E’ in ESG is about far more than the transition away from fossil fuels. It’s an area that’s rich in investment opportunities across a wide arrange of themes. As consumer preferences and stakeholder concerns continue to evolve, investors are likely to see new products and market segments materialise.
Balancing act
Smart cities and circular economies
The enormity of climate change is not only a challenge of science. It is a challenge of finance. So, the level of innovation necessary to combat climate change must be met by the same level of innovation to craft the financial instruments to support the solutions we need. This is why the United Nations Capital Development Fund (UNCDF) was proud to stand by the UK and the UN Development Programme (UNDP) in commending the Fiji government’s plan to issue a sovereign blue bond in 2022, which was announced at the UN Climate Change Conference (COP26) in Glasgow by the Fijian attorney-general and minister for economy, Aiyaz Sayed-Khaiyum, at the Alliance of Small Island States Pavilion. A blue bond is a relatively new form of a sustainability bond, which is a debt instrument that is issued to support investments in healthy oceans and ‘blue’ marine economies. In a similar way to conventional bonds, investors lend money to a bond issuer, who agrees to repay the interest every year for the term of the bond and repay the original capital on a certain day. In a blue bond, earnings are generated from the investments in sustainable ‘blue’ economy projects.
The level of innovation necessary to combat climate change must be met by the same level of innovation to craft the financial instruments to support the solutions we need
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This blue bond will raise up to $50m (£37.4m) for investments to deliver a sustainable blue economy, create jobs and protect Fiji’s ocean and biodiversity. The government of Fiji is working closely with the UK, UNDP and UNCDF to develop and issue the bond by the summer of 2022. “Fiji’s pioneering approach will help provide finance to deliver new marine protected areas, sustainable fisheries, green shipping and nature-based solutions to protect vulnerable communities from sea level rise. The UK is proud to be supporting Fiji in this ambitious and innovative endeavour,” says Lord Goldsmith, the UK’s minister for the Pacific and the international environment. Funds raised through the bond will contribute to setting Fiji’s blue economy on a carbon-neutral path by 2050, and help Fiji meet its commitments under the 2030 Sustainable Development Goals (SDGs), specifically Goal 14: Life Below Water, in the face of a sharp Covid-induced economic downturn that began in 2020. “For UNDP and UNCDF, it is a privilege to work with the government of Fiji and the government of the UK to develop the framework for Fiji’s new blue bond and design investible projects to be financed by the bond proceeds,” says Achim Steiner, administrator of UNDP. “The blue bond will spur new efforts in Fiji to protect and restore the ocean while opening up a range of new opportunities in the form of jobs and livelihoods. This is vital as many communities are still suffering from the socioeconomic consequences of the Covid-19 pandemic.”
The blue bond will spur new efforts in Fiji to protect and restore the ocean while opening up a range of new opportunities in the form of jobs and livelihoods
Blue economy
The ocean holds deep cultural, socioeconomic and dietary significance for Fijians, with 76% of the country living within five kilometers (km) of the coastline and a marine ecosystem valued at $1.16bn. Fiji is home to 5% of the world’s coral reefs, including the world’s third-longest barrier reef system, the Great Sea Reef, which extends for 200 km and is teeming with marine life. But this crucial resource is under threat on multiple fronts, including from climate change and over-exploitation, requiring urgent financial resources to preserve and protect it. The blue bond will provide investors with attractive investment opportunities which support ocean-friendly sustainable development. “What we are doing as UNCDF, together with UNDP, is helping structure the investment pipeline with the support of the UK government’s Blue Planet Fund and other partners. We are looking at marine-protected areas, green shipping and fisheries. These are vital areas for Fiji,” says UNCDF executive secretary Preeti Sinha. Fiji has been a leading climate advocate for small island developing states in global forums, consistently urging developed countries to provide innovative finance to help the developing world cope with the impacts of climate change. The announcement comes just five years after Fiji issued sovereign green bonds to raise funds for climate change adaption and mitigation projects prior to assuming the presidency of COP23. This latest attempt to raise funds is a bid to achieve the vision outlined in the country’s national ocean policy – ‘a healthy ocean that sustains the livelihoods and aspirations of current and future generations of Fiji’.
1 Sovereign green bonds are debt issued by governments to raise money for climate and environmental projects.
Ocean-friendly vision
In recent years money has flooded into environmentally-friendly investments driven by a desire to do good but also by potentially healthy investment returns. Bobby Chada, an investment analyst at Capital Group, anticipates a bright future for green power as the world’s transition to a low-carbon economy gathers pace. Chada says clean energy is benefiting from three important secular tailwinds, which he calls the ‘green trifecta’. These are falling costs for renewable energy, new energy policies and economic stimulus. “The biggest reason I expect clean energy companies to do well is that renewable technology just keeps getting cheaper,” he says. The second of these three trends is the host of new policies crafted by countries to curb their greenhouse emissions. Chada says that while little progress has been made on decarbonising the global economy since the UN’s Paris Agreement in 2015, in recent months it has started to look like the world is ‘kicking into gear’. “The US and China, which have long been climate laggards, have made major commitments to cut emissions and embrace clean energy,” he says. “Of course, it remains to be seen how they back up those commitments, but the direction of travel is clear.” The joint announcement by the US and China at COP26 to boost climate co-operation over the next decade is a hopeful signal that change is now beginning. For utility companies Chada says this potentially means growth, which he argues makes the sector more attractive than has historically been the case. In terms of economic stimulus, Chada adds that governments around the world are boosting clean energy as part of their plans to inject life into their economies after the Covid pandemic. Indeed, the International Energy Agency (IEA) estimated that clean energy investments could reach $5trn (£3.7trn) per year by 2030, versus $2trn currently.
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Clean energy is benefiting from three important secular tailwinds: falling costs for renewable energy, new energy policies and economic stimulus
“The momentum to decarbonise the world economy is powerful and enduring enough to drive historic changes,” he says. “This means it is time to stop thinking of utilities as steady value investments that do not produce double-digit growth.” Chada expects those utilities which already have a large renewables footprint to continue to expand. He says companies like Enel, Endesa and Ørsted have the largest clean energy development teams, the ability to upsize their projects in construction and the deepest pipelines of new development projects. So how does Capital Group find these investment opportunities? Matt Lanstone, head of ESG research and investing, says its approach to ESG centres on identifying the issues that are most material to the long-term success and sustainability of companies. “We understand that the enduring profitability and growth of a company is directly tied to its relationships with customers, employees, suppliers, regulators and the environment in which it operates,” he says. With this in mind, in 2020 Capital Group’s investment analysts created more than 30 industry-specific ESG investment frameworks that capture those issues it believes to be material to each sector in the stock market. These issues include long-term secular environmental trends such as the energy transition. “A key objective for us is to identify companies that are likely to drive sustainable long-term results,” Lanstone says. “However, at that point our work is not done. In our fast-moving global economy and society, material ESG issues can change quickly – which means we have to constantly review and adapt our frameworks.”
This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
Materiality is key
The ‘green trifecta’
Utility revolution
How investment groups determine the environmental issues related to companies and identify long-term investment opportunities
The ‘E’, which forms part of the ESG acronym, stands for environmental and encompasses many of the issues we all discuss on a daily basis, particularly in relation to climate change. One crucial element is decarbonisation, which is an important structural trend and one that investors who are applying an environmental lens must take great care over. Decarbonisation is the term used for the process of removing or reducing carbon dioxide output and it is important because carbon dioxide has a significant and long-lasting detrimental impact on the environment. When governments and industries talk about getting to ‘net zero’ they are talking about reducing carbon dioxide output while carrying on with many of the activities that are important to the global economy. The challenge in reaching this target is that greenhouse gases are part of all human activities. So this does not just entail ceasing to run coal-fired powerplants and switching to electric vehicles, it is much broader: ranging from transportation, agriculture and forestry, to the energy required to produce the boxes used for Amazon deliveries.
Decarbonisation is an important structural trend and one that investors who are applying an environmental lens must take great care over
Electric vehicle subsidies can also be viewed as being unfair as most of the benefits go to high-income households – who tend to be purchasers of these more expensive vehicles
Leading by example
Energy consumption is directly linked to a nation’s wealth – so the more affluent a country is, the greater its energy use, which means energy demand will continue to rise as emerging nations develop. While the scale and impact of the need to transition is unprecedented, there are lessons that we can look to in history. Importantly, the required changes to a global system built around carbon offer potentially profitable long-term investment opportunities. There are comparisons with energy transitions that have taken place in the past, such as the rise of oil in the 1920s or coal in the 1830s. In this century we are at the beginning of the renewable phase, the key drivers are already in place, and this transition is amplified by the need to swiftly resolve the environmental threats. The issues become even more complex because it is important to understand some of the social challenges related to transitioning to renewable energy sources. The ESG investment analysts at Capital Group, one of the world’s largest investment managers as measured by assets under management, reference solar energy as a way of understanding the social and environmental issues. One example is net metering, whereby people who have the resources to place solar panels on the roof of their house can opt out of electrical grid fees. That causes a problem because people who cannot install solar panels on their roof – often poorer people – subsidise the cost of grid access for richer people who have solar panels. Additionally, electric vehicle subsidies can also be viewed as being unfair as most of the benefits go to high-income households – who tend to be purchasers of these more expensive vehicles.
We asked two of Capital Group’s investment professionals, Natalya Zeman, an ESG specialist with eight years’ experience, and her colleague François Beaudry, an equity investment research analyst covering European utilities companies, for their views. They believe that this transition will create multiple investment opportunities across sectors. So how do they try and find these companies? Many energy companies balance declining fossil-fuel-based earnings with growing renewable investments. The analysts believe the stock market will foresee the ‘end of life’ of fossil fuels and reflect this in share prices well before a company’s revenues go to zero. This means that companies with structurally declining earnings need to be forward-looking and develop growth businesses in order to attract investment. One example of the long-term potential is Denmark-based Ørsted, the largest developer of offshore wind farms in the world. Ørsted was once a traditional utility company dominated by oil and coal-powered plants, but over several decades it has reinvented itself to become a leading renewable energy company. According to Capital Group, what is important is for companies to build a skills base to develop renewables. The learning curve is steep and companies that will succeed in this transition are those who are able to adapt and adopt a serious approach with a focus on profitable solutions that resolve environmental issues.
Social challenges
Jessica Ground, global head of ESG at Capital Group, explains why the environment is such a focus for investors right now
For more information go to ESG Clarity. To read more about ESG at Capital Group click here.
