Investment Notes

Savvy investors will embrace decarbonisation

May 24, 2022
Alex Debney By Alex Debney

Savvy investors will embrace decarbonisation

Earlier this week the Intergovernmental Panel on Climate Change (IPCC) released their latest Working Group Report titled Climate Change 2022: Mitigation of Climate Change.

The IPCC are the peak international body for assessment of climate change science. Their latest report is a dramatic warning we must embrace a clean energy future rapidly, with emissions peaking in 2025 and reducing rapidly. Emissions reduction of 45 per cent is required by 2030 if we are to have a chance of staying at 1.5 degrees.

‘Now or never’ is the message from the World’s leading climate scientists – with some labelling the report their final warning.

If our planet does not stay below that threshold, one in seven of Earth’s population are projected to experience frequent severe heatwaves and extreme weather, driving global insecurity and worsening cycles of famine and poverty. As a result we will see global refugee numbers far beyond anything ever witnessed throughout history.

In short, ‘Transformational change’ must occur in all regions and sectors to mitigate global climate disaster. But what does transformational change look like? And how can it benefit investors?

Transformational change

Two ways investors can embrace transformational change are:

  1. behavioural change (as individuals and/or organisations); and
  2. financing sustainable initiatives to close the current investment gap.

A clear data point from the World Inequality Lab and the IPCC shows people from wealthy countries emit far more. That top 1 per cent of emitters are responsible for seventy times more pollution than people in the bottom 50 per cent.

That aggregate data is driven by the myriad choices of individuals and organisations. Taken together, those choices have the power to drive real change and avert disaster.

Lifestyle and cultural changes such as car-free mobility, electric mobility, flying carbon-neutral and shifting towards plant-based diets can speed up emissions reduction. If widely adopted, such changes would save over two gigatonnes of atmospheric CO2 each year. Or four times the mass of all humans alive today.

Beyond behavioural change, the IPCC report notes financial flows are three to six times lower than levels needed by 2030 to limit warming to below 2°C. Though it won’t cost the Earth to bridge the shortfall. There is sufficient global capital and liquidity (even post-pandemic) to close that enormous investment gap.

For savvy investors the investment gap also deserves a better name – the ‘climate opportunity’.

Myriad investment strategies are available to investors to take advantage of the climate opportunity. Three immediate pathways include: adding a sustainability screen, investing in environmental, social and governance (ESG) funds, and investing in impact investment.

1. Add a sustainability screen

One strategy is to layer a sustainability screen over all investments, which requires more effort for an investor but may also be more rewarding.

Implementing a sustainability screen adds an extra element to traditional investment diligence. For example, when assessing a listed equity investment an investor will also look at the sustainability initiatives and scorecard for that company alongside traditional diligence.

Fortunately, a proliferation of useful sustainability tools for investors, such as Sustainalytics, can assist investors in readily testing the sustainability of listed large-cap companies. And other asset classes are following suit.

The strategy has become more popular amongst investors – following the UN & IPCC call to action, coupled with recent outperformance of sustainable businesses. For example, Morningstar’s U.S. Sustainability Leaders Index (50 U.S. companies with the best Morningstar ESG scores) returned 33% over 2021, beating the broader U.S. market by 8%.

2. ESG investing – rely on experts

If the work involved in adding a sustainability screen isn’t appealing, an alternative is to invest with ESG funds. The strategy involves assessment of fund managers, passive vs. active approach, their teams, and track record.

One key area to also understand for any fund is the stated strategy. Strategies differ wildly between ESG funds. Take for example the Columbia Sustainable U.S. Equity Income ETF, which has a bias towards cashflow generation through investing in stable dividend producing businesses, versus technology ETFs that track indices like Kensho Cleantech.

Some ESG funds also maintain only a partial focus on sustainability and will still invest in fossil fuel companies (in line with the broader market). An assessment of their top holdings alongside their stated strategy is an efficient way for an investor to form a view. Importantly with both targeting sustainability companies or investment with ESG managers, outperformance is not guaranteed. As is the case with traditional funds there is a wide spread of performance between strategies.

At a minimum though ESG investing is reallocating capital to a more sustainable future and is likely to hedge against future climate and litigation risks.

3. Impact investing – directly invest in emissions reduction

Impact investment differs from ESG in that it drives direct incremental positive outcomes while generating market rate financial returns for investors. At Conscious Investment Management we’re focused direct investment into private market strategies to drive positive social and environmental outcomes.

A core sustainability strategy of our funds is distributed solar, which drives decarbonisation of the power industry, directly aiding corporate net-zero transitions. It involves financing solar generation on-site at major energy consuming assets such as industrial facilities, community assets and shopping centres. As assets are behind-the-meter (i.e. not selling energy into the energy grid), cashflows are underpinned by long-term and contractually locked-in returns with high quality businesses. Returns are also inflation-linked to protect the relative value of that income stream.

Under this strategy our investments also avoid grid-related risks such as electricity spot pricing volatility, and curtailment risk from the energy market operator. As asset sizes are also smaller upfront development approvals and construction timeframes are shorter than utility-scale solar or wind assets.

Importantly by financing and operating solar generation at these sites we are providing a direct and measurable pathway for businesses to decarbonise. That is how, with the ongoing support of our investors, we can continue to play a significant role in driving emissions reduction for our planet and communities.