Factoring in the environment

Rising global population and increased resource scarcity have gradually become more interlinked with climate change and the combination of these issues may generate disastrous consequences. Concerns are mounting over humanity’s environmental impact and fears are growing that we may not be able to feed ourselves in the not too distant future.

The global population has reached the 7bn milestone and over the next 40 years is predicted to rise by one third to 9bn, with most of that growth primarily in emerging markets, according to the United Nations.

Accelerating economic growth in developing countries, combined with rapid urbanisation, means 70 per cent of these consumers will live in cities, and demand more meat, dairy and processed foods, according to a study from fund house F&C. But a changing climate and higher oil prices are interfering with farmers’ ability to meet this growing demand, leading to food shortages and high prices.

“Increasingly, climate change is being seen less as a standalone issue and more as a threat multiplier, as it is overlaid on existing resource stress and is going to make the increasing demand for resources even more difficult to meet,” says Vicki Bakhshi, associate director, Governance & Sustainable Investment, at F&C.

Pressure on natural resources will reach breaking point. Water demand will increase by 40 per cent by 2030, according to the Water Resources Group, energy demand is set to swell by one third by 2035, according to the International Energy Agency and food demand will grow by 70 per cent by 2050, according to estimates by the World Bank and the UN.

These considerations greatly impact the investment decisions of asset managers, which increasingly use extra-financial information such as environmental, social, and governance (ESG) issues in their investment process in order to assess the real risk-adjusted returns of the stocks they invest in.

“Companies that are now recognising what might be the challenges of the next 10 to 20 years for their business and developing plans for that, will be better positioned to respond to these challenges and will have a more efficient business model,” says Richard Stathers, head of responsible investment at Schroder Investment Management. “In theory you should see their valuations being at a premium compared to others that continue to be inefficient and polluting, for example.”

However, although disclosure standards are improving, lack of information, even for European companies, and lack of homogeneity in the metrics used by firms to calculate that information, can inhibit the integration process, he says.

Moreover, often it is not possible to quantify the impact of ESG issues into valuation or stock selection, and the analyst has to make a qualitative assessment of the effect of individual factors, such as how a company manages the environmental impact or treats the workforce, or the impact of poor risk management, and decide whether that company should be at a premium or discount versus other companies.

One notable exception is the impact of carbon emission on climate change. Thanks to the emission trading scheme, which the EU was the first to launch in 2005, it is possible to assign a cost to the carbon a company emits, which can be integrated into the operational cost of running that firm.

Regulation and government action are perceived to be very important in supporting the growth of a more resource-efficient economy.

“We are dealing with huge environmental externalities and market failures,” says Christoph Butz, head of SRI investments at Pictet & Cie, “and it is obvious that a solution will necessitate adequate political responses in order to internalise negative environmental effects into prices of products and services.”

Without the right regulatory signal, polluters will continue to pollute and offload negative effects upon the wider society, whereas those companies that behave responsibly will not be able to reap the fruits of their endeavours, at least not on markets, he argues. “Government action and regulation remain crucial for setting the right incentives for the whole economy to become more resource-efficient. Then more efficient companies will inevitably prevail.”

If energy and other natural resources will be traded at their ‘true’ all-inclusive prices, then markets will take up environment-related technologies automatically and at a much faster pace, says Mr Butz. “But the system changes slowly, and often vested interests stand in the way. Past investments often ‘cement’ structures that are rarely the most efficient in terms of energy or resources use for the future. The incumbent economic actors that stand to lose most from a regime that might leave them less well-off have understandably little incentive to change the status quo.”

Challenges in implementing the right incentives are many. The biggest problem is that we live in an economically globalised world, but our environmental, social and governance standards are still subject to local legislation, says Mr Butz.

“If we cannot agree on a set of internationally accepted standards, then some countries will undermine the process by undercutting these standards and profiting from a relative cost advantage,” he adds.

Macro-economic research assessing the cost of negative environmental externalities is welcomed by analysts. A study published in the August edition of the American Economic Review concludes that in several key industries the gross external damage from sickness and death caused by the pollution is larger than the value added. Coal in particular, is estimated to cause about $53bn (E40bn) damage a year, despite excluding climate change and using a conservative estimate of health risks. Coal’s damages bill ranges from 0.8 to 5.6 times the value added, according to the study.

“We need to see externalities and the costs of ecosystem services integrated into economic forecasts and macro-economics. The more this is done, the easier it should be to integrate them into company analysis and stock selection valuation,” reinforces Schroders’ Mr Stathers.

Impact on performance

There is increasing evidence that integrating the consideration of ESG issues into investment decision-making and ownership practices would improve long-term returns to investors, states Ms Bakhshi at F&C.

Generally, within asset management groups, a sustainable advisory board, supported by external research providers, advises portfolio managers in terms of ESG issues but individual fund managers have their own processes for stock selection. “If we think there are factors that are material to that investment decision, such as the company which has particularly high environmental risk or particularly poor governance, we will pass that information, but it is up to them to decide how to integrate that into their investment decisions,” explains Ms Bakhshi.

Some niche asset managers centralise this kind of analysis, but for a universal asset manager that invests in different asset classes, it is very hard generally to centralise that analysis, explains Thomas Kjærgaard, head of SRI at Danske Capital. He underlines that The Principles for Responsible Investment (PRI) initiative from the UN has provided an effective international framework instrumental to build the capacity of investors to integrate ESG information into their investment decisions.

Portfolio managers know about ESG-related risks the companies face, but their main focus is whether this is a good investment in terms of financial investment discipline, says Mr Kjærgaard. Although it is very hard to prove that ESG integration has a positive impact on performance, he says, it is crucial to be able to demonstrate that the SRI policy does not cause any negative impact on the portfolio.

A very aggressive SRI policy, where all the companies that produce alcohol, tobacco, weapons or that are involved in the extraction of oil or coal are excluded, for example, can leave the portfolio manager with a very limited investment universe. This can affect performance. More dialogue and engagement with companies is the preferred avenue.

“Before we consider excluding it, we engage with the company to try and improve their practices and minimise risk in relation to their activities and that dialogue is more effective if it is in collaboration with other investors,” says Mr Kjærgaard.

Thematic investing

Responsible investing is also about identifying mega-trends or drivers expected to impact investment opportunities and offer areas for growth. Many thematic funds are centred around natural resource scarcity and the need to provide food, water and energy to a growing population.

Firms providing solutions to these challenges are likely to see demand for their products and services grow and investors can benefit from that, believes Steve Falci, head of strategy development, sustainable investment at Kleinwort Benson Investors. But these companies need to be attractively priced and have strong management and competitive advantage.

For example, an agriculture fund invests in agriculture producers, in suppliers of machinery technology and fertilisers to help increase the crop yields or service providers who contribute to assure the quality and the delivery of the food. Renewable energy funds invest in technologies that are going to make or facilitate the increased use of renewables.

Resource efficiency is also another key theme. Companies to invest in range from electrical engineering firms improving the efficiency of combustion in a boiler to smartmeter manufacturers and builders of energy-efficient homes and transportation.

A water strategy finds opportunities in water utilities, water technologies and water infrastructure companies. Opportunities in water technology are significant, explains Mr Falci. They range from ultra-violet light disinfection that allows water to be purified without the use of chemicals, to desalination through a more sustainable technology than the standard one, which requires high levels of energy.

“Where water technology also plays a huge part is metering,” he says. “If we want to be able to manage water uses effectively, we need to measure it effectively.”

There are also companies which help manage the infrastructure of piping systems. By using advanced acoustics, special technology can map out weaknesses and can strategically make repairs where there are already leaks. This way, older pipes can be repaired internally, without having to dig up the street.

But apart from the water fund, which has a balance between industrials, water infrastructure, technologies and utilities, generally single theme funds invest in higher growth, higher beta stocks and are therefore more risky than mainstream equity markets, says Mr Falci.

The renewable energy sector, for example, which had a “phenomenal run” from late 2003 to the middle of 2007, has been particularly hit by the economic slowdown, although the water and agricultural themes have also recovered very strongly in 2009 and 2010, he says.

“It is important to look at thematic strategies in a portfolio context, as they are nice diversifiers and offer a good reward potential,” explains Mr Falci.

Alternatively, multi-theme funds give broader exposure across environmental solutions, providing a diversified one-stop solution. “Even if those strategies are all driven by the same long-term drivers, they can behave differently in individual market environments, and offer different return patterns. This way, portfolio managers have the opportunity to either over or underweight the themes, based both on valuations and earnings expectations,” he says.

“By having exposure to several different areas, such as water treatment, pollution control, renewable energy, and so on, you can build diversified portfolios that have got relatively low risk, as opposed to having all your eggs in one basket,” says Ian Simm, CEO at Impax, a specialist environmental investment manager.

Sectors that include companies operating in the environmental market areas – such as those responding to environmental regulation and technology and constrained natural resources – have very attractive growth rates.

“Environmental sectors are typically growing much more rapidly than their mainstream economy,” says Mr Simm.

“The solar sector has grown at least 30 per cent every year for the last seven and eight years and the wind sector has been growing between 15 and 20 per cent every year for the same length of time, whereas global GDP is growing by less than 5 per cent a year. Typically these sectors are starting from a relatively small base, but there is huge potential for them in the future.”

Moreover, the cost of equipment is falling very rapidly. For example the cost of solar panels has dropped by 70 per cent in the last four years, making them more affordable for customers and leading to a bigger and faster rate of adoption, he says.

“Energy efficiency, water treatment and waste management are very attractive at the moment, but we still retain exposure to renewable energy, environmental consultancy and some of the other areas as well,” adds Mr Simm.

SRI in private banking

Private banks are actively moving into the socially responsible investing space to meet increasing client demand or draw investors’ interest. The most notable example is Bank Sarasin, which over the past three years has successfully implemented a policy of having all its clients portfolios screened against ESG factors, unless clients opt out. But other banks are also introducing interesting initiatives.

Bank Julius Baer launched a new service in April, available to both their discretionary and advisory clients, which measures the C02 emissions of their equity holdings and gives investors the possibility to reduce or neutralise these emissions.

This new offering, called green portfolio services, has been developed in cooperation with South Pole Carbon, a Zurich-based company, which calculates C02 emissions and manages C02 reduction projects on a global scale.

After paying a small fee for the calculation of C02 emissions of their equity investments, clients asking for this service have two alternatives: they can decide to offset C02 emissions by financing specific projects aimed at reducing them, according to UN standards, or they can restructure their own portfolios by choosing companies that generate less C02 emissions, explains Silvia Wegmann, portfolio manager and sustainability expert at Bank Julius Baer.

For its discretionary clients, the Swiss bank already offers sustainable or thematic portfolios that are tailored to client needs and preferences. Alternatively, it offers model portfolios investing in a variety of themes, which are rotated according to market opportunities. While the renewable energy sector is facing some difficulties today, water and energy efficiency are very attractive themes, says Ms Wegmann.

“In our sustainable discretionary portfolios, we do not invest in funds but we invest directly into equities of companies, as transparency is very important in sustainable investing,” she states, explaining that the bank uses an external research partner, Ethical Investment Research, for support.

Today, just few wealthy clients demand sustainable portfolios. It is not in the hope of better performance they choose these portfolios, but because they want to invest their money in a responsible way for the next generation, she says.

“Experience shows that over time, performance of sustainable investments will generate approximately market performance. But often clients will be even willing to accept a small opportunity cost in terms of performance.”

Julius Baer has a different philosophy from its Swiss competitor Sarasin. “We want to act according to client wishes,” explains Ms Wegmann.

“The company has to meet certain quality standards before we invest in it. If clients want to invest according to ESG rules, we do offer these products, but it is not a philosophy the bank wants to impose on them.”

A growing planet

According to research from the Global Footprint Network, humans are already using the resources of one and a half planets today. With the global economy projected to grow three fold by 2050, and population expected to increase by 30 per cent, drawing down on the natural capital of the planet will generate serious issues. The research estimates that if everyone lived like an American, by 2050 we would need four and a half planets to support the world. We will need three planets if we all live like the Europeans and half a planet if we all live like the Indians