Be green, but don’t put all your eggs in one basket

May 14, 2021 09:42
Photo: Reuters

Investors are becoming increasingly engaged in environmental and ecological issues such as climate change and biodiversity. The COVID pandemic has accelerated this. According to Morningstar, net flows into sustainable funds available to European investors in 2020 were almost double those of 2019.

This has led to questions of whether the investment flows have created their own momentum in financial markets. In the electric vehicles sub-sector, for example, valuations have become stretched in some cases.

In these market conditions, of vital importance is diversification across asset classes as well as environmental themes, while making full use of the breadth and depth of investments available.

Despite the re-rating across environmental themes, we yet see undervalued opportunities particularly within companies providing solutions to the ‘circular economy’, including sustainable materials and resource stewardship. One of our recent equity investments was in a company that commercialises biomaterials, for example. By contrast, our portfolio exposure to clean energy – where overvaluations have become more common in our view – has recently been at its lowest for the last three years.

Currently, there is welcome public focus on the issue of climate change, but we believe the broader issue of biodiversity could, in just a few years, become as much in focus. Biodiversity is linked to climate change: forests capture carbon, and increased temperatures endanger many species. But biodiversity is broader than climate change. Biodiversity is essential to nutrition and to other ‘ecosystem services’ , like the discovery of new medicines for example. The accounting and financial infrastructure currently being developed for climate change could be applied in the biodiversity space.

Finding environmental solutions companies that are slightly off the radar has never been more important. Fortunately, the ecological investing universe is vast. We consider opportunities across seven broad themes: the circular economy; clean energy; water; mobility; energy efficiency; sustainable agriculture, nutrition and health; and environmental services. These seven themes apply across both our equity and our bond investments.

Diversification within green bonds

Within the green bond sector, finding sufficient breadth of issuers to actively manage interest rate, sector and credit risk has been a challenge. An increasing number of green bond issues of different maturities have enabled us to manage duration risk across different currencies, while we have had to rely on the unlabelled green universe to manage credit risk. It is only more recently that green bonds have been able to assist with credit risk as well, thanks to the issuance of green bonds further down the rating scale into high yield. The current run rate of green high yield issuance in 2021 is more than double 2020 and five times greater than 2019.

We also welcome the growth of sustainability-linked bonds (SLBs). SLBs are different from green bonds. Green bonds are bonds from which the money raised is linked to climate-change or environmental projects. SLBs vary their contractual features – such as paying a different coupon – depending on whether the issuing company achieves environmental key performance indicators (KPIs). SLB KPIs are typically focused on the environmental characteristics of a firm (for example its carbon footprint) rather than the direct environmental impact of its product and services. Nevertheless, we believe that when used in combination with a green bond, they become a more powerful, forward-looking instrument. An example is the combined green SLB bond issued by a major Austrian electricity company recently.

The UK government announced a green gilt in its March Budget, and we have been working closely with the UK’s Investment Association (IA) to provide input into its structuring process, to achieve as impactful a bond as possible. In our view, the green gilt is likely to be well supported by investors.

Re-engineering the system

Central banks have been showing signs of turning green. A change has been announced to the remit of the Bank of England to include climate change in considerations of economic growth. However, the Bank of England holds about £20bn in corporate bonds, making it a much smaller player in this market than the European Central Bank (ECB). The ECB’s targeted longer-term refinancing operations, a programme that provides cheap funding to banks for more targeted lending could become a powerful tool to support green lending. The US Federal Reserve is somewhat behind the ECB but has recently created a committee to look at embedding climate-related risk into considerations of financial stability.

In our view, the main stimulus needed to re-engineer the system to build solutions and projects needed to achieve climate change goals will not be from central banks, but from governments. And their main tool will be fiscal policy. Governments will increasingly recognise the importance of ‘internalising’ (charging to companies) ‘externalities’ (hidden costs to the environment, such as when a factory pollutes the air or contributes to the extinction of species).
The scale of change required will create huge investment opportunities over the next years. Some of those opportunities are clear now. Others will become apparent over time. The changes will be both more far-reaching, and more diverse in their effects, than many expect. That is why diversification should be at the forefront of the investment process.

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Rhys Petheram: Head of environmental solutions and fund manager, Jupiter Asset Management. Jon Wallace: Fund manager, environment and sustainability, Jupiter Asset Management.