At the Jupiter Investment Conference held at Claridge’s Hotel, London, Charlie Thomas, Head of Strategy, Environment and Sustainability, and Rhys Petheram, Fund Manager, Fixed Income, explained how capital markets are responding to sustainable development challenges such as climate change with unprecedented scale and speed. By unpicking the three main drivers of change – technology, investor sentiment and the regulatory landscape – Charlie and Rhys examined the implications for returns in global equity and bond markets.
- Regulatory and technological drivers are combining with favourable investor sentiment to drive a new and unprecedented change in the investment opportunity presented by sustainability challenges.
- Capital markets are responding to the challenge, with the green bond market seen as a key conduit to closing the financing gap.
- The Jupiter Global Ecology Diversified fund offers an active approach to this dynamic sustainable investment landscape. With limited drawdowns since inception, Rhys and Charlie believe that a collaborative approach across global equity and bond markets allows them to take positions that best suit the fundamentals.
Three key drivers of change
Charlie started by explaining that there are three key drivers of change for sustainability: regulation, technology and investor sentiment. In the past, regulation has led to a technology response, with investor sentiment responding as the opportunity develops. Once a ‘linear’ relationship led by regulation, this has developed into a circular relationship between regulation, technology and investor sentiment. For example, maturing technologies and falling costs have led to greater ambition among politicians to address sustainable energy goals.
As a result, we’re also seeing an increase in the ‘velocity of change’ – the rate of change in the investment opportunity.
Velocity of change: the offshore wind market
Offshore wind is a clear example of a market that is experiencing rapid change. The market has doubled every three years over the last 10 just in Europe, which leads the way globally, with newer markets developing in places such as the US, Japan and South Korea. Once an industry reliant on regulatory support, the increased use of offshore wind in the energy mix is now largely being driven by technological development (for example, the increasing size and scalability of offshore turbines) and a fall in energy costs.
Fig 1. Sustainable themes: Capturing change
Source: Bloomberg, New Energy Finance 1H 2019 Offshore Wind Market Outlook, 31.07.19.
Changes in regulations as a catalyst
The global waste industry has also changed dramatically. The statistics for global plastic waste are overwhelming: for example, of the 6.3bn metric tons of plastics that have been produced since the 1950s, just 9% has been recycled; and a plastic bag is used for an average of just 12 minutes. Only over the past few years have people become more aware of the extent of the plastic waste problem, as information sources such as BBC’s Blue Planet II helped to drastically raise awareness.
Prior to 2018, developed markets’ ‘solution’ to the plastic waste problem was mostly to push the problem elsewhere, by exporting vast amounts of waste to China. However, when China decided to impose an import ban in 2018, this was no longer viable. This change in regulation forced countries to reassess the way they dispose of their waste, and it also brought investment opportunities in the form of companies providing new waste solutions. According to research from the Ellen MacArthur Foundation, there are three strategies which combined should transform the global plastic packaging market: recycling with radically improved economics and quality (50%); re-use of plastics (20%); and fundamental redesign and innovation (30%).
Charlie believes these kinds of influences on investor sentiment will play an important part in aiming to meet long-term political objectives of some of the most pertinent environmental issues.
Fig 2. Sustainable themes: Capturing change
Source: Data as at July 2019: https://www.visualcapitalist.com/mapping-the-flow-of-the-worlds-plastic-waste.
How are financial markets responding to these challenges?
Rhys explained how financial markets are responding to these challenges. In the EU, an estimated €500bn is required every year for sustainable development across transport, water & waste and energy sectors, but only half of this is currently being spent on these sectors, meaning there’s a ‘financing gap’ of around €250bn. However, those three key drivers – technology, regulation and investor sentiment – are reaching a state of velocity whereby they’re clearing the way for financial markets to deliver solutions for these financing gaps.
Fig 3. Sustainabilty and capital markets
Source: European Commission – Financing Sustainable Growth: https://ec.europa.eu/info/sites/info/files/180308-action-plan-sustainable-growth-factsheet_en.pdf.
The green bond market
This is perhaps best evidenced by the development of the green bond market. A ‘labelled’ green bond is a bond issued by any entity (i.e. a government, supranational, corporate or bank) where the proceeds are linked to green projects. Green bonds are not secured on these green projects; they’re pari-passu instruments, meaning their credit risk is the same as other bonds issued by that entity. This is an important feature of green bonds as it gathers appeal for the broader market, and it’s been the key reason for market growth.
Annual issuance of green bonds has grown fifty-fold since the first corporate green bond was issued in 2012. Year-to-date, $120bn of green bonds have already been issued, and industry insiders such as the Carbon Bonds Initiative are expecting a total issuance of around $250bn for the full year.
It’s not just the size of issuances that’s important though, in Rhys’s view – it’s also the diversity of these bonds, especially for green investors who are not used to seeing these kinds of entities (i.e. governments, supranationals and banks) issuing in the green space.
Rhys thinks the growth of the green bond market has generally been positive. However, at the same time, he has been quite vocal on concerns around ‘additionality’, a question of whether the activities financed by a green bond would have happened anyway, and whether these bonds are meaningfully contributing towards tackling issues such climate change. He believes we’re already starting to see considerable improvement in these areas though, and that the proposed EU green bond standard should go some way to improving the effectiveness of the green bond market, in directing finance to projects that can have a meaningful impact on climate goals – not just in the EU, but globally where these standards could set a benchmark for others to follow.
Fig 4. Sustainability and capital markets.
Source: Bloomberg data as at 30.08.19.
Labelled green bonds are just the tip of the iceberg
The ‘labelled’ green bond market, at around $389bn, is just the tip of the iceberg. There is also a $1.06tn ‘unlabelled’ climate-aligned bond market, which is comprised of bonds issued by corporates that generate at least 75% of their revenues from environmental solutions, bringing the total investable universe to over $1.4tn.
Why is the size of the green bond market so important? First, Rhys said it’s due to social need, i.e. the financing gap described above can be filled by growth in these types of bonds. Second, the size of a market is important for fixed income investing from a portfolio construction perspective. Fixed income investors like deep, liquid markets, and Rhys thinks a $1.4tn market can address risk factors associated with fixed income investing, whether it’s from an absolute risk or tracking error perspective. Finally, the size of the universe is advantageous from a multi-asset perspective, allowing Rhys and Charlie to consider the full capital structure (i.e. equity and bonds) of the companies they invest in.
Case study: Orsted
Orsted is an example of a company Rhys and Charlie found attractive both from an equity and bond perspective. The Danish offshore wind developer has a 25% global market share and it delivers power to about 10m people, with an aim to deliver energy to 30m people within five years. It used to be an oil & gas company called the Danish Oil & Natural Gas company, before it decided to transition into the green space.
Fig 5. Capturing change
Source: Bloomberg as at 31.07.19. Company examples are for ilustrative purposes only and are not a recommendation to buy or sell.
Rhys and Charlie bought both the company’s bonds and equity in June 2016. They believed its transition from oil & gas to offshore wind would be a re-rating opportunity for its bonds and equity. They also saw value in the company’s decision to de-lever its balance sheet and enhance its capital structure through an IPO.
As the chart demonstrates, this re-rating impact played out as Rhys and Charlie had expected. By the start of 2019, the company had fully transitioned into the green space, and it’s now moving to its next phase of growth within wind development. Rhys and Charlie still think it’s an attractive opportunity from the equity perspective, so they’ve added to the fund’s equity position. However, as they felt its bonds had re-rated too far considering the risks, they took the opportunity to sell their bond exposure. Rhys believes this kind of collaborative multi-asset approach can enhance value.
An active approach to a dynamic investment landscape
A multi-asset approach can have more than just a diversification effect – it can also manage downside risk. By looking across a company’s capital structure, thinking about its business risk profile and identifying where a business is within its cycle, Rhys and Charlie think it’s possible to position a fund in the way that best suits company fundamentals.
Fig 6. Managing downside risk
Source: Bloomberg as at 31.07.19. Since inception 29.06.16.
To conclude, Rhys reiterated that the relationship between the three key drivers – regulation, technology and investor sentiment – is evolving, and it’s evolving at a rate of velocity that we haven’t seen before. This velocity is having a knock-on impact to the investment landscape. Financial markets will increasingly be considered as enablers for closing the financing gap. This in turn is building a rich, larger, more diversified investment opportunity set, which helps Rhys and Charlie to manage risk for clients in a way that they couldn’t before.
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