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 2019.1
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, the prices of some shares have in our opinion become valued too highly in some cases.
In these market conditions, of vital importance is diversification – not putting all your eggs in one basket. As multi-asset environmental solutions investors, we diversify across asset classes (company shares and bonds) as well as environmental themes; and within each we also fully explore and utilise the breadth and depth of investments available to us.
Despite changes in market prices across environmental themes, we yet see undervalued opportunities particularly within companies providing solutions to the ‘circular economy’ (recyclability and reusability), 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’ 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 bond issuers to actively manage different kinds of risk, such as bond price sensitivity to changes in interest rates, sector risk and credit risk (companies’ ability to repay), has been a challenge. An increasing number of green bond issues of different maturity dates have enabled us to manage interest rate sensitivity risk across different currencies, while we have had to rely on the unlabelled green universe 2 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 (that is, bonds considered riskier than investment grade). The current extrapolated rate of green high yield issuance in 2021 is more than double 2020 and five times greater than 2019.
Global Green High Yield Bond Issuance ($bn)
Source: Jupiter, 07/04/2021
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 amount of interest– 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 the combined green SLB bond issued by a major Austrian electricity company recently.
The UK government announced a green government bond (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 we place diversification at the forefront of our process and search widely for companies making a difference
2 Unlabelled bonds are issued by companies whose products and services deliver environmental solutions (for example a clean mass transport operator).
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.
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