Sustainable investing won’t work without real financial returns
“Every complex problem has a solution which is simple, direct, plausible — and wrong.” HL Mencken 1992
The scale of the capital needed to deliver Net Zero and a greener economy is immense.
Limiting global warming to 1.5-2.0° (Net Zero 2050 or Net Zero for short) will require staggering amounts of private sector capital – up to $100 trillion over the next three decades. Plus, we need to incentivise the private sector to deliver a greener and fairer economy, while meeting social and biodiversity criteria.
Investment must generate a financial return.
This investment must be financially as well as socially viable. “Doing good” isn’t enough. Investors rely on returns to fund retirement, meet future societal obligations & to finance future investments, education, and an improving quality of life. Without a fair return, the capital required for Net Zero will not flow. Investing in good ESG companies will not, on its own, deliver net zero.
ESG scoring is largely silent on this point …
We are big supporters of ESG and UN SDG measurement to ensure investments are aligned with values. But as investing tools they can only take you so far. The logic behind many ESG scoring systems, and the upcoming EU Sustainable taxonomy, looks to be: ”if asset owners fully understand a company’s wider impact” they would make “the right” investment decisions. What’s missing to us is a key question: “is it really a good financial investment?”
… and ESG scoring on its own cannot deliver positive risk adjusted returns
Many researchers argue that investing in “good” ESG companies, or alternatively ESG improvers, is sufficient in itself to create alpha in the portfolio. We are sceptical – it’s just not that simple, and recent research seems to be supporting our view. Factors that investors have always taken into account, such as quality (high ROIC companies), and having high levels of intangible assets and strong intellectual property, seem to explain much of the outperformance that many attribute to ESG scores. Yes, we agree, having positive ESG attributes can make a company more resilient, more supportive of innovation, and better placed to generate profits in the future. But if you can’t identify how an ESG or sustainability attribute will contribute to better long term financial performance, then you won’t know if a stock is cheap or expensive. And that, in turn, is what drives long term financial returns.
Similarity, traditional financial analysis can be too myopic for a net zero world
Changes associated with the transition to net zero and the greening of our economy are so fundamental and profound that they will eventually impact every aspect of our economy & society. The sheer scope of the necessary investment (~ one quarter of all company capex for the next 30 years), and the complexity of the different possible pathways, make it very challenging for financial analysts to comfortably forecast. The future will look very different from the past. Not all business models or technologies will prosper or even survive. And just because one of the decarbonisation themes is apt to become very large, doesn’t mean it will create financial value. The need for solid, long term financial analysis has never been greater.
Themes will drive longer-term investment performance
These deep changes are creating incredibly attractive opportunities. But there will also be negative returns in many legacy industries and misallocated capital in new ventures. Vested interests, green washing, green wishing (we like that term) and simple “kicking the can down the road in the hope that the problem will go away” will create some investment blind alleys. Understanding underlying competitive advantage in these new markets allows us to identify thematic winners and losers. Analysing the impact on cashflow from decarbonisation for a company with high emissions gives us a view on potential share price performance.
Blending sustainability with traditional financial approaches
Future financial value creation will be driven by a complex interplay of changing societal objectives, politics, regulation, and technology. Value creators will be those that innovate and embrace change. For the analyst, the challenge is using a thematic lens to identify key long-term KPIs like potential market size, industry structure and the underlying drivers of competitive advantage to then evaluate potential returns on capital and future investment needs. Here, it’s better to be broadly correct than precisely wrong. Valuation isn’t something that only asset managers need to worry about. It’s also an issue for asset owners, as they think about which investment strategies they want to follow.
There is no simple algorithm
We understand the appeal of ESG scoring. It’s scalable and it makes comparison of investment strategies and funds easier. But how you analyse the data and link it to the potential financial performance of a company is far more important than the raw ESG score. And this is true even if you’re not in the business of aligning investments with values. We have argued for many years that all investors need to include sustainability factors in their investment cases, even if their only concern is generating the highest financial return. New businesses are emerging that solve our decarbonisation problems. Many old business models are no longer working. Companies increasingly will have to bear the costs of their environmental and social impacts. Good governance becomes more important & well-managed companies more likely innovate and maintain their “licence to operate”. Investing using a sustainable lens makes good financial sense.
A better future is a blend of sustainability and finance.
For many investors, knowing that they are “doing good”, as defined by an ESG score, will be enough. We are however unconvinced that this is a viable long term investment strategy. It’s already a crowded trade and after a very strong 2020, returns are not as good. A better long term future is to blend sustainability analysis with traditional finance tools. Underpinning it all is a need to ensure that our capital generates a fair return. Only then will the private sector materially and positively contribute to delivering on our net zero and wider green/societal targets.