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Thematic investing

sustainability and investing

Global Environmental Opportunities: transforming sustainable investment

July 2018

Luciano Diana, Head of Environmental Strategies, Marc-Olivier Buffle, Senior Product Specialist

Thanks to the emergence of a thriving environmental products industry, investing to safeguard the planet no longer means sacrificing returns. 

01

Overview

Danica May Camacho was born on October 30, 2011, to the sort of fanfare rarely seen in Manila’s crowded public hospitals. That’s because she represented a global milestone – her birth brought the world’s population to seven billion. It was at once a joyful occasion and a reminder of the challenges posed by ever more people competing for finite resources.

In less than 30 years’ time, the planet will be home to nine billion human beings, a larger proportion of which likely to be part of the middle class. This is certain to put even more pressure on the environment, testing it to breaking point.

Investors are increasingly alert to these challenges.

Many now recognise that, as stewards of capital, they have a crucial role to play in placing the economy on a more sustainable footing. But for them to become part of the solution, investors need to resolve a paradox. How can they become responsible guardians of the environment and simultaneously secure an attractive return on their investments?

We believe the solution to that conundrum has already begun to take shape. With governments and businesses responding to growing public pressure to reverse ecological degradation, a distinct and attractive group of environmental equity investments has emerged. These are companies that combine strong environmental credentials with innovative products and services designed to safeguard the world’s natural resources.

Such firms form the core of our Global Environmental Opportunities (GEO) portfolio. 

02

A burgeoning environmental products industry

Public shaping the agenda

Once a niche activity, environmental investing is now moving firmly into the mainstream. There are several reasons for that.

To begin with, society’s attitudes towards protecting the planet have changed considerably in recent years.

That's partly because a growing proportion of the population has personal experience of the damage ecological degradation can cause. In 2015, pollution killed nine million people – three times more than AIDS, tuberculosis and malaria combined.Floods and droughts have brought untold misery to millions more. Social media has also helped shape world opinion. Thanks to platforms such as Twitter and Facebook, people can now voice and share their concerns about pollution and sustainability in a way they couldn’t before. 

People power has, in turn, brought about a change in government priorities. China is a striking example of this trend.

Fig. 1 how to spend it
Growth in China's environmental spending (in RMB bln) 
china spending
Source: CEIC, Environmental Financing Strategy, Credit Suisse, Pictet Asset Management

In the run up to the 2008 Olympics, the US embassy in Beijing started tweeting hourly air quality data from its roof-top monitor. This was the first time the public had access to live data on airborne particles known as PM2.5, which kill more than 4 million people worldwide a year. As a result, local residents began voicing their concerns about air quality, eventually taking to the streets to stage large public demonstrations.2

In response to growing social discontent, China’s leadership unveiled a ground-breaking action plan in 2013 to tackle “Airpocalypse” with investments worth hundreds of billions of dollars and a slew of regulations.

China’s investment in the environment has in fact risen six-fold since the early 2000s (see chart). But this is unlikely to be the end of its spending boom. Beijing has promised to invest even more heavily in advanced environmental science and technology.

Also giving sustainable investing a shot in the arm is a sharp drop in the cost of technologies such as renewable energy, water recycling and agri-tech. In the US wind power is now cheaper than any other form of energy, having seen a 40 per cent drop in production costs over the past decade. The costs of producing utility-scale solar power have declined by more than 60 per cent over the same period.

Stars aligned for environmental industry

The combination of people power, government policies and economics has given rise to a thriving – and eminently investable – industry for environmental products and services. China's generously-funded anti-pollution drive, for example, is likely to boost the prospects of firms that develop environmental technologies such as filters for engines and industrial applications for pollution control.

More broadly, as corporations worldwide embrace sustainable business practices, publicly-listed firms specialising in the development of a broad range of environmental technologies have mushroomed, while the number of patents filed for environmental products over the past decade has more than tripled.

Fig. 2 becoming innovative

Global environmental technology patents

world patent
Source: WIPO

The economic  benefits – and investment potential – manifest themselves in several ways:

  • Precision agriculture: A GPS guidance system can save a farm of 1,000 acres about USD13,000 in variable costs annually, paying for itself within one year. Even if only 10 per cent of US farmers use GPS for planting seeds, it could save 16 million gallons of fuel, four million pounds of insecticide, and two million quarts of herbicide per year.3
  • Renewable energy: Renewable energy usage has been growing rapidly thanks to falling production costs. Being bid at less than USD0.02 per kilowatt hour, solar power will soon be cheaper than any form of fossil fuel-based power generation.4 The cost of electricity from offshore wind farms, once one of the most expensive forms of green energy, is expected to drop by some 70 per cent over the next two decades.5
  • Smart cities: Installing a suite of connected infrastructure such as water, electricity and waste, or upgrading ageing systems should cut bills and improve resource management. Barcelona, for example, saves USD58 million annually with smart water technology that uses connected sensors and cloud servers to monitor irrigation and water levels.6
  • Energy efficiency: Investing in electric public transport, using more renewable energy and increasing efficiency in commercial buildings and municipal waste management could cut energy costs by about USD17 trillion worldwide by 2050.7
  • Pollution control: Pollution mitigation and prevention can yield large net gains for the economy. In the US, an estimated USD30 in benefits has been returned to the economy for every dollar invested in air pollution control since 1970.More specifically, we see strong  growth for companies developing technologies such as filters for engines and industrial applications for pollution control.

Critical mass

Overall, we estimate that the environmental products industry is already worth some USD2 trillion, and can grow by about 6-7 per cent per year.
Fig. 3 environmental industry in numbers
EIInNumbers_center.jpg

Median 2016-18e sales CAGR (%) in local currency. Source: Bloomberg, Pictet Asset Management

That should matter to investors: companies operating in this sector should, according to our estimates, see sales growth of 6.5 per cent per year, outpacing that of firms in the MSCI World equity index by more than 2 percentage points.9

03

A process to unlock the potential of environmental investments 

As with all rapidly-evolving industries, identifying the most promising investment opportunities isn’t straightforward.

That is why investment managers of our GEO strategy have developed a process that deploys both a scientific, rule-based framework and traditional company-by-company research to build their portfolio.

The first step in the process is to identify firms with the strongest environmental credentials. These are companies that neither make excessive use of raw materials nor generate disproportionate amounts of waste. Then, from this group, we seek businesses that specialise in the development of products or services that mitigate environmental damage.

In order to identify firms with these characteristics, we perform an ecological audit that establishes the environmental footprint of more than 100 sub-industries. This audit incorporates two novel measurement tools – the Planetary Boundaries (PB) framework and Life Cycle Assessment (LCA).1

The PB is a model that defines the ecological “safe operating space” within which human activities should take place.2

Developed by a team of leading scientists and economists, the PB framework sets ecological thresholds for nine of the most damaging man-made environmental phenomena (see chart). The model quantifies a set of boundaries, which, if breached, would endanger the environmental conditions that have been instrumental to human prosperity over thousands of years. For example, if the world’s supplies of freshwater are to remain stable, humanity’s total consumption of water must remain below 5,000 to 6,000 cubic kilometres per year. Similarly, the PB states, if carbon dioxide emissions are to remain within acceptable levels, the proportion of CO2 in the atmosphere must not rise above 350 parts per million. 

Fig. 4 planetary boundaries
environmental impact performance
Source: Stockholm Resilience Centre, Pictet Asset Management, as of 29.12.2017

The LCA, meanwhile, is a framework that is used to calculate the waste emissions and resource usage of each industry that makes up the global economy. The model analyses every activity in the production of a good or service: the extraction of raw materials, manufacturing processes, distribution and transport, product use, and disposal and recycling.2

In our process, we combine the LCA with the PB to construct a lens that can pinpoint industries with the smallest environmental footprint. 

Here is an example of how the process works:

  • The planetary boundary states that the ozone layer should be 276 millimetres thick. For the ozone hole to begin to close, the world’s total emissions of ozone-depleting substances should remain below 6.6 billion tonnes per year. At the corporate level, this means that the threshold for the emission of such substances is set at 1.05 kg per USD1 million of revenue per year. Only companies whose entire LCA-based emissions stay within the Planetary Boundaries are eligible for inclusion in our investment universe.3

Such analysis is necessary because we believe most of the environmental reporting that is carried out today is too narrow or too subjective. The majority of environmental footprint models focus exclusively on manufacturing processes; they fail to take into account the wider ecological impact of, say, suppliers, or of the products and services over their entire lifespans. Take the car industry as an example. A car’s lifetime emissions are four to five times higher than those stemming from its manufacture alone. Just measuring the level of emissions during the car production process is therefore insufficient to establish automakers’ overall ecological footprint.

Once the LCA-PB audit is complete, the second phase of the process involves taking a deeper look at the core business of each company that is identified in step one. Here, our goal is to discover which firms are developing products and services that make a real difference in reversing environmental degradation. For each company we assign a proprietary “thematic purity” value, which indicates what proportion of a firm’s enterprise value (EV), revenue or EBITDA is derived from environmental products and services. For a company to qualify for inclusion in the portfolio, its purity value must be at least 20 per cent.4

These filters narrow down our investment universe to about 400 companies. Here, we double check that individual companies in the universe indeed meet the criteria defined by the PB. We then conduct detailed bottom-up analysis to identify firms with the most attractive risk-return characteristics for an efficient portfolio. We use a proprietary scoring system, which takes into account the strength of the business model, management quality, valuation and operational momentum metrics. The ESG analysis is systematically integrated in this stage as well.

The result is a concentrated portfolio of around 50 stocks, which offer the attractive risk-return profile and at the same time have a low ecological footprint, across a diversified list of environmental industries.

But our investment process does not end there. Our aim is to be an active owner of the companies we invest in. For this, we exercise voting rights through a proxy voting platform and engage with the companies to ensure they have the best possible governance structure in place. We believe this responsible form of capitalism not only mitigates risks but also leads to sustainable long-term capital returns.
Fig. 5 Actively engaging

Example of how we've engaged with a UK-based environmental utility company

timeline

Source: Pictet Asset Management