In a recent paper, we provided data on the materiality of climate change for investors. Issues that are of particular concern for investors include the multi-metre sea level rises that scientists believe are already baked in by existing carbon emissions, the value of carbon-intensive assets that could become obsolete under de-carbonisation scenarios needed to limit temperature increases below 2.0\u00b0C, and the staggering costs of a predicted rise in natural disasters.<\/p>\n
Trend #2 Multi-Stakeholder Drive Society<\/h3>\n
The expectations that society places on companies around social and environmental issues appear to be on the rise <\/span> 1<\/a><\/sup> , even as some populist political figures back away from climate accords, support coal mining, or boost rainforest logging. Ever rising inequality cannot be a stable equilibrium. At the time of writing, in June 2020, recent material events in the United States have highlighted the critical importance of, and growing expectations around, diversity and racial justice, issues that were already of increasing importance for investors. Standard accounting metrics don\u2019t incorporate the negative environmental and social impacts created by some companies\u2019 business activities \u2014 whether degrading the environment or causing social harm. The potential liabilities are off-balance sheet, and this is why they are called \u2018externalities\u2019. This has allowed many companies to \u2018over earn\u2019.<\/span> 2<\/a><\/sup> Greater socio-economic accountability is now forcing the internalisation of these costs, changing the competitive dynamics and turning former winners into losers. This pressure from stakeholders can come from regulators, governments, legal claims, non-governmental organisations (NGOs), and consumers employing social media. A holistic investment approach can help identify mispriced contingent liabilities, and identify winners. For example, multiple studies have highlighted how more diverse companies perform better.<\/span> 3<\/a><\/sup> <\/span> 4<\/a><\/sup> <\/p>\n As an example, Bayer underestimated the cost of externalities from the controversial glyphosate weedkiller Roundup when it paid $63 billion to acquire its maker Monsanto in June 2018. The externalities were internalised when health-related court judgements went against Monsanto and investors scrambled to estimate the cost of 13,000 related court cases and country-wide bans of the product. Bayer lost $55 billion of its market capitalisation from mid-2018 to June 2019. Other externalities that might be mispriced today include plastics pollution, carbon emissions, irresponsible marketing of tobacco products in emerging markets, selling unhealthy food<\/span> 5<\/a><\/sup> , unsustainable agriculture, and the environmental footprint and social cost of the fast fashion business model.<\/span> 6<\/a><\/sup> <\/p>\n Our stable climate is not the only natural resource experiencing degradation. Companies whose core activities use resources unsustainably are facing material risks; this presents opportunities for competitors promoting efficient growth. Resource-efficiency opportunities extend beyond the energy and power sectors, encompassing industrials, transportation, manufacturing, agriculture, and real estate. Investors can fund technology supporting the transition from today\u2019s linear economy (make, use, dispose) to an asset-light \u2018circular economy\u2019 that minimises waste and makes the most of resources by recovering and recycling them.<\/p>\n Resource degradation can seem academic and removed from investment decisions, but this is increasingly not the case. A UN-backed study predicted, for example, that exploitable fish stocks within the Asia-Pacific region could disappear within 30 years<\/span> 7<\/a><\/sup> . Land degradation is already harming agricultural productivity on 23% of the planet\u2019s land area.<\/span> 8<\/a><\/sup> In all, the world loses around 1% of its soil each year, half a percent of arable land, and some studies show there are perhaps 30 to 70 good harvest years left, depending on location.<\/span> 9<\/a><\/sup> <\/a> Water stress is also a growing issue globally, with a quarter of the world\u2019s population living in countries now with high-water stress and at risk of \u2018day zeroes\u2019 (the term used in 2018 when Cape Town, South Africa nearly ran out of water).<\/span> 10<\/a><\/sup> <\/p>\n As emerging markets (which are a majority and rising proportion of the world\u2019s growing population) consume resources at levels previously associated with developed economies, all three of the previous trends will become more material. Businesses that can provide goods and services more sustainably will benefit, and those that stick to resource-intensive processes face increasing risks.<\/p>\n For example, consider just the production of basic materials needed for eight billion people. Aside from energy and transportation, carbon emissions from the production of steel, cement, plastics, and aluminum alone may prevent countries from meeting global emission reduction targets in the coming decades.<\/span> 11<\/a><\/sup> More generally, our current model of economic growth is unsustainable. If everyone on earth produced as much carbon as the average person in the United States, global emissions would increase more than threefold<\/span> 12<\/a><\/sup> , and we would likely face a catastrophic impact on asset prices and society from uncontrolled and irreversible global heating.<\/p>\n New models for financial services and for provision of affordable healthcare provide investment opportunities that would help solve demographic challenges. Investors also have clear options to more sustainably meet the demands of younger populations in emerging markets by bypassing certain capital-intensive or high-carbon business models.<\/p>\n How technology is reshaping investment opportunities needs no explanation. Some may question why we are even claiming it as a sustainability trend; technology is the glue that binds nearly all solutions to achieve a more sustainable future. Solving global challenges at the interface of technology and sustainability is a huge investment opportunity. The impact of this may have the magnitude of the industrial revolution at the speed of the digital revolution<\/em><\/span> 13<\/a><\/sup> and spans finance, health, food and agriculture, industry, real estate, transportation, and energy.<\/p>\n As an example, Deep Mind, the British artificial intelligence (AI) company acquired by Google in 2014, was able to cut energy costs by 56% in Google\u2019s vast data centres solely through AI-driven energy management improvements with no hardware changes at all.<\/em><\/span> 14<\/a><\/sup> \u00a0Deep Mind has also applied machine learning algorithms to Google\u2019s wind power fleet, producing a 20% increase in the realised price of wind energy sold by better predicting wind output.<\/span> 15<\/a><\/sup> A second example is the potential of autonomous vehicle fleets, electric vehicles, vehicle connectivity, and shared-mobility technology to materially disrupt traditional vehicle sales (and oil demand) in the coming decade.<\/span> 16<\/a><\/sup> Aggressive scenarios foresee passenger kilometres travelled in private cars falling by more than 70% by 2030, from a 2018 baseline.<\/span> 17<\/a><\/sup> <\/p>\n Our argument for using sustainability as a framework for superior investment decision making is economic. Sustainability trends are already having a tangible impact on asset performance. In our database of investment managers, we see evidence that sustainable solutions are driving returns. We recognise the pattern because we have seen it before: consider how falling costs in areas, such as gene sequencing, rapidly fed through to increased investment returns in healthcare venture capital returns. Similarly, we are now seeing large and significant cost reductions in clean technologies. Clean energy technology is now applied beyond the energy industry in areas such as retail, transportation, manufacturing, agriculture, and real estate.<\/span> 18<\/a><\/sup> Examples include rapid declines in the cost of wind and solar power and battery storage. Such rapidly evolving technology is reshaping the economics of sustainable businesses amid decreased capital chasing deals. Thanks to this combination, the underperformance of the prior decade\u2019s capital-intensive or subsidy-dependent clean technologies is disappearing. Investment returns from cleantech companies held by private equity and venture capital (PE\/VC) funds have increased remarkably in the latest vintages (Figure 1<\/strong>).<\/p>\n FIGURE 1 RETURNS OF CLEANTECH COMPANIES BY YEAR OF INITIAL INVESTMENT VS BROADER UNIVERSE<\/strong> Source: Cambridge Associates Private Investments Database.<\/span><\/p><\/div>\n Notes: Performance includes 1,411 investments and reflects gross deal level returns from 2005 to 2017. These investments are composed of all company-level investments made by private equity and venture capital partnerships assessed as eligible for the CA Clean Tech Company Performance Statistics. As of September 2019, Cambridge Associates (CA) screened over 93,000 investments held by over 7,800 funds to identify cleantech investments. CA includes companies and projects in the cleantech sector if they (1) develop non-fossil fuel energy sources, (2) promote industrial efficiency by conserving resources and replacing existing processes with less-polluting alternatives, (3) recycle waste efficiently, or (4) provide a product or service that creates an environmental improvement. The full report is published quarterly and can be found at https:\/\/www.cambridgeassociates.com\/private-investment-benchmarks.<\/p>\n<\/div>\n We also find evidence that focusing on sustainability boosts returns for public equities managers. A notable array of managers is building strong track records from genuinely integrating sustainability in an economic way rather than through environmental, social, and governance (ESG) box ticking. The latter often obscures best practices and makes thoughtful investors sceptical. We even find evidence of sustainability adding value in index investing. Our 2016 paper investigated why a simple ESG index in emerging markets had materially outperformed the conventional index. The MSCI Emerging Markets ESG Leaders Index<\/span> 19<\/a><\/sup> selects companies based on ESG metrics, taking the best half of each sector from the parent MSCI Emerging Markets Index. In other words, it simply overweights more sustainable companies and deletes the least sustainable ones. Our attribution analysis showed that conventional factors like style, sector, country, or country-active biases alone could not explain the significant outperformance. Updating this data through April 2020 gives nearly seven years of data since the launch of the live index in June 2013, and this phenomenon has persisted, with roughly 60% of the 2.4% annualised alpha over the standard index not explained by other factors, but rather by ESG-based stock selection. We argue that sustainability can continue to add value looking forward in emerging markets as lower ESG standards<\/span> 20<\/a><\/sup> here catch up.<\/p>\n Beyond emerging markets equities, a study in 2020<\/span> 21<\/a><\/sup> found that the majority of 745 sustainable funds using ESG criteria, from a universe of 4,900 funds across seven categories<\/span> 22<\/a><\/sup> , outperformed non-ESG funds over one, three, five, and ten years through December 2019. The study showed that this outperformance continued through the COVID-19 sell-off in six of the seven categories in first quarter 2020.<\/p>\n Sustainability trends are clearly material; however to generate outperformance over an investment\u2019s holding period, they must be mispriced at the time of investment. Sustainability isn\u2019t properly priced because investors tend to have short-time horizons, behavioural biases, and an over-reliance on history that is less relevant in the face of issues like a changing climate.<\/p>\n Financial analysis is typically based on three- to five-year horizons, with linear extrapolation afterward. A paper by Generation Foundation explains that sustainability issues are not \u2018black swans\u2019, or unpredictable material events, but are rather \u2018white swans kept in the dark\u2019 by the short-time horizon of typical financial analysis.<\/span> 23<\/a><\/sup> Financial analysis tends to break down when a phenomenon is accelerating (e.g., climate risk) or de-anchors from the status quo (e.g., the sudden repricing of an externality, or a future step change in regulation against carbon). Cash flow projections also underestimate almost-certain occurrences at an unforeseen point, such as single, catastrophic, weather-related events, which are becoming more frequent. For example, electric utility PG&E Company, described by The Wall Street Journal<\/em> in 2019 as the first \u2018major climate-change bankruptcy\u2019<\/span> 24<\/a><\/sup> , rapidly fell from a $25 billion market capitalisation to Chapter 11 bankruptcy protection. Their downfall was caused by liabilities from wildfires started by their power lines, with these fires now more prevalent due to increasingly dry and hot weather patterns extending north in California.<\/p>\n Investors show short termism and narrow focus when they invest in fossil fuel producers based only on profit expectations that depend on high energy prices and production volumes. The need to de-carbonise the global economy presents new threats to the value of these assets. These threats include regulation, legal action, or faster-than-expected substitution as renewable power and electric vehicles become increasingly economical.<\/span> 25<\/a><\/sup> The 2015 Paris Climate Agreement\u2019s target to limit warming to 2\u00b0C implies rapid declines in carbon emissions to reach carbon neutrality in around 35 years. Multiple studies<\/span> 26<\/a><\/sup> have shown that such scenarios mean a substantial portion of known coal and oil & gas reserves are unburnable and become \u2018stranded assets\u2019, impairing their value to investors. For example, the original stranded assets paper by Carbon Tracker<\/span> 27<\/a><\/sup> stated that up to 80% of known reserves were unburnable in a 2\u00b0C scenario.<\/span> 28<\/a><\/sup> <\/p>\n Other studies have examined why markets may price these risks incorrectly.<\/span> 29<\/a><\/sup> <\/span> 30<\/a><\/sup> Beyond short termism, one possible potential systematic overvaluation bias is the energy industry\u2019s net asset value (NAV) assumptions, which assume future exploitation of 100% of current economic reserves. This made perfect sense historically<\/em> \u2014 if you owned an asset, why wouldn\u2019t you monetize it? \u2014 but is challenged by stranded asset scenarios. There is also a potential \u2018overvaluation trap\u2019 where capital markets overvalue reserves, and companies, therefore, invest in more reserves despite the risks, since stopping it would signal that current reserves are less valuable.<\/span> 31<\/a><\/sup> <\/p>\n The other very clear indication that participants do not discount 80% of current reserves as unburnable is that almost all fossil fuel producers keep investing the vast majority of their capital expenditure adding more. Top oil & gas companies jointly spent only 1% of their 2018 budgets on clean energy.<\/span> 32<\/a><\/sup> Investors in new reserves either don\u2019t believe emissions will be curbed, or conclude that if they are, someone else\u2019s assets will be stranded. As long-term investors, we don\u2019t take comfort from the former, since the economic consequences of the current \u2018business as usual\u2019 uncontrolled warming climate scenario would be materially negative for these companies\u2019 valuations<\/span> 33<\/a><\/sup> \u00a0due to widespread physical risks potentially impacting asset values. The latter is simply not realistic: research has shown that just the known reserves of listed<\/em> energy companies exceed the global carbon budget for a 2\u00b0C scenario despite comprising a small proportion of reserves.<\/p>\n At the time of writing in June 2020, we have seen major declines in the values of fossil fuel assets through the COVID-19 crisis. It may be important to consider to what degree these longer structural challenges could compound shorter-term demand destruction. Has the peak demand for oil been brought forward, and should we view apparent cyclical opportunities to invest in fossil fuel assets with more caution than in previous cycles? Figure 2<\/strong> illustrates the potential threat.<\/p>\n FIGURE 2 WHEN STRUCTURAL CHANGE MEETS CYCLICAL CHANGE<\/strong><\/p>\n Source: Carbon Tracker.<\/p>\n<\/div>\n Sustainability trends, including the move to a low carbon economy, may impact the asset values of many other businesses, and these companies may be mispriced, given the lower profile of climate issues in industries outside of the energy and utility industries. Carbon is emitted everywhere in a portfolio, and risks span assets in the basic materials, autos, real estate, agriculture, transportation, chemicals, and insurance sectors. Agriculture, forestry, and other land use alone is responsible for 23% of all man-made carbon emissions.<\/span> 34<\/a><\/sup> A 2017 joint study by the International Energy Agency and the International Renewable Energy Agency<\/span> 35<\/a><\/sup> , estimates that necessary carbon mitigation efforts could strand up to $7 trillion of assets within upstream energy and related infrastructure, and when expanding the window to include the electricity generation, industrials, and buildings sectors, the total of potentially stranded assets rises to $20 trillion.<\/span> 36<\/a><\/sup> <\/p>\n Evidence suggests that collectively, investors struggle to assess the materiality of issues that are emotionally charged. This is unsurprising since globally existential threats, of which we believe climate change and resource degradation are examples, are rare. Many of the impacts of climate change are believed to be irreversible, which makes it unique. It\u2019s problematic for investors to make comparisons with prior \u2018disasters\u2019 and incorporate the resulting mean reversion into their assumptions. More so, it is difficult or even uncomfortable to comprehend that the old financial toolkit may not work anymore! Vested interests and politics also obscure economic sustainability arguments.<\/p>\n The potential unsustainability of a fossil fuel\u2013based economy, and issues like \u2018stranded assets\u2019 are not just emotive, but also can be a controversial or even taboo topic for investors happy to take clear positions on other disruptive trends. This is completely understandable<\/em> since our economy was built around fossil fuels, whose reliable supply and affordable cost were historically seen as issues of national importance. But, this can result in behavioural biases when assessing how our relationship with these fuels is changing. Furthermore, emotive biases in the other direction could eventually push other investors to discount carbon-intensive assets even if their price were to eventually incorporate the impact of stranding; the move to a lower-carbon economy is a transition where the exact pace is unclear, and this requires objective assessments by investors.<\/p>\n Some prominent financial experts believe climate change is a materially underpriced risk, and we agree. Mark Carney, the Governor of the Bank of England, has repeatedly warned of a future climate \u2018Minksy Moment\u2019<\/span> 37<\/a><\/sup> (a term used to describe a sudden collapse in asset prices based on economist Hyman Minsky\u2019s investigations of financial crises throughout history). A potential scenario of asset price collapse could follow very extreme weather events that cause direct losses, particularly for the insurance industry, but then lead to both an acceleration in regulations against carbon and a repricing of physical risks.<\/p>\n Sustainability trends are directional. They take us somewhere new.<\/em> They imply that historic data may be less useful. They also imply a need to embrace uncertainty and change. Where we have useful data, it is often recent and therefore open to questioning.<\/p>\nTrend #3 Resources Degradation<\/h3>\n
Trend #4 Demographic Challenges<\/h3>\n
Trend #5 Technological Revolution<\/h3>\n
Evidence of Investment Performance Impact<\/h3>\n
\nAs of September 30, 2019 \u2022 Pooled Gross IRR (%)<\/p>\n![\"FIGURE](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/06\/Materiality_01.png\")
<\/a>Why Sustainability May Be Mispriced<\/h3>\n
Short Termism and Narrow Focus<\/h4>\n
![\"FIGURE](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2020\/06\/Materiality_02.png\")
<\/a><\/p>\nBehavioural Biases<\/h4>\n
Historic Data and Trends May Now Be Less Useful<\/h4>\n