As we emerge from COP 26, one thing is clear, that a huge amount of private capital must be deployed if we have any hope of reaching net zero and maintaining global temperatures at a level with which we can all live. What is far less clear is how this capital should be deployed and what impact this will have on investors in both conventional and ESG strategies.
To gain some clarity, it is necessary to assess the legacy of COP from two perspectives: first the impact on the earnings power of companies and second, the way those companies are valued by investors. Like a sculpture that can only be fully appreciated when viewed from multiple angles, two perspectives are essential to the creation of a successful investment strategy in a post-COP world. However, both perspectives are inevitably long term in their focus, and neither can tell us what will drive market prices in the weeks and months following COP.
Earnings
From the perspective of profitability and earnings growth, COP creates both risks and opportunities. For those businesses that have not previously fully paid for the climate and societal impact of their products and processes, the realisation of the commitments made at COP may represent a significant drag on profitability or the destruction of formally valuable assets.
This impact can be expressed as an additional financial risk that must be assessed when making investment decisions. Quantifying this risk and incorporating it into an assessment of a company or asset class is an essential element of any investment process in a post-COP world.
While COP represents additional risks to some companies, for others, it unlocks huge opportunities, as policymakers provide support to companies developing ‘solutions’ to climate change and those with a positive impact. The UN Sustainable Development Goals and efforts to track progress towards these goals are good examples of how policymakers at both a global and country level are seeking promote more sustainable growth. Companies with products and services aligned to this framework or to the broader net-zero commitments emerging from COP may experience significant earnings growth over the next few years, increasing the intrinsic value of the business.
However, the change in the intrinsic value of a business does not fully describe the attractiveness of the investment. Equally important is the price of that business, or more specifically the gap between the price and a reasonable estimate of that intrinsic value. This is especially important when investors have identified a strong theme and are eager to align portfolios to that theme in the belief it will drive returns. When the outlook for a company appears so positive, it is easy to forget that returns over the next five to 10 years are more likely to be driven by the evolution of the valuation gap than the change in the intrinsic value of the business.
Investors who overestimate either the risk of net-zero targets or the long-term growth implied by being aligned to a net-zero world are vulnerable to poor returns, even if policymakers are successful in their efforts to limit climate change.
Value
To help investors reach their goals in a post-COP world we therefore need to move beyond simple exclusions and the naïve pursuit of themes and instead consider the potential outcomes that are priced into each listed company and asset class. In addition to the financial benefits, we need to recognise the benefits of engagement. It may be far more impactful to own companies with poor sustainability profiles that are out of favour with investors if fund managers can use the votes conferred by our shareholdings to effect change at a company.
A good example of this is the change in the composition of the board at Exxon that was wrought by Engine No1, a small activist fund that gathered support from large passive fund managers. By helping businesses to reduce their sustainability risk, it is possible to improve the long-term growth prospects of a business, reduce risk and prompt a change in the valuation leading to improved returns.
However, this approach is incompatible with a pristine ESG profile in the near term. It is therefore essential that the end investors understand the strategy and are comfortable owning businesses that are capable of improvement over the long term. As ever, the implementation of a successful investment strategy is dependent upon clear communication and the discipline to execute – both characteristics we would have liked to see more prominently displayed at COP26.
