Holding back the tears
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
While the final text of COP26 fell short of what many had hoped for, the writing is on the wall for fossil fuels and, from an investment perspective, the age of sustainability has only just begun…
Was COP26 a success or failure? In many ways it is irrelevant. Alok Sharma may have been upset at the last-minute watering down of the final text of COP26. However, its success cannot be attributed to the choice of words settled on at the end. The COP26 conference final agreement is clearly important, but its legacy is likely to be so much more.
For example, the conference set the conditions for the US and China (together constituting over 50% of carbon emissions) to agree to have their own set of discussions, presumably to hammer out a path to reducing carbon emissions together.
And the fact that the world will now have an annual ratchet (rather than every five years) is likely to be a significant breakthrough. That India and China proposed to “phase down” rather than “phase out” coal is semantics. Everyone knows where we have to get to, and a few words altered here or there isn’t going to have a lasting impact.
In our view, it is innovation and finance that will lead to real change. There is a clear desire from developed market consumers to support products that help the transition to a low carbon economy. Tesla’s share price may be ‘nuts’, but so is Rivian’s which is now the world’s third most valuable auto manufacturer, despite having near zero revenues.
Underpinning Tesla however, is a queue of buyers for all of its expected 900,000 cars that it hopes to produce this year. And regulations / incentives aside, there is significant demand for EVs from other manufacturers.
Demand is there for EVs, but as well as for many other products or solutions that will enable consumers and corporates (not to mention governments) to get to net zero. What the world needs is supply. And it is companies and corporates that are racing to get there.
The truth is, as John Kerry wrote in the FT last week, “The net zero transition is an unprecedented investment opportunity”. The COP summit shows how strong the secular growth opportunity is, one that incorporates emerging as well as developed markets. From wherever they hail, companies that embrace the “net zero” opportunity early will steal a significant lead over competitors, and will therefore have dominant positions in the new low carbon world.
Aside from rhetoric, politicians can help. For example, the US state department under John Kerry and the World Economic Forum have partnered to create the First Movers Coalition which is a platform to help catalyse demand for low carbon products and solutions in eight ‘hard-to-abate’ sectors: aluminium, aviation, chemicals, cement, direct air capture, shipping, steel and trucking.
According to the coalition, these sectors represent more than one-third of the world’s carbon emissions. The coalition aims to give companies who are innovating the confidence that there will be demand for such products as ‘green steel’ (i.e. steel manufactured without using fossil fuels).
There are a raft of public and private companies working on all sorts of solutions, to be the supplier to meet this huge demand. COP26 or not, they had already spied the significant financial incentives for being first to market, or establishing a patent for a technology that will help companies decarbonise.
Politicians’ words may help along the way, but it is finance and investment that will create these solutions. Impax Environmental Markets (IEM) is a trust that has for two decades been investing in specialist small- and mid-cap companies, all of which have a strong sustainability focus within their product or service. It focusses on companies that offer solutions to environmental challenges within four main areas: clean energy and energy efficiency, water treatment and pollution control, waste technology and natural resource management, and sustainable food.
As a result of mainstream investor attention on these once niche areas, IEM has performed very strongly. The managers have expressed caution on valuations in their universe of stocks, but it may be that in an epoch shift of the size that we are experiencing, higher valuations may be justifiable and linger for longer?
The same might not be said for IEM’s premium to NAV, which has reached heroic proportions of 12.2% at the time of writing. The manager and board are restricted in the number of new shares they can issue to meet demand because of the need to manage capacity in the strategy. This illustrates the weight of demand from investors to get access to the sustainable economy, but nothing will insulate shareholders from what could be a nasty bump downwards in the share price if demand slackens – as surely it must at some point.
Alternatives for investors to consider include Menhaden Resource Efficiency (MHN), which has a highly concentrated portfolio, but which arguably has a very different angle to IEM. It trades on a very wide discount of 30%, and might be seen more as a long-term global growth portfolio, albeit with stocks’ longevity predicated on their sustainability credentials. More comparable to IEM is Jupiter Green (JGC).
In September 2020, the board announced that the trust would be shifting its focus, investing more in small- and mid-cap companies (‘innovators’ and ‘accelerators’ in the terminology of the manager). It is early days yet on this more focussed and higher growth version of a long-standing strategy. After a very strong start in Q4 2020, the trust suffered from its exposure to small cap, innovative clean energy stocks in Q1 2021.
Jon Wallace, the manager, used the opportunity to buy more in the stocks he had most confidence in (such as Ceres Power, Evoqua, and Monolithic Power) which have contributed strongly now that their share prices have rebounded. We observe that JGC has a slightly higher volatility than IEM, but if manager Jon Wallace can use this extra risk well, then the prospects for this relatively small trust look good. The board has been issuing shares at a premium this year, but the shares currently trade on a discount of c. 4%.
As is the case in markets everywhere, many managers in the ‘sustainability’ space see valuations as fairly full, which could be a note of caution to investors. Zehrid Osmani, manager of the Martin Currie Global Portfolio (MNP), highlights the increasing difficulty in finding attractive valuations within listed renewable energy companies. That does not mean that he has abandoned the case for sustainability as an investment theme, rather he reflects the need for a creative approach.
His solution has been to purchase the infrastructure and services that support renewable energy, which trade at more attractive valuations, rather than the energy producers themselves. Zehrid’s views are particularly poignant as he has been a long-term advocate of ESG investing, with Morningstar ranking MNP as one of the most sustainable global equities strategies even amongst open-ended funds.
Where some investors see high valuations, perhaps others see a more nuanced picture. Those who follow the team behind Capital Gearing Trust (CGT), which has a mandate to preserve and grow capital in real terms, will know they have a hawk eye for value. In CGT’s recently published Interim results, the team comment that they have been recycling the proceeds of property sales into a range of listed infrastructure trusts, which they are attracted to because of the “asset backing and long dated inflation protected cash flows”.
The team have been taking advantage of placings (and thereby investing at close to NAV) in a range of listed funds, including Renewables Infrastructure Group (TRIG) which – along with the other trusts in the renewable energy infrastructure sector – are front and centre in the energy sustainability story. The CGT team view the opportunity as making sense as we come into “an increasingly inflationary environment” as they see it.
TRIG aims to provide a sustainable dividend over the long term through investment in a range of different renewable energy technologies in the UK and Europe. In this regard TRIG is differentiated from the peer group as no other peers have a mandate which includes such a wide breadth of asset types and geographies.
As with all of the renewable energy infrastructure funds, TRIG’s dividend is a key attraction – and especially so given the portfolio is fully developed and is not still being ramped up – as is the case with the latecomer entrants to the sector. TRIG has achieved a progressive dividend every year since listing. However, mindful of the uncertainties that 2020 has presented, the board’s target dividend for 2021 is the same as that for 2020.
The solidity and resilience of the revenues shown during the last financial year – backed by strong diversification by asset type and geography – means the dividend remains attractive and, at the current share price, TRIG yields 5.1%. The current premium to NAV of 14% may suggest that, as is the case with the Capital Gearing team, investors may wish to wait for the ‘value’ opportunity presented by further share issuance for this or other trusts in the sector which are otherwise on expanded premiums.
Rising valuations have not dissuaded the team behind BlackRock Sustainable American Income (BRSA), which adopted a formal ESG objective in July of this year. We note that BRSA is likely to be somewhat insulated from the extreme ends of the valuation spectrum thanks to the managers’ clear bias towards value opportunities within their investment process. BRSA’s managers aim to keep its carbon emissions and environmental risk scores well below those of its benchmark, the Russell 1000 Value index.
While it is still early days for the new mandate, the team remark the inclusion of a sustainable approach to value investing will act as a positive tailwind: when faced with two equally attractive investment opportunities, the one with the superior ESG credentials should be given the edge.
BlackRock’s chief executive Larry Fink attended COP26, and is a well-known proponent of the investment opportunities – and risks – presented by climate change.
At the conference Larry was a strong advocate for investors not abandoning traditional energy companies over ESG concerns, observing that divesting does nothing to reduce carbon emissions and arguably pushes energy companies into private investors’ hands, who are significantly less accountable for their actions than public companies. At the same time, he also highlighted that the decarbonisation process is one that will take decades and, as has been evidenced by energy prices this year, there will be periods of undersupply.
The managers of BlackRock Energy and Resources Income (BERI) take their boss’s same pragmatic view. BERI’s board shifted the emphasis in the mandate in mid-2020, explicitly positioning the trust towards the decarbonisation of the global economy. At the same time BERI is not trying to be an explicitly ‘green’ trust: allocations between mining, traditional energy and energy transition stocks are expected to be dynamic.
The past year has illustrated what this means in practice, with the team significantly increasing traditional energy exposure in November 2020 on valuation grounds, and continuing to add since. Energy stocks have contributed very strongly to the performance of the trust since then, such that it has significantly outperformed sister trust BlackRock World Mining. BERI trades on a discount of 6%, and in our view represents a practical expression of a vehicle that embraces the reality of the journey we will all take to net zero. Whilst investors may not shed tears over the current c. 30% exposure to traditional energy companies, they perhaps understand that it is a responsible and necessary ‘evil’ to get to a zero-carbon economy.