The butterfly economy and its investment potential

investment viewpoints

The butterfly economy and its investment potential

Alina Donets - Portfolio Manager

Alina Donets

Portfolio Manager
Kristina Church - Head of CLIC™ (Sustainable) Solutions

Kristina Church

Head of CLIC™ (Sustainable) Solutions

The importance of Natural Capital within the circular economy creates a ‘powerful force’. Portfolio Manager, Alina Donets and Kristina Church, Head of CLIC™ Solutions, discuss this theme and why it is a long-term investment opportunity.

 

1. What is natural capital and why is it important to the global economy?

Nature is the most productive asset of our economy. More than 50% of global GDP currently depends on nature. Natural capital includes all the renewable and non-renewable resources in our biosphere, including clean air and water, fertile soils and sediments, biodiversity, and finite mineral resources. Nature also provides enabling and protective services (like pollination and air filtration) that support economic processes and prevent disruption from climate change, storms, erosion, and disease. We are extracting crazy amounts of material and overexploiting nature.  At the same time we are not fully harnessing the regenerative power of nature. As a result, the value of nature is declining, threatening our economies and ability to sustain the same kind of returns in the future.

 

2. Why does natural capital sit at the heart of the supply chains of major global sectors, and how does the degradation of nature put some of these industries at risk?

We rely on nature directly and indirectly across multiple industries.

For instance, the USD 5 trillion agricultural industry depends as much on rapidly-degrading soils, just as the forestry industry depends on forests, which are shrinking. Within the pharmaceutical industry, two-thirds of newly-developed drugs are based on or inspired by natural products. Meanwhile, the non-material value of nature supports much of the USD 9 trillion tourism industry and can account for as much as 20% of local property prices.

Unfortunately, present levels of raw material usage and consequences of human and economic activity are unsustainable and contribute to ecosystem degradation. Resulting issues like water stress or chemical pollution create substantial economic, social and environmental damage across all levels of human life.

Nature is the most productive asset of our economy - more than 50% of global GDP currently depends on nature

3. How does natural capital fit into the circular economy, and why is it a standalone investment theme, rather than part of a broader sustainability investment strategy?

At Lombard Odier, we believe that the world is embarking on a necessary transition to a Circular, Lean, Inclusive and Clean (CLIC™) economy. While the CLIC™ economy encapsulates the move to a net zero emissions economy in a fair and inclusive manner, it is first and foremost built on natural capital. The transition to a more bio-friendly CLIC™ economy is happening now and it is accelerating. Natural capital will be its most vital foundation. Global businesses are already recognising the need for transformation toward Circular and Lean operating models. Such companies tackling the challenges linked to the circular bio-economy and leaner forms of industry can now be found in listed equity markets. And just as their privately owned peers, they are seeking capital to continue innovating and building solutions. The profound metamorphosis of our linear economic framework into a new circular model is first and foremost driven by value creation and superior economics

Our Natural Capital strategy is highly complementary with our existing Climate Transition strategy. The transition to the “butterfly”, circular bio-economy and net zero economy are mutually reinforcing. To achieve the net zero economy, we must first transition to a more bio-aligned economy.

 

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Sources: 1 The current targets of the CBD (Convention on Biological Biodiversity) are the Aichi targets, which will end in 2020. 2 Task Force for Nature-related Financial disclosures. For illustrative purposes only. 3 Ellen Macarthur foundation, Towards the circular economy (2013). 4 2DS Smith (2019). 5 Nielsen. 6 PwC, Nature is to big to Fail (2020).

 

4. Lombard Odier’s Natural Capital investment strategy combines opportunities in the transition to a leaner form of industry and investment in the bio-circular economy. Can you just explain those two elements in more detail?

Powerful forces are now pushing for this outdated linear model to evolve into a new circular economy. Policy support for nature is accelerating globally, and technology costs are falling, enabling increased investment opportunities. Consumers are also pushing for natural preservation. These forces are propelling this new economic model that prospers in harmony with nature.

Harnessing the power of nature means shifting more of our economy into the bio-based economy which is more efficient and circular. This is about greater reliance on bio-materials and increase take-up of nature-based materials across many more industries. It is also about the using waste as resource, about bioenergy, and a variety of regenerative farming, forestry and fishery practices

Preserving nature also means shifting towards greater circularity in the areas of production and consumption where substitution with bio-economy is not yet possible, as well as eliminating waste in our industrial activities. This about creating a much leaner form of industry, or in other words about more efficient use of our resources, a shift in our consumption model and about zero waste strategies.

Preserving nature also means shifting towards greater circularity in the areas of production and consumption where substitution with bio-economy is not yet possible, as well as eliminating waste in our industrial activities

5. At the heart of this strategy there are 4 revolutions going on. What are the four and why are they important?

The Natural Capital Investment strategy is a global equity strategy, also inspired by His Royal Highness the Prince of Wales’ vision of the Circular Bioeconomy and developed in partnership with HRH’s Circular Bioeconomy Alliance. The Narrative of the strategy and the targeted key sectors are based on the 10-point action plan for a Circular Bioeconomy coordinated by Marc Palahí.

We have identified four key revolutions that also form the basis for investible themes: Circular bio-economy which unlocks innovation across water, food solutions and materials, harnessing the regenerative features of nature; Resources efficiency that targets leaner forms of production through dematerialization and materials performance; Outcome-oriented approach to consumption; and Zero waste world.

The strategy is focused on identifying companies that are already profitable and well positioned to take advantage of these four unstoppable growth opportunities.

 

6. Is it possible to create a truly global portfolio of companies which can benefit from these opportunities?

Natural Capital is equally important to people and business regardless of their geographic location, and unfortunately it has been equally indiscriminately endangered worldwide. Especially as global supply chains today are tightly interlinked, many companies globally are already taking steps to transition to leaner business models. This opens opportunities globally for the solution providers that would enable such transition.

Equally, technological advances now allow companies to leverage the self-regenerative features of nature to create new solutions that can build the foundation of the bio-economy, which has a potential to create positive externalities. Such innovation is also not constrained geographically, and often benefits from cross-border collaborations and information flows.

We have already identified over 550 companies globally that partake in this key revolution on both ends of the butterfly model: transition to lean industries and the bio-economy. And we expect this number to grow in the future.

Many companies globally are already taking steps to transition to leaner business models

7. How does the investment process work?

The four key revolutions across Circular Bio-economy, Resource Efficiency, Eco-Awareness and Zero Waste serve as the foundation for defining the scope of the strategy's focus. The Sustainability team has performed extensive work to identify the business activities that operate in, and enable these four revolutions. The Equity research platform then pinpointed the exact list of companies operating in these businesses that also have to constitute at least 30% of the economic activity for a company. The team uses a combination of algorithmic and fundamental research to come to the investable universe of over 550 companies, focused on small to mid-cap companies globally.

After this, the portfolio manager identify the companies with potential for superior growth profiles and excess economic returns, combined with solid ESG credentials including assessment of any controversies. The result is 40-50 stock high conviction portfolio, with good diversification and focus on high quality companies.

 

8. Why do you believe a focussed, high conviction strategy of 40-50 positions is appropriate; does this not create a higher risk approach?

We believe around 50 companies is an optimal size of a high conviction but well balanced portfolio. A concentrated strategy allows us to leverage the internal expertise around Natural Capital developed across the Sustainability team, and effectively reflect it in the long term financial performance of the strategy with the support of the fundamental Equity and portfolio management teams. All that while still maintaining a well-diversified portfolio.

The bio-economy is potentially a more important, and an under-explored part of the next economic revolution

9. How does this strategy correlate with other sustainable investment strategies?

There is an increasing attention on and appreciation of the importance of the circular economy, leading to launches of investment strategies focused on the circularity. However, we believe this focus is not recognising the full scope of the transition that is underway. Circularity only addresses the right wing of the “butterfly” model1, essentially helping to reduce the waste of resources to alleviate the pressure on natural capital. The bio-economy is potentially a more important, and an under-explored part of the next economic revolution. We believe that our strategy is the first of its kind, effectively capturing both sides of the butterfly model, and really investing across the full scope of the natural capital revolution.

 

10. Why is the ‘take-make waste model transition to a sustainable bio-based economy’ a multi-year investment opportunity rather than just a reaction to Covid-19?

The key aspects that are driving the revolution toward a bio-economy are not dependent on the pandemic behaviour and outcome. The environmental advantages and economic efficiency of the bio-economy and resource efficiency are proven and create a strong basis for evolution toward it. In fact, COVID-19 may serve as a reminder of the dangers of being misaligned with nature. The pandemic-related restriction on human and economic activity served as a good reminder just how severe our intrusion to nature is when the economy is left uncontrolled. Equally, the zoonotic nature of COVID-19 reminded us of the dangers of distorted ecosystems on human lives. The pandemic is thus a reminder of urgency, and just one supportive event along the way.

 

source.

1 We think about the circular economy via the metaphor of a butterfly. Our linear’ Take-Make-Waste’ economy is outdated. Just as a hungry caterpillar eats too much of nature’s resources, so our current economy relies on extracting more and more resources, producing more goods and consuming products in an entirely unsustainable fashion. Over time, this leads to destruction of natural capital and prevents future economic growth. However, powerful forces are driving a metamorphosis. The linear economy starts transitioning into a more circular economy, or a butterfly with 2 wings. On the left wing the circular bio-economy and on the right, leaner industry. 

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