CIO views: sustainability roads less travelled

Fixed income: not all strategies created equal

Sustainability, quite rightly, lies at the heart of many investment strategies. However, not all sustainable investment strategies are created equal. Some focus on low emissions now; some only on direct emissions (those generated directly by the company‘s operations) and some on both.  Other strategies incorporate both direct and indirect emissions (those generated through the supply chain and in the use of the product by customers). A very small number of approaches may also look to predict a company’s future emissions and the likely rate of decarbonisation.

Given the variety of approaches, it is easy to imagine that investors may assign different valuations to the same instrument. By way of example: basic supply and demand theory suggests the simple and perhaps more popular approach to focus on low emissions now could lead to strong demand for bonds from low-carbon issuers, resulting in yields somewhat lower than the underlying credit quality suggests is appropriate. Conversely, companies with higher emissions and faced with lower investor demand may have to pay a little more when issuing bonds, and some may even struggle to issue at all. We believe this potentially offers an opportunity for investors who are able to identify those high-emission issuers that have a robust decarbonisation strategy, and lock in additional returns while supporting companies in their transition towards low carbon or net-zero alignment.

Convertibles: today vs tomorrow

In the convertible bond market, ESG¹ enthusiasm has helped drive record borrowing from well-known companies involved in sustainable activities. By this we mean those companies engaged in electric mobility, insulation or energy-efficient materials or components, to name a few.

Over the past year, such borrowers have issued convertible bonds with favourable terms for the company: a low or zero coupon paired with a large premium on an underlying stock that we believe is often highly valued due to its  recognised (and priced in) green credentials of the business. Such convertible issues have been heavily over-subscribed by investors and led to pockets of over-valuation in the asset class, in our opinion. Partly, this is due to requirements for investors to fulfil certain regulations or their aim to beat ESG benchmarks.

More broadly, however, it reflects a flock to fund today’s sustainable companies at the expense of tomorrow’s transition opportunities. As investors in the transition to a CLIC™ economy, we look for  companies implementing sustainability-focused strategies today that should underpin the transition. This includes companies in all sectors – not simply those already well-known for their sustainability alignment today.

For us, the transition provides the opportunity to tap into new growth markets driven by rapid change – technological, regulatory and consumer-driven – fuelling the shift to a more sustainable future. We believe that companies able to focus on sustainability objectives are the ones to watch. They could represent today’s under-valued equity stories and challenged credit profiles, depending on the capital expenditure needed to implement the transition. However, from a capital return prospective, we believe they could also offer a favourable profile tomorrow.

¹ ESG stands for environmental, social and governance.

Alternatives: from intuition to science

Human beings are intuitive thinkers, but human intuition is imperfect¹. When initial problems arise, the fastest, most intuitive actions are often enacted. As the problems become more structural, the human approach tends to become more scientific.

Sustainable investments have often been driven by this combination of intuitive responses but also with individual biases. Fortunately, the trend towards a scientific approach has started to occur in multiple sectors, and a key example is the climate transition. There have been clear government or private sector initiatives – Paul Hawken’s project drawdown or Lombard Odier Portfolio Temperature Alignment – to quantify carbon impact and resulting temperature forecasts across many industries and regions. This is great news, because a more efficient use of capital will drive results faster, and it signals the early stages of this capital reallocation. We believe those who have established a clear strategy and process will hold an information and implementation advantage. Lombard Odier has taken this path across asset classes, and we have implemented it in our sustainability-focused long/short equity strategy, Terreneuve. 

We are also mindful of valuations and the pace of development in the sustainability space as human intuition and bias have played a role in broader market adoption. The ‘environmental’ aspect of ESG² receives a disproportionate amount of attention, in our opinion. We note significant retail-investor euphoria in the clean-energy and green-tech segments over the past six months. For example, flows surged into passive investment vehicles based on the S&P Global Clean Energy Index³, which up until April had a limited scope of only about 30 underlying constituents. Two ETFs alone, ICLN and QCLN⁴, had their assets under management surge from just under USD 600m combined at the end of 2019 to a peak of USD 10.5bn by February of 2021.

We focus on a broad range of sustainability themes, understanding a company’s fundamental trajectory relative to current valuations, and consider the full value chain rather than just the names making headlines. This approach has enabled us to identify diverse opportunities as progress towards greater sustainability is made, and to use the extreme weakness and volatility in a handful of segments to align ourselves for the next leg upwards.
 

Sustainability: accelerating the CLIC™ transition

The climate transition is a secular trend. Following the US’s renewed commitment to tackle climate change, 80% of the global economy is now under some form of the net-zero target—a massive leap from the 16% we observed only a year ago. Conceptually, the race to net zero – understood here as limiting a global temperature increase to 1.5°C above pre-industrial levels – is straightforward: we must achieve net-zero CO2 emissions by 2050. However, for many investors it remains a practical minefield.

So far, the prevailing logic underpinning climate-conscious investment has been to allocate capital to low-carbon enterprises. The approach is surprisingly problematic. Indeed, low-carbon strategies leave hard-to-abate sectors such as steel, cement, glass and chemicals entirely unaddressed. Yet these sectors are as critical to a functioning economy as they are to climate-change mitigation.

While there will undoubtedly be climate-transition champions in these sectors, investors face a difficult task in identifying them—as of today, companies active in these sectors all have huge carbon footprints. However, climate leaders and laggards become apparent by analysing their decarbonisation trajectories on a forward-looking basis. The task is complex and requires deep carbon expertise, but it comes with major market and climate upsides.

At Lombard Odier, we have developed market-leading capabilities to identify tomorrow’s climate transition champions across all sectors and asset classes. They allow us to invest in, and accelerate the CLIC™ transition while mitigating risks and realising untapped value where it matters.