What constitutes a leading active equity approach to sustainable investing?

Climate Transition opportunity

Increasing physical manifestations of an already damaged climate draw stark attention to the scale, scope and urgency of a climate transition. At current pathways, temperatures are on track to rise around 3°C this century. To maintain temperature rises well below 2°C, we need to reduce carbon emissions 50% by 2030 and to net-zero by 2050. By our estimates, annual investment needs to almost double to USD 5.5 trillion this decade and rise to USD 7.2 trillion in the 2030s to remain below a 2°C increase¹.

At Lombard Odier, we believe the climate transition will continue to accelerate in a post-COVID-19 world, powered by a positive feedback loop of economic and market forces. In our view, this transition is already one of the most important drivers of risk and return. Capital should therefore be reallocated to both decarbonise and adapt to a carbon-damaged world.

We believe the urgency of the climate transition creates significant investment opportunities across multiple sectors. To capture growth opportunities in this area, it is key to focus on solutions, transition and adaptation candidates. In a carbon constrained world, regulatory forces and/or carbon repricing provide direct growth avenues for solution providers – the massive increase in energy efficiency solutions and renewables come to mind.

Through active management, we believe it is possible to overcome inherent limitations in passive strategies and focus at the same time on relevant industries such as hard-to-abate, but economically vital, carbon intensive industries that are transitioning e.g. cement producers. We seek to identify transition candidates with a lower-temperature trajectory in those industries, thereby building a long-term competitive advantage.

Finally, companies working to adapt to climate damage should also receive due consideration. For example, a carbon-damaged world facing crowded cities, rising sea levels and flood risks will necessitate civil engineering companies that can offer flood and water management services.

Many equity approaches focus solely of a narrow universe of solution companies, whereas we believe having a wider opportunity set of solution companies, transition companies and adaptation candidates is a strength. Accordingly, we focus on seeking a global pool of companies whose growth will benefit from regulations, innovations, services or products related to the global fight against or the adaptation to climate change.

Natural Capital opportunity

Natural capital, the natural resources and ecosystem services our economy relies on, is a fundamental bedrock of growth. The World Economic Forum estimates that USD 44 trillion, or over half of the world’s GDP, relies on ecosystem services, such as minerals, habitats, water and biodiversity. Industries from pharmaceuticals to heavy industry rely directly or indirectly on natural capital. Yet, natural capital is often taken for granted and perceived as a free resource, resulting in growing waste, idle assets, lopsided distribution and unnecessary emissions.

The decline of natural capital poses a real economic risk; however, the good news is that natural capital is hugely productive and a highly regenerative resource. Recognition of the value of natural capital offers an immediate opportunity for growth. New business models are emerging that seek to use these resources as biological building blocks for a range of bio-based materials, replacing industrial alternatives. For example, nature-based materials – bio-based polymers and composites – are entering consumer products and will revolutionise sectors like construction, textiles, transport and the chemicals industry. If we can successfully leverage such materials, we can move to an economy built around these renewable resources.

Powerful regulatory, consumer, market and investor forces are driving an eco-friendly transition. The EU Green Deal, for example, has set policies and targets on a circular economy. The industry has identified some USD 440 billion needed a year to protect nature, but the current investment rate lags at only USD 55 billion p.a². Private and illiquid investments in natural capital are certainly not new e.g. private green equity, owning physical land/forests, but we identify an untapped need to mobilise and scale public equity finance in this space.

We estimate the transition represents trillions of dollars per year of investable opportunities. We see policy and companies pushing towards a transition from a take-make-waste economy to what we might call the “butterfly” economy, with the two circular wings of this butterfly encapsulating two distinct growth avenues around natural capital:

• harnessing the power of nature through the circular bio-economy and

• protecting natural capital via a leaner, industrial economy.

As with the man-made impacts the world is seeking to redress with climate transition, we need to recognise and accelerate our transition from an unsustainable “take-make-waste” model to a sustainable bio-based economic model. This transition is already happening, made possible by innovation, technology and digitalisation.

We believe there are four core revolutions centred on the transition to an economy that uses more resources in a more sustainable, circular and regenerative manner:

1. The circular bio-economy seeks out growth avenues nature-based solutions, ranging from  wood-derived biomaterials, to smart farming techniques and waste water solutions.

2. Achieving resource efficiency focuses on doing more with less, through better materials, better processes, and longer-lived products, avoiding adverse impact on nature.

3. The outcome-oriented economy recognises that we need changes both how we produce, but also in how we consume, extending product life through business models built around re-use, repair and the sharing economy, and the move towards more experiential forms of consumption.

4. The transition to zero waste, finally, seeks to close the loop on our ecological footprint and maps out opportunities in less wasteful supply chains, recycling and remediation, and the urban infrastructure necessary to support these revolutions.

These revolutions present growth opportunities not only to providers of new technologies and solutions, but also to transitioning in champions in high-impact industries such as food retail, consumer electronics, capital goods and real estate. In these industries, industry leaders that are embracing these new models are discovering new ways to attain competitive advantage and opportunities for the growth of their brands.

Historically, opportunities in natural capital were accessed via private markets (for example, via funds investing in timber). However, we believe it is now possible to deliver a liquid, diversified global equity strategy that recognises Natural Capital as a unique investment opportunity.

Conclusion

Our core conviction is that casting a wider sustainability net can create strong alpha opportunities in global equities. To achieve this, we believe a focus on the transition to net zero and options in natural capital is required. We anticipate both these areas will create significant alpha potential for investors, demonstrate firm commitment towards achieving a net zero position and aim to highlight positive impact. Investors seeking the most diversified sustainability-led strategy should look at a combination of these opportunities.

At Lombard Odier, we have a deep expertise in sustainable investing. Our approach is deeply different from ESG-driven or carbon footprint-focused strategies that generally fail to identify opportunities brought by the transition from a WILD to CLIC™ economic model. By using a combination of sophisticated data sources, academic rigour and technical innovation to create leading-edge, science-based tools that provide unique insights, we have equipped our investment team to make forward-looking investment decisions with the highest level of information and, therefore, conviction.

 

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