Forming convictions in circularity

Look beyond silos, and it’s clear that the sustainability transition is driven by interconnected themes. Seek opportunities, and it becomes evident that identifying truly sustainable investments is a complex exercise requiring analysis of current industrial practices, policy direction and the systemic changes rewiring the economy. These were key messages from investors and researchers speaking at our Transition Investment Summit in London this month.  

Combining nature and climate

Speaking at the event, Jennifer Devine, Head of the Wiltshire Pension Fund, described the multi-thematic approach to sustainability that the UK scheme is taking. Aiming to improve portfolio resilience, the fund invests in sustainable equities across climate and natural-capital exposures, local renewable-energy infrastructure, and public and private emerging-markets transition debt. 

“We’re looking at assets that can sequester carbon, companies big and small that are going to benefit from the transition, and nature will be our next piece of work,” Devine said. “We’re coming at sustainability from every angle we can think of.”

The Environment Agency Pension Fund, another UK scheme, has allocated 17% of its portfolio to climate solutions and 4% to natural-capital investments, which must evidence net nature-positive benefits. “Science tells us we can't solve climate without solving nature, and the interlinkages between them are ingrained,” said Investment Manager Becky LeAnstey. “That is what sustainable investment is about: thinking beyond silos to the interlinkages and how they come into effect.”

Since setting a target to become net zero by 2037, the City and County of Swansea Pension Fund has reduced its carbon exposure by 50% and is allocating to natural-capital assets, such as a local biomass plant that recycles wood that would otherwise go to landfill. “It employs about 60 local people, provides energy security for about 110,000 homes, and in my experience has generated more stakeholder engagement from members, unions and employers than any investment that we've done previously,” said Jeffrey Dong, Head of the Welsh scheme. 

“I've been doing this job for 20 years now, and the last six years have been the most engaging in terms of interest and impact locally, but also in terms of asset value.”
 

Harnessing circularity

Investing in nature as a real asset was also explored: the integral role of natural capital and biodiversity to a stable planet and well-functioning economy, and the investment opportunities in transforming value chains in specific soft commodities from being extractive to regenerative.

Circular approaches to resource use are vital to this transition, and forward-thinking companies can benefit, said Alina Donets, Portfolio Manager of the LOIM Circular Economy strategy. “We have ignored resource productivity, failing to decouple materials use from economic activity – virtually creating a cap to further growth,” Donets said, pointing to how rapid biodiversity depletion is tied to economic productivity and development.

“We need a system change in the way our economy uses resources, so we stop damaging nature and allow it to self-regenerate,” she said. This requires improving efficiency in the use of resources across value chains, aimed at reducing demand for virgin materials, increasing productivity, and extracting greater utility at the use phase; and the expansion of the bioeconomy to allow natural resources to self-regenerate. 

The growth opportunities available to companies working to improve the quality and efficient use of water in our economy illustrates how circularity both supports productivity and environmental integrity. Water systems are “highly linear, ineffective and polluting,” said Felix Philipp, PhD, Senior Research Analyst, Materials & Circularity Lead at LOIM, and contribute to humanity’s breaching of planetary boundaries.

Inefficient water use is a global problem, with up to 25% of supply not reaching developed-world consumers due to leaks and more than 2 billion people in emerging markets not having access to clean water and sanitation, intensifying their vulnerability to extreme weather events, Philipp said. Pollution is chronic, as more than 60% of wastewater flows unfiltered and untreated into the environment, contributing to pollution, biodiversity loss and public-health issues.

“These challenges have been driven, exacerbated – even enabled by – a mispricing of water, a lack of pricing of externalities and significant growth in demand for this precious resource,” he said.

Demand for water has grown six-fold in recent decades and is projected to increase 40% by 2030, he continued. “Where does that leave us? It’s clear that our current water system is reaching its limits.”

Philipp described how regulators are establishing frameworks to increase water supply and price pollution, with the burden falling on the entities responsible. Water infrastructure is also being targeted for investment, and digital technologies that can enable more efficient monitoring and management of water are maturing.
 

Investable solutions

How can circular solutions become a driver of investment opportunity in the water sector? Philipp approached this question by first identifying the main areas of corporate activity. These span across all parts of the value chain: from water utilities, to providers of solutions such as treatment capabilities, to engineering companies responsible for sustainable management of water infrastructure as well as ecosystems including soil and water decontamination projects.

Investors focused on circularity can find investment opportunities in the niches that support regeneration of the essential natural resource of water. Philipp highlighted several areas, including the digitalisation of water that drives significant improvements in the efficiency of water usage and distribution. Advanced water-treatment solutions that can filter out pollution are another key area that addresses chemicals of emergent concern and traditional pollutants. Similarly, quality measurement equipment is instrumental in advanced water testing, and for upgrading municipal and industrial infrastructure in mature markets like the US and Europe.

Such companies seek “to capitalise on these opportunities and accelerate the transition towards a more circular water system,” Phillipp concluded.
 

Green, grey or red?

Aquaculture, data centres and genetically-modified crops – how should a sustainable investor assess and classify these activities? Assessing such debatable activities with regard to their contribution to the sustainable transition formed key debates at the summit.

Indeed, it is not always easy to define the boundary between companies accelerating, or not accelerating, the transition; and investors in such cases need to weigh up the positive contribution and potential negative impact of these activities. Sometimes this can lead to lively discussions, such as the subject of aquaculture, resulting in polarised opinions. As of today, the majority of listed companies worldwide are in this grey zone and require a rigorous assessment of their activities built on robust science-based frameworks, to the extent possible.

“Our framework tells us that only 26% of companies in the MSCI World can be classified as being sustainable,” said Elise Beaufils, Deputy Head of Sustainability Research at LOIM, illustrating the scale of the change – and potential opportunity – ahead. “If 80% were already sustainable, there would be no discussion about the sustainability transition, it would be a resolved problem.”

Under the Sustainable Finance Disclosure Regulation (SFDR) in Europe, asset managers are required to develop their own criteria for defining a sustainable investment, drawing their interpretation of what could be considered sustainable from a legal definition of sustainable investment that embeds three ‘tests’: contribute to the transition, do no significant harm, and demonstrate good governance.

Applying such tests brings into focus the fact that most companies are neither strictly sustainable nor unsustainable. They currently exist in between, not necessarily supporting nor impeding the transition.

“If a company is not a sustainable investment, it does not necessarily mean that it is unsustainable,” Beaufils said. “Think about an accountancy firm. It is not really accelerating the transition, nor is it slowing it down,” Beaufils said. It is neither sustainable nor unsustainable, it is rather what we call a grey investment.

“We see sustainable investments, the green companies. Then we see grey investments – companies that are not there yet, either only marginally contributing to the transition or involved in activities not accelerating the sustainable transition. And then we find red investments, the potentially unsustainable businesses.”

As well as classifying green companies, our framework finds 11% of companies in the MSCI World are deemed to be red. As the transition progresses, we will continue to analyse businesses and the remaining 63% of companies to determine whether they will shift towards accelerating or opposing the transition. 
 

Fishing for answers

To engage the audience on applying this green, grey and red classification, Beaufils asked a simple question: is aquaculture an area of sustainable investment?

The complexity of arriving at an answer soon became apparent. Audience members focused initially on salmon farming, where sea lice are a chronic problem in Scottish fisheries that lead to pesticide use to combat infestations, but which also kill other marine life, harming local biodiversity. Large volumes of fish waste emanate from the farms, polluting local environments. As nets inevitably break in places, escaped fish infect wild salmon and compete for food. Interbreeding may also have an adverse impact.

But the aquaculture industry, more broadly, provides employment – beyond the British Isles to South-East Asia and Latin America. Farming fish, prawns, oysters and other seafood has a much lower carbon footprint compared to grazing land-based livestock for red meat and dairy products. 

In future decades, seafood production will need to grow to meet the dietary needs of a growing human population. Beaufils referenced the planetary health diet, developed by 37 scientists working in the EAT-Lancet Commission on Food, Planet, Health, which addresses malnutrition and the environmental damage caused by the industrial food system. The planetary health diet would require consumption of fruits, legumes and grains to double by 2050 and account for 50% of our dietary needs. Red-meat intake, meanwhile, will halve and fish will become a more prominent  protein source. 

But how can the supply of fish be increased from current levels to meet this need? Oceans have already been overfished: in 1974, 90% of fish species remained within biologically sustainable limits, compared to 64.6% in 2019, according to the Food and Agriculture Organization of the United Nations. 
 

Is aquaculture green?

On one hand, without robust management systems, there are potential environmental risks that aquaculture can incur such as biodiversity and pollution risks. On the other, the industry is key to the transition of the land and oceans system, i.e. mitigating climate change. 

“What's the solution? Together we have listed all of the main issues associated with aquaculture practices”, Beaufils said to the audience. “But we have also looked into the benefits – the relatively low carbon footprint of aquaculture compared to other animal proteins, and the fact that it is absolutely needed as a part of the planetary health diet”.

This potential driver of strong demand for fish as a low-carbon protein source provides the incentive for policy frameworks and drives corporate innovation for aquaculture farms to embed sustainable practices. Beaufils highlighted the Aquaculture Stewardship Council standards, which aim to minimise pollution, reduce impacts on biodiversity, and leverage remote-sensing technologies and recirculating aquaculture services to optimise feeding regimes, manage water quality and monitor any disease outbreaks in real time.

“At LOIM, we're going to look into the current practices and business model of farms to assess the technologies and innovative sustainable practices that are used by companies to mitigate potential adverse impacts on the ecosystem including pollution risks and fish escaping.”

The verdict? Given its potential to accelerate the transition, aquaculture has been classified as an eligible activity. But to invest in this industry, sustainable investors need to identify the companies striving to work in balance with the ecosystem to produce a dietary staple, i.e. companies that have/are successfully transitioning to sustainable practices and effectively mitigating their adverse impacts in the industry.

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