Environmentally aware investors increasingly want portfolios that address climate change. Evaluating carbon handprints, or the way a product or service affects the environment is a good way to find companies that are providing powerful solutions to the world’s climate challenges while offering attractive growth potential.
Climate-focused portfolios are enjoying huge inflows from investors. Globally, more than 400 funds that included climate change as a key theme tripled total assets under management to $177 billion as of December 2020, according to Morningstar. Many portfolio managers seek to address climate change by identifying “good actors”—companies with low carbon footprints. This approach has its merits and is especially popular among passive portfolios.
But we think there’s another dimension to climate-aware investing that can be very effective. Instead of looking at carbon footprints, we believe investors should look at a company’s carbon handprints. In contrast to carbon footprints, which measure the negative impact of companies on the environment, companies with carbon handprints are creating positive solutions to global climate challenges.
Why Focus on Climate Solutions?
Companies with formidable carbon handprints will be at the forefront of efforts to reduce the world’s carbon intensity. Many offer products and services that will facilitate the transition to a low-carbon economy or help communities become more resilient against the physical effects of climate change. Examples include companies providing decarbonization solutions for clean energy, resource efficiency, transportation and sustainable agriculture, as well as resiliency solutions for water and infrastructure.
Identifying climate solutions requires a deep understanding of the world’s biggest climate challenges. The UN’s Sustainable Development Goals (SDGs) are a good place for investors to start. The UN’s 17 goals and 169 specific targets address areas of critical importance to humanity, including access to sustainable energy, eliminating poverty and hunger, and improving access to education and healthcare. Of these, the goals and targets related to addressing the negative impacts of climate change can be used as a roadmap for investors in the hunt for companies that offer compelling climate solutions.
Our research found that 57 of the 169 SDG targets are specifically related to climate solutions. We’ve identified more than 45 products and services that are aligned with these goals in a proprietary, multi-year study of the SDGs. For example, target 7.2 is to “increase substantially the share of renewable energy in the global energy mix by 2030” and products that will enable its achievement, including wind turbines, solar panels, batteries for energy storage and smart grid systems (Display). The next step for equity investors is to search for publicly listed companies that generate revenue from these products. Our research suggests that about 750 companies globally are moving the world toward a greener future, creating a broad investment universe from many sectors and industries.
Massive amounts of capital will be deployed in the decades ahead to combat climate change. According to UBS, the capital investment needed to decarbonize the global economy is estimated at $140 trillion—or about $4.7 trillion annually—through 2050. Companies enabling decarbonization should enjoy a multi-year tailwind from global efforts to reduce emissions driven by governments, corporations and individuals (Display). This helps explain why many companies that are delivering climate solutions enjoy powerful long-term growth drivers.
Three Investing Principles
So how can investors tap into the transition to a low-carbon economy? First, search for climate solutions across regions and sectors. Often, climate-focused funds are one-dimensional, with a narrow focus on popular industries such as renewable energy. With a diversified approach, investors can capture change in the drive for clean energy as well as areas such as resource efficiency, transportation, agriculture, water and infrastructure.
For example, Neste, a Finnish oil refining company, produces renewable diesel fuel from waste fat, residues and vegetable oils. In the materials sector, DSM of the Netherlands produces improved animal feed that helps cows burp less, which reduces the emission of enteric methane—the largest source of farm greenhouse gas emissions. Waste Management Inc., based in Houston, Texas, generates carbon emissions from waste processing, collection trucks and landfill methane. But the positive impact of its handprint from carbon reduction services is 3.3 times the negative impact of its carbon footprint.
In many cases, Scope 4 carbon emissions are a good guide to finding companies offering climate solutions. Scope 4 represents the avoided carbon dioxide emissions from the use of a product or service. Vestas Wind Systems provides a good example of the importance of Scope 4 emissions. The company’s Scope 1 and Scope 2 emissions—direct and indirect emissions generated during the manufacturing phase of its wind turbines—are dwarfed by the emissions avoided through the use of its products. In fact, the company estimates that every wind turbine helps avoid 40 times more emissions than those generated during the manufacturing stage.
Second, make sure that target companies have solid fundamentals; not every company focused on solving climate change is a good investment with strong long-term return potential and an attractive valuation. With a disciplined stock selection process, investors can find well-run companies with differentiated products, sustainable competitive advantages, high returns on capital and strong balance sheets.
Third, invest in portfolios that actively engage with their portfolio companies. Portfolio managers who engage with management can get a better idea of the impact and strategy of a company’s climate solutions—and the potential risks. Engagement also informs an in-house view that is more comprehensive than third-party ratings. And by encouraging firms to become more responsible corporate actors in their business practices, investors can help create additional shareholder value over time.
There’s no silver bullet to addressing climate change. As a result, many different technologies—evolving at varying speeds—will make important contributions to solving the world’s carbon emissions problem. For equity investors, we believe capturing a diverse set of companies with enduring carbon handprints can foster positive environmental change and strong long-term return potential in a climate portfolio.