The theme attracting one-third of every investible dollar
When it comes to identifying ethical investments, no one would blame you for being a sceptic. Green-washing and black-cladding are but two of the many ways a company may claim to operate in an ESG-friendly manner, without making any real change to their business models. But despite this opaqueness, there is undeniable momentum building accross the theme.
According to the Global Sustainable Investment Association, ESG-related assets now account for one-in-three dollars managed globally and are poised to reach A$56 trillion by the end of this year. This reflects record-breaking inflows into ESG products...amid rising concerns around the impacts of climate change and other issues widely affecting societies - Canstar
Hari Balkrishna runs the Global Impact Equity Strategy at T. Rowe Price, which seeks a dual mandate of long-term capital appreciation while also positively affecting the environment and society. He believes impact investing is the perfect theme to invest in if you want to continually find companies with exciting growth prospects. We are actively seeking out positive impact companies.
Impact investing can be smart finance, because ultimately the companies that we're investing in will be delivering positive environmental and social good, meaning more consumers want their products and more regulators want to incentivise those products. Put plainly, impact investments have better top line and bottom-line growth prospects in the index and over time because of the fact that they generate that positive impact.
I was fortunate enough to interview Balkrishna to explore his views on the impact investing space and learn more about his strategy. In this exclusive Fund Manager Q&A, we discuss:
- The fund's impact inclusion criteria
- How impact differs from conventional ESG investing
- An example of a compelling transition stock
- How the fund goes about ensuring they are investing in truly impactful ventures
- What the future of the impact space looks like
If you are looking to invest in an ESG-friendly manner but are worried about sacrificing returns or being unable to find companies that are truly making a difference, then impact investing may be the theme for you.
Note: This interview took place on the 2nd of May 2022.
What is your impact inclusion criteria?
Broadly speaking, every stock that goes into our portfolio has to demonstrate a positive environmental or social impact against our three pillars of climate and resource impact; social equity and quality of life; and sustainable innovation and productivity.
Importantly, the relevant pillar has got to be material to their business models - the majority of revenues or profits tied to one of those pillars. It also has to be measurable by us, so both ex-ante and ex-post we need to be able to measure what that impact is.
We also require additionality: we need to be able to make a difference to the impact delivered through our involvement. And then it also needs to form part of a portfolio construction mix that makes sense from a risk management perspective.
While we also consider companies that are undergoing transitions away from traditionally harmful industries, currently more than 90% of our portfolio companies actually have the majority of their revenues or profits already tied to impact. Only a pretty small minority of companies in the portfolio require vetting to understand the exposure of future revenues or profits to impact.
We absolutely will track each impact thesis over time. To give you an example, one of the big bets we have in the strategy is NextEra Energy (NYSE: NEE). NextEra is the largest renewable investor in the US, and currently has 30% of its power generation coming from renewables. Our bet is that the majority of their generation will come from renewables by the end of the decade.
That's something we are tracking on an annual basis - making sure that the impact thesis is on track. And if it isn't or we feel like they're not going to get there, we wouldn't shy away from exiting the stock.
What is an example of a transition stock with a compelling decarbonisation trajectory?
Linde (NYSE: LIN) is another good example. We currently estimate about 50% of its revenues are aligned with our impact pillar of climate and resource impact through the reduction of greenhouse gases. There are certain elements of its business model that are quite carbon-intensive. They are an industrial gas company, so they're helping a lot of heavy industries basically decarbonize and improve operations with their gas transport.
But the important point with Linde, and what we are trying to track, is if the carbon emissions mitigated by Linde is greater than the carbon emissions that they actually generate.
In the case of Linde, it's a multiple of two: they're mitigating twice the carbon emissions that they're actually emitting. We want to consistently track that number very closely to make sure that's still the case.
From an engagement standpoint, we're very focused on engaging with a company like that - which has a big carbon footprint - and impressing upon them the need to accelerate the transition to a zero-carbon future. This includes accelerating the green hydrogen initiatives, and improving the renewable energy mix in their power generation, as a few examples.
A lot of the transition is tied to initiatives based on technologies that are unproven to a degree (i.e. green hydrogen, carbon capture). How do you ensure that these technologies are going to achieve their desired impact in the long run?
With every piece of future technology, some of them are going to work and some of them won't. Looking at specific examples, I think carbon capture and storage is already viable. A lot of these solutions already exist; They're expensive, but they exist. Pivoting to hydrogen, again, it works. It's just the question is cost. Particularly with the cost of hydrocarbons and where they are today, I would actually argue that green hydrogen is getting cheaper and cheaper on a relative basis.
I think the business case for green hydrogen is very similar to the business case that was presented for solar or wind around a decade or so ago, where they were more expensive than fossil fuel. Today, they're notably cheaper.
Accordingly, what we track pretty closely would be the Levelised Cost of Energy for all these different technologies to make sure that they're commercially viable at some point. Because ultimately for something to truly work from an adoption perspective, you need to be commercially viable. Electric cars really took off in the last few years at a point when the total cost of ownership of the electric car became cheaper or at par with an internal combustion engine. Until then, they didn't really gain much traction.
Looking at government policy and regulation, what role do these bodies play in decarbonisation?
Without being too disparaging to governments around the world, I think there is a golden opportunity to move much faster. I'm a little disappointed with the direction so far from regulatory bodies and politicians in large events like COP26 or Paris Agreement equivalents, where a lot of big words get said, but generally leave much to be desired in terms of action.
Do you think there has been a successful collaboration between the public and private sectors?
In terms of partnership between the public and private sector, it's not where it needs to be for us to truly solve these issues. But I think the good news is that commerciality takes over, so when looking at renewable energy and renewable power today, it is genuinely an order of magnitude cheaper than fossil fuels. There is a clear case to be made commercially for an acceleration of renewable energy. When you look at a range of other climate oriented verticals, such as recycling and a circular economy, they require political will and regulatory support. It's coming slowly, but there's a lot of innovation happening in the private sector in that example.
Overall, I would emphasise that innovation is being driven by the private sector. Governments could do more, but the good news is, from a commercial perspective, the cost of a lot of these technologies coming to the point where it's getting widely adopted anyway.
While a company's main operations might be sustainable, there may be some aspects of the supply chain that do not align. How do you go about reconciling these for your investments (for example, the large amounts of copper and other resources needed to build wind turbines)?
The way I think about it is the balance or skew of impact for everything we're investing in.
The reality is no single company is perfect. By virtue of merely existing, we all have a carbon footprint.
To create a solar panel or to build a wind turbine, you will need some resources. But if you think about the life cycle emissions of renewable power, it is still meaningfully carbon negative.
There is certainly an ask on the Earth's resources, but the key is when you think about copper or other metals that go into a wind turbine for example, the amount of renewable energy that's actually generated from one life cycle more than offsets those carbon emissions in production.
"It's the same with electric cars. When creating an electric car, you're obviously mining for cobalt, you're mining for lithium, but the life cycle emissions of an electric car, even including power from the grid is still meaningfully better than that of a combustion engine car. As we assess stocks, we have to assess these aspects that determine the balance and skew of negative and positive impact together”
Why do you think impact investing is so powerful?
Impact investing can be smart finance, because ultimately the companies that we're investing in will be delivering positive environmental and social good, meaning more consumers want their products and more regulators want to incentivise those products.
"Put plainly, I think impact investments have better top line and bottom-line growth prospects in the index and over time because of the fact that they generate that positive impact. This, I believe, is the attraction of impact investing; you don’t have to give up on the financial side because positive impact can lead to good financial outcomes too”
An example is Rockwool Insulation (CPSE: ROCK-B) in Europe. They make insulation solutions for the thermal efficiency of buildings. This is important as buildings constitute about 40% of global emissions, so by inserting stone wool insulation into a wall cavity, you can meaningfully improve thermal insulation. Regulation is really helping drive an acceleration in the amount of building insulation that's going into various buildings. Accordingly, Rockwool is one example where tailwinds have emerged because of impact.
They used to be a 2-4% organic growth business, to now potentially going to 7 -9% organic growth for many years to come. Not just one or two years, but instead this could be a multi-decade opportunity to retrofit a lot of old buildings all over the world and introduce stone wool insulation, as an example.
In Australia, there's been a lot of momentum, if not euphoria, towards impact investing. Do you still think these funds remain under- or overappreciated by investors, or at the correct level?
Impact is definitely an area that is still a pretty small and certainly a nascent part of the market.
In terms of where I think impact investing can go, there's huge growth potential as more and more people hopefully see it the same way that I do, which is that if you invest in impact, I think you can actually make superior returns while simultaneously generating real change as well.
It's the cleanest way to access ESG, because you've got to find companies with measurable impact that's actually reportable, removing the lack of transparency that can arise with other ESG-themed investments. But I still think it's at a relatively niche stage, especially in public markets.
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