By Peter Lorange Chairman Lorange Network and S. Ugelstad Invest President Emeritus, IMD, Lausanne

Introduction

Today, there is ever-increasing awareness of the need to factor environmental concerns into investment decisions. But what specific criteria do investors and asset managers need to take into account when creating their portfolios? Peter Lorange sets out the issues and outlines some general approaches. 

Since its “officially” tracked inception back in the mid-1990s, or at least when it started to be of significant interest, impact investing has seen dramatic growth. According to many, this trend will continue upwards due to increasing climate problems, government and business commitments to these, and the increasing voices of younger-generation investors who are statistically more conscientious and concerned with “making a difference” and who want their investments to make more than money (these are often referred to as “personal values investors”).

In this note, we shall discuss the following aspects of the impact investing phenomenon:

• Climate deterioration as a key driver behind the development of impact investment.
• Emission of atmospheric pollutants, including CO₂ .
• Implications for:
  • investors
  • asset managers
  • corporations
• The challenge of reporting.

At this point, it should also be noted that there are several “competing labels” to impact investing, “responsible or socially responsible investing” (which reduces harm) or “sustainability investing” being perhaps the most commonly used alternative, or even “regenerative investing” (which increases capacity). However, in this article, we’ll use only the impact investing label.

Global warming – the key driver

Recently we have been seeing dramatic changes in the world’s climate, mostly for the worse. Examples: temperatures have gone up significantly, almost everywhere, and the ice formations around the North Pole, including Greenland and in the oceans of northern Russian are melting at an alarming rate. To a lesser extent, we see this also in the far south. Hurricanes are becoming more abundant, with major instances of damage from flooding and/or strong winds, perhaps most noticeable in Central America, the Gulf of Mexico and South East Asia. Large areas of our earth are experiencing sustained extreme drought, perhaps above all in areas of Africa, and so on. We could go on and on. Most scientists, as well as politicians, seem to agree that our Earth’s climate is deteriorating.

There have been noticeable responses, but so far without much tangible result.   First of all, there seems to be general political agreement that the climate challenge is a global phenomenon. A small minority of politicians seem to deny this, such as ex-President Trump in the US. However, the almost general acceptance that climate deterioration is a worldwide dilemma is noticeable.

Second, there have been at least four global conventions (such as the COP25 United Nations Framework Convention on Climate Change (UNFCCC), the World Climate Conference, the WHO Global Conference on Health and Climate) where this phenomenon has been the topic, and where revised targets and ameliorating actions have been discussed and even agreed upon, so far without much effect. The first such conference, held in Rio, was followed by global meetings in Kyoto, Doha, Copenhagen and Paris, and another such global meeting is scheduled for Glasgow in 2022.

The meeting in Paris was indeed different from previous ones, in that the so-called Paris Agreement (UNFCCC) was agreed to by the majority of delegate nations, including all of the world’s large powers. Specific CO₂ emission targets were set (see next section), and deadlines established. A differentiation between the so-called developed nations and the developing ones was introduced, whereby some lesser-developed nations were granted more time and greater emission quotas, so as to guide their economic development. The bulk of the economic burden was to be carried by the developed countries, the US in particular.

As we know, the US withdrew from the Paris Agreement during the reign of President Trump. However, it is noticeable that all the other world nation signatories remained. Further, significant “polluters”, such as China, have committed themselves to specific ameliorating emission targets, such as to become carbon-neutral by 2060 in the case of China. And the US has rejoined the Paris accord and even established a cabinet-level position to deal with the climate issue, headed by former foreign secretary, presidential candidate and senator John Kerry.

The key driver: emissions of pollutants, such as CO₂

The emission of polluting gases into the world’s atmosphere seems to be at the heart of the problem. The best-known is CO_2. However, there are many other potentially dangerous pollutants, such as oxides of sulphur (SO_x) and of nitrogen (NO_x), and carbon monoxide (CO). Noticeably, the emission of ozone gas a few years ago was curtailed, through a worldwide agreement, mostly among industrialised nations. Spray bottles, then-conventional refrigerators and so-called “reefer” ships were forbidden or significantly curtailed. Alternative technologies were developed. The result seems to have been a significant improvement in the so-called ozone hole in the atmosphere around the South Pole.

The major challenge, however, is to limit the emission of CO_2. The statistics regarding the global emissions are not encouraging. According to the EU Commission’s EDGAR (Emissions Database for Global Atmospheric Research), “the global GHG emissions trend has increased since the beginning of the 21st century in comparison to the three previous decades, mainly due to the increase in CO₂ emissions from China and the other emerging economies”. EDGAR reports that, compared to 1990 numbers, in 2019 CO₂ emissions from the power industry saw a 78% increase, from other industrial combustion by 67%, from buildings by 8%, from transport 78%, and from other sectors 100%.

Where are these emissions coming from now? Are there specific industries? It may be useful to distinguish between types of firms that are directly contributing to CO₂ emissions, in contrast to firms that might indirectly be close to the source of this problem. The eco-experts claim that the fuel, agriculture, fashion, food retail, transport, construction work and technology industries rank as the seven most polluting industries. A few more comments to consider:

• Direct polluters – Perhaps surprisingly, a very significant source of CO₂ emissions is cattle. We are accordingly witnessing a gradual change in eating habits, away from meat, in part to reduce health risks, but also to help reduce CO₂ emissions (plant-based hamburgers, etc.). The shipping industry is also a major source of CO₂ Stringent new rules for emissions in this industry are coming into effect in 2022. In the airline industry, new engine technology is leading to important reductions in CO₂. In general, technological advances are critical. Coal-fired electricity power plants are still a problem. However, new natural-gas-powered power plants are no less expensive! Thus, we see positive effects from alternative used of fuel to burn.
• Indirect polluters – CO₂ emission results, in most cases, from the burning of materials that are carbon-rich, such as oil, coal and/or wood. Thus, major indirect polluters are oil-producing companies, as well as coal mining firms.

So, what are some of the key implications of these pollution-related issues? We shall now discuss these for three stakeholder groups:

1. For investors

The key for most investors will be to restructure their investment portfolios, with less focus on direct and/or indirect polluting entities. Many investors are utilising so-called index funds for shaping their portfolios. For them, it will be critical to be able to identify good alternative index funds which avoid the direct/indirect polluters, while nevertheless providing satisfactory promised investments returns. In general, it appears that there are indeed such funds available, i.e. which do not “impose a penalty” on investors for “going green”! 

2. For asset managers

Examples of major asset management firms that have pioneered the development of impact investing (avoiding heavy polluters) are Blackstone, BlackRock, UBS, Credit Suisse and others. These firms tend to pursue two avenues:

• They tend to offer specific “clean firm” investment opportunities.
• They tend to offer funds that are “light” or totally devoid of polluting firms, based on indexes that are similar.

Many asset managers are also following through in the way in which they rate their specific holdings when it comes to companies that might be dealing with pollution challenges. Are such firms specifically making progress in implementing strategies that would result in their becoming “cleaner”? And/or are top management, as well as boards of directors, also showing clear commitment to the avoidance of pollution? While such rating behaviours on the part of asset managers do not typically lead to specific changes in strategies, board compositions and/or top management positions, such ratings can often send important signals to the investment community, to politicians and to employees alike. So-called activist investors are increasingly following suit when it comes to these rating actions.

3. For companies

As already alluded to, corporations will now typically want to develop strategies that specifically take into account how to reduce environmentally dysfunctional effects, such as pollution. And, in most cases, this will also be reflected in these companies’ reporting (to be discussed in the next section).   Examples of how (formerly) heavy polluters have changed or are changing their strategies are:

• DONG, a Danish publicly traded company formerly controlled by the Danish government, which used to be the major Danish company active in the country’s offshore oil sector and now is the world’s largest owner of offshore wind turbines for electricity generation.
• BP, the major UK-based oil and gas producer, which has declared that no dividends are to be paid in the foreseeable future, so as to make use of this liquidity stream to diversify instead.
• Food companies, such as Nestlé, Tyson and Hormel, which are becoming active in plant-based “meats” (hamburgers, sausages, chicken, etc.).
• Yara, the world’s largest producer of fertilisers, based in Norway, which is reactivating its 100-year-old technology of developing fertilisers through electricity (non-CO₂-polluting), away from the oil-based conversion (CO_2-emitting).

There is, of course, a potentially major challenge for many firms to implement a viable strategy away from being fundamentally “dirty” to becoming “clean”. While technological solutions often exist, these might be expensive, and at times excessive. To support the transitions of such firms, a special financing investment has been developed: “pollution-reducing restructuring bonds”. This has been offered in particular by Credit Suisse, as well as by Goldman Sachs. Also, blue bonds are a recent type of sustainability bond that finances projects related to preserving ocean biodiversity and general ocean conservation. Another example is the earlier-introduced green bonds, a type of fixed-income instrument specifically earmarked to raise money for climate and environmental projects.

A related issue is the fact that so-called “dirty” firms will be faced with rather more expensive costs of capital for their financing of new investments. We see this already, and this evolution is likely to continue. Thus, it will become less and less viable to remain “dirty” for many firms. This is quite significant for the bulk of such firms, which commonly tend to be faced with large, new capital investments (oil exploration, coal mine development, etc.).

Reporting

There is a clear trend towards more explicit reporting of environment-enhancing corporate efforts. For instance, the world’s previously largest accounting firms have, together with the World Economic Forum, developed a set of standards for this. Some countries, New Zealand being the first, have mandated such reporting, including now also the early adoption from Switzerland.

A key “problem” with this is the fact that it may be difficult to come up with stable criteria for what constitutes severe pollution:

• Take the electric car industry, for instance. Most observers might classify this type of industry as non-polluting, in that it significantly reduces the burning of fossil fuels in conventional engines, thereby contributing to significantly reduced CO₂ But the manufacturing of batteries for electric cars typically involves significant open-pit mining malpractice. To find the required rare earth metals thus involves significant damage to Mother Nature. Perhaps even worse, many such open-mining ventures employ child labour.
• Consider the manufacturing of Teflon coatings for kitchen accessories, pioneered by DuPont. At the time of its development, DuPont research paid little to no attention to potential health risks. For them, at the time, the key was to come up with a successful type of fibre for this purpose. And they did! It became clear only much later, however, that there were serious dysfunctional health effects. So, what we see is that the discovery process in many corporations might only gradually become sufficiently cognisant of such dysfunctional secondary effects.
• The evolution of so-called steel-studded tyres for cars provides a similar picture. Initially heralded for dramatically easing the difficulties of driving during icy conditions in such regions as Scandinavia, Canada, etc., it became clear that the effects regarding wear and tear of asphalt roads were severe. Therefore, most countries prohibited these types of tyres. It was subsequently realised that the emission of relatively small particles of dust from the studded tyres’ grinding effect on asphalt would be highly dangerous for people’s health, i.e. from the cancerous effects of breathing in this dust. While this has been the reality all the time, it was not fully understood until much later! And it is not the particles from only steel-studded tyres that are toxic, but rather those from all tyres (these are called “tyre and road wear particles” (TRWP), and are the tiny debris produced by the friction between tyres and the road surface.

Clearly these types of challenges make it difficult to come up with broadly accepted measures for what constitutes pollution enhancement. What are the good measures for investors as well as asset managers to follow regarding the selection of non-polluting assets or of indexes on which to base their judgements when it comes to index-based investment vehicles?

Conclusions 

Impact investing is clearly on the rise. This is driven by a much more universally accepted realisation that pollution and CO₂ emissions are a reality! While, for many years, there seems to have been a wide-spread recognition regarding this general challenge, in a more abstract sense, there now seems to be more urgency and specific actions regarding these issues. The United Nations says the need to reduce carbon emissions by 7 per cent a year is urgent, and many climate scientists advise that we have to limit temperature rises to 1.5 degrees Celsius for a liveable and safe climate. We see this, therefore, not only at the governmental level, but also when it comes to corporations.

Perhaps most important of all, a broad base of investors seem to be following suit! According to the Global Impact Investing Network’s 2019 research, “there are over 1,340 active impact investing organisations across the world who collectively manage US$502 billion in investments intended to bring about positive change.” Since then, the numbers have risen further. As sustainable businesses lead the way into a better and safer future, both next-gen leaders and investors can integrate sustainability into their strategies and projects.

About the Author

Peter Lorange, after having sold his shipping company in 2006, has been a successful entrepreneur and owner of a highly diversified family office.  He has been regarded as one of the world’s foremost business school academics, holding the position of President at IMD, Lausanne for 15 years, as well as several positions on shipping company boards. His entrepreneurial journey spans across key areas such as education, shipping, investments, and pre-dominantly Family Businesses.  Peter founded the Lorange Network, a digital learning and networking platform, in 2017.  Peter is Norwegian, residing in Küssnacht am Rigi, Switzerland.