Broadening the Path to Low-Carbon Investing

Building a low-carbon equity strategy requires a wide view of the forces shaping businesses and returns, including climate change. 

Investing in climate-focused stocks might seem relatively straightforward. After all, how hard can it be to identify companies around the world cutting emissions or enabling the transition to a low-carbon economy?

But effective low-carbon equity strategies involve more than just vetting companies for carbon emissions. Many other variables must be weighed too, since so much can determine a stock’s risk/reward profile beyond the long arm of climate change.  

Investors with a climate focus must take a holistic view of the biggest environmental challenge of our time, because adapting to climate is just one ingredient of business sustainability and return potential. Both also hinge on a company’s strategy and execution, the macroeconomic environment, and shifting cyclical and secular trends. Moreover, climate’s impact on a business is variable, shaped by geography, policies, politics and people. How they converge continues to shape possible global scenarios for the green transition—from optimistic to dire. 

That’s why company fundamentals such as profitability and capital discipline are equally vital inputs in active climate-focused strategies. Strong fundamentals help quality businesses surmount macro hurdles beyond climate risks, such as inflation and higher interest rates. Attractive share valuations support return potential and help investors avoid risks in expensive parts of the market. We believe that integrating these three targets in stock selection—quality, climate and price—can better align a portfolio’s climate goals with investors’ long-term financial objectives (Display). 

How Climate Change Efforts Can Strengthen Economic Growth 

To find stocks with these strengths, investors must appreciate the direct, complex relationship between climate and economic growth. Climate change remains a major determinant in GDP output, with powerful effects on assets, industries, workplace conditions, communities and politics. 

Global warming, perhaps the biggest threat to economic growth, is certainly the most scrutinized for its potential outcomes. For example, an International Monetary Fund (IMF) paper directly links rising temperatures to reductions in real growth rates.¹ It also concludes that successfully abiding by the Paris Agreement’s goal to contain temperature rises to 1.5 degrees Celsius over preindustrial levels would limit climate change’s net impact on growth to well under levels created by normal business cycles. 

However, the IMF study leaves an important question on the table: Could a massive global response to climate change do more than just limit its detraction and instead improve economic growth? We believe so. In particular, investment in the energy transition could help reverse the effects of rising temperatures and boost global growth in the long run. 

Although the transition is underway, studies contend it’s already falling behind, especially with respect to funding. A recent McKinsey report estimated it will take US$275 trillion in spending just on physical assets to support the global transition of higher-emission industries and economies to reach net zero by 2050.² But based on that scenario, today’s annual expenditures fall short by US$3.5 trillion. 

Transition Spending in Historical Perspective

How does this compare with prior epic investment booms? In fact, spending on the energy transition as a percentage of GDP is relatively modest when compared with the late 19th-century UK railway expansion and post–World War II infrastructure projects across America; these accounted for about 2% and 3% of each country’s GDP, respectively (Display). The implication is that if those spending levels were achievable then, why not now? 

One reason stems from where the funding would originate. UK railroad construction money was mostly privately sourced. The US infrastructure boom was publicly funded, much like today’s global transition to renewable energy. Although every country has a stake in climate change, sovereign resources to fund the transition differ dramatically. This means that global warming’s impact will vary across regions, with implications for real assets, migration, labor, politics and divergent capital investment. Our analysis also suggests that energy transition spending will be inflationary in the near to medium term but deflationary in the long run as economies of scale and other factors play out—an evolution that will vary the effects on sectors and individual companies too. 

How Will Companies Fit into the Transition?

In the transition to low-carbon economies, some companies will lead the way, play a supportive role or benefit from dynamic changes. Others will muddle through or fall behind, a fact that may not be easily spotted by investors.  

Knowing where firms may fit into the transition starts by understanding how climate change will support or alter their businesses.   

This is no easy task given the complicated variables at play. But we think climate change will clearly have far-reaching influences as part of a select triumvirate of global macro mega-forces likely to play out for years, along with changing demographics and deglobalization. Pathways most likely to define this linkage include rising temperatures, extreme weather events, mass migration pressures, political instability, conflict over resources, habitat loss, deforestation, biodiversity shrinkage, rising sea levels and other physical risks. 

As a result, we believe an active approach to climate-focused equity selection is needed to discern between businesses that are enabling the transition to low-carbon economies, implementing change or benefiting from the shift, versus those that are at risk.

Making those distinctions takes more than leaning into climate-focused stocks or avoiding those precariously exposed to the risks. In our view, finding companies that strike a strategic balance between quality, climate and price can help a portfolio capture stronger return potential at significantly lower carbon exposure than the benchmark’s.

Quality: A Solid Foundation for Sustainable Growth

Companies with high-quality features enjoy flexibility to navigate short-term market stresses and longer-term challenges. We believe strong profitability, measured by return on assets (ROA) and return on invested capital, is a robust predictor of future earnings power. Capital discipline can help support margins, particularly in a world of higher interest rates. 

Quality business models also tend to be more predictable and potentially less volatile. It’s an especially important consideration for climate-focused investors, given how economic conditions, geopolitics and market volatility can place unique strains on low-carbon industries, especially alternative energy. 

For instance, rising interest rates in 2023 dealt two strong but transitory blows to the solar and wind industries. First, many projects were initially bid years ago, during a zero-rate environment, and the sharp rise in rates made their estimates less viable at current levels. Second, historically high inflation hurt US utilities and alternative energy developers, who have to cross more regulatory barriers to pass on cost hikes to customers. We think many solar and wind companies, especially those with higher-quality businesses, can withstand these short-term pressures. Even better, these headwinds are starting to fade, as interest rates approach peak in many regions and developers bid on new projects with the current cost environment in mind.

Climate: A Panoramic View of Risks and Opportunities 

Evaluating climate credentials requires a panoramic view of both risks and opportunities. Carbon emissions are a prominent risk, and companies that don’t control the associated costs may face lower expected returns and additional volatility. In contrast, companies with clear carbon targets and strategic plans to curb CO₂ emissions should enjoy advantages versus peers with higher carbon intensity. 

Paths to carbon reduction differ by sector and are especially challenging in hard-to-abate industries. Providing incentives for energy transition rather than penalties to lagging companies was a major theme at the recent UN-sponsored COP28 conference on climate change. Many industries have struggled to build consensus on what’s needed to phase out fossil fuels. So, the carrot versus the stick approach could help more firms innovate climate solutions that may mushroom across industries and sectors. 

Meanwhile, green opportunities are already surfacing in a range of industries—including those that aren’t typically targeted by climate-focused investors.  

Identifying the most compelling climate-driven corporate stories requires fundamental equity research (Display). Is the cost of carbon emissions reflected in a company’s valuation? Does a business strategy address transition and physical risks? How might green opportunities boost a company’s future cash flows? By asking the right questions, active investors can identify opportunities that may not register on the radars of many passive climate-focused investors. 

Price: Valuation Underpins Future Return Potential 

Shares of quality, climate-advantaged businesses shouldn’t be bought at any price. Valuation discipline is a principle of prudent equity investing and must be applied in climate-focused portfolios.  

Staying focused on valuation deserves extra attention when quality or climate attributes are in vogue and pockets of the market become expensive. Our research shows that quality global stocks (companies with high ROA) are attractively valued at the 23^rd percentile of their monthly history since 1990. Valuations of stocks with healthy balance sheets, based on net debt to market capitalization, are also appealing. And stocks with attractive valuations based on their price to free cash flow ratio trade near the low end of their valuation range since 1990 (Display). We believe that select high-quality, climate-focused companies can be found within these groups at attractive valuations.

Quality in Action: The “Greenabler” Chain Effect  

One type of quality, climate-focused company can be found among the greenablers. These firms are enabling other companies across the value chain to improve their climate credentials. In other words, their products and services help a wide swath of industries to decarbonize, bolstering their climate focus—and growth potential. 

Autodesk is one such greenabler. The firm provides computer-aided design software for clients in various industries, including infrastructure, water and transportation—all with a sustainability bent. Autodesk helps businesses such as Schneider Electric, which designs fuel-efficient machinery, and Eaton Construction, which builds energy-saving LEED-certified structures. Schneider and Eaton customers such as California High-Speed Rail Authority and Walmart are then direct beneficiaries of these sustainability innovations across their operations, thus completing the chain (Display).

Consulting services are also pivotal in the low-carbon transition. AECOM Technology, for example, serves transportation, water and environmental markets, and advises clients on green design and engineering approaches to their operations to cut emissions. One of the first companies to receive approval from the Science Based Targets initiative for its 1.5⁰C goals, AECOM partners with suppliers to help them set carbon reduction targets; it reached its own operational net zero emissions target in 2021.

Greenablers can be overlooked in industries often assumed to be “less green,” like manufacturing. Consider Prysmian Group, the world’s largest cable producer, supplying the power, energy, infrastructure, construction, industrial and telecom markets. Global decarbonization hinges on energy transition and electrification, so Prysmian is well positioned to enable customers to connect renewable generation capabilities directly to power grids. Its own decarbonization goals include a 90% reduction in Scopes 1 and 2 emissions³ by 2035. 

Green Expenditures: Investing in Resilience 

Climate resilience can also be gauged by scrutinizing a company’s investment and spending agenda. 

The key indicator is capital expenditure on environmentally sustainable activities, or green capex, which we think clearly telegraphs a firm’s preparedness for the low-carbon transition. 

In the near term, we see green capex focused primarily on innovations in solar, battery storage, energy efficiency and electric vehicles. Over time, green investment should broaden in areas such as onshore and offshore wind generation, carbon capture, and multiple forms of hydrogen and nuclear power. 

As more companies step up to fund these transitions, a wide range of industries and sectors should benefit, creating more investment opportunities from green capex. 

For example, we see low-carbon investment potential arising from increased green capex into managing risks and opportunities associated with biodiversity. Within this scope is biodiversity consulting. This growing specialty area helps businesses manage long-term hazard risks or resolve their current environment-related challenges to their bottom line and/or in their backyard. Land/water management—such as sustainable forestry—and substitution business models that align with the circular economy (e.g., reusable products) all have wide multi-stakeholder reach as well. 

Quantitative Research Helps Estimate Expected Returns

Alongside fundamental research to identify stocks with attractive credentials, quantitative analysis may help develop return forecasts. We believe that the combination of fundamental and quantitative research may provide a climate-focused portfolio with an advantage over the portfolios of peers that only deploy one type of research.

In the illustrative examples below, based on real companies in distinct sectors, we show how quality, climate and price can be used to shape return forecasts (Display). For climate, we incorporate a carbon price of $50 per tonne, applied to the industry context. This helps us compare between companies within and across industries at a time when more firms are applying their own shadow prices on carbon, which complicates comparisons. While the mining company offers high quality and an attractive valuation, the cost of carbon drags down its return potential. In contrast, the pharmaceutical manufacturer enjoys stronger return potential by virtue of the limited costs of its carbon emissions. 

Avoiding Unintended Exposures 

These examples illustrate how a quality-driven approach attuned to valuation can create a diversified and differentiated low-carbon equity portfolio. Often, climate-focused portfolios tilt toward sectors such as industrials or materials, where prominent players in the green transition can be found. Sector tilts may create unintended exposures that leave a portfolio vulnerable to macroeconomic shocks. We saw this recently in the utilities sector, which is also popular in climate-focused portfolios and is highly sensitive to interest-rate risks. 

In 2023, utilities stocks underperformed for three reasons. First, since utilities are income stocks with a higher correlation to bonds, sector valuations typically compress in rising rate environments (especially when market risk appetite is rising). Secondly, utilities are capital-intensive businesses with ongoing debt and equity financing needs; the rising cost of capital inhibits their ability to create economic value. And finally, higher interest rates reflect the current inflationary environment, which creates cost pressures for utilities and customers. If natural gas prices rise and customers feel that pain on their bills, utilities may have trouble investing and passing through future rate increases.

A Diversified Climate Approach for a Changing World

Of course, the current environment could change if interest rates begin to decline. But the utilities example serves as a reminder that climate-focused equity portfolios are first and foremost equity portfolios—not merely a niche allocation. They are vulnerable to all the macro and market forces that drive equity returns and risk—and must be managed accordingly. 

By following a roadmap to quality stocks with attractive valuations, we believe investors can create a climate-aware portfolio that taps into a wider array of sectors, industries, business models and return sources. With a diversified equity strategy and risk-management tools, this type of portfolio can be designed to deliver through macroeconomic cycles, while capturing the extraordinary capital growth being unleashed by growing efforts to decarbonize the world.

¹ M.E. Kahn, K. Mohaddes, R.N.C. Ng, M.H. Pesaran, M. Raissi and J.C. Yang, “Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis” (working paper, International Monetary Fund, 2019). Available at: https://www.imf.org/en/Publications/WP/Issues/2019/10/11/Long-Term-Macroeconomic-Effects-of-Climate-Change-A-Cross-Country-Analysis-48691
² McKinsey said its analysis was not a projection or prediction and did not claim it to be exhaustive but rather a simulation of one “hypothetical, relatively orderly path” toward 1.5⁰C using the Net Zero 2050 scenario from the Network for Greening the Financial System.
³ Scopes 1, 2, 3 and F emissions are measured in metric tonnes of CO₂-equivalent greenhouse gas emissions per annum:

• Scope 1 are direct emissions, such as the exhaust from cars or trucks that businesses use to transport products.
• Scope 2 are indirect emissions from the production of electricity or heat in homes or buildings owned by a business.
• Scope 3 are indirect emissions from all other activities, including those associated with producing food or manufacturing products. Sources among businesses can be extensive, so must be accounted for across their entire supply chain.
• Scope F are emissions released by the future combustion of fossil fuels that have been produced and that instead of being consumed, are sold to a third party to combust (e.g., the coal extracted and then sold by a coal miner).