As part of our Responsible Wealth initiative, we have been working with sustainability economist Dimitri Zenghelis to explore the pathway to a net zero carbon economy, and the ramifications for long term investors. Here, Founding Partner Charlotte Thorne interviews Dimitri, as well as CIO Robert Sears, to explore this subject in depth.
CT: Dimitri, one of your key arguments as a sustainability economist is that the transition to a net zero carbon is both imminent and inevitable, can you explain why?
DZ: What’s important to understand, is that it is the stock of greenhouse gases and not the flow that causes global warming. In order to stabilise that stock, you have to bring net emissions down to zero. It’s like filling up a bathtub; the level at which the water stabilises depends on how quickly you turn off the tap. We can either do this the easy way, by managing the transition, or we can do it the hard way by creating such a hostile climate that we depopulate and de-industrialise, and bring down emissions as a result. Obviously, we want to avoid that, but what we are looking at here is a question of when, not if. Decarbonisation is inevitable, and it will have direct and indirect impacts on every single sector of the economy.
The other corollary of the stock-flow dynamic is that we don’t have much time. We currently need to get to net zero pretty soon after the middle of this century to avoid the nastiest climate risks, and if we delay, we’re going to have to reduce emissions a lot faster; we might even need to start thinking about sucking emissions back out of the atmosphere. Now, you might rightly ask how much it will cost to decarbonise, and the simple answer is we don’t yet know, but the longer that we delay, the more expensive it will become.
CT: Given the scale of the problem, do we need to reduce consumption and de-grow our economy to bring down emissions?
DZ: That’s a key question; there’s a common misconception that reducing emissions requires lower growth. People talk about the second law of thermodynamics, and that you can’t have exponential growth in a planet of finite physical resources, but that makes a very significant category error. If you think about it, if we were forced to live within our resource and greenhouse gas envelope forever, then exponential growth is exactly what you’d expect to happen. Why? Because we would innovate; we would learn to use our finite resources more efficiently. Knowledge isn’t like other resources that deplete, it works in reverse and builds on itself. That’s the key to decoupling; we’re going to have to innovate to get more out of the resources that we have. From a practical perspective, degrowth is really the worst way to reduce emissions. It would condemn billions of people to endemic poverty, and it would mean job losses and wage cuts. If you look at any historical examples of rationing consumption, they don’t tend to coincide with any form of ecological renaissance. The environment is rarely a concern in the minds of hungry people.
Eco-economic decoupling explained
In an eco-environmental context, decoupling refers to an economy that can grow without corresponding increases in environmental pressure. An economy that could sustain or increase economic growth while reducing the amount of resources, such as water or fossil fuels, used and without allowing environmental deterioration at the same time would be said to be decoupled.
CT: Why, when we have never been able to achieve this before, do you think we can do it now?
DZ: This is where those who argue for de-growth have a point; we haven’t managed to decouple in the past. But the simple fact is that we haven’t really tried on a major scale. Encouragingly, where there has been policy change, we have seen extraordinary advances. Take renewables for example, in the last decade there has been a 90% fall in the cost of solar technologies . Wind, which is a more mature technology, has seen a cost reduction of around 40%. Now the sun doesn’t always shine, and the wind doesn’t always blow, but battery technology costs have fallen by around 90% over the same period. These technologies are now fully compatible with other grid technologies like gas and coal, and indeed in the next decade not only will they outstrip others in terms of operating costs, but the capex will be so low that it will just make sense to scrap existing fossil fuel power stations and switch to renewables, even if you’re doing so before the end of their lifecycles. That’s how competitive these things are becoming.
We’re going to see cheaper electricity and better cars, and the market on its own would never have delivered this and no economist would have forecasted it. Even if you don’t give two hoots about the climate, you still end up with a superior and more productive economic equilibrium. This isn’t about burden sharing, it’s about opportunity. Sustainable growth is the only growth option; all of the others will snuff themselves out. For investors, there will be value in being at the vanguard of these opportunities, in steering the transition, and if you’re a more conservative investor, then you need to ensure that you’re not caught out and left holding devalued and stranded assets.
CT: Robert, what does the transition to a net zero carbon economy mean for us as investors?
RS: As Dimitri has said, this is all about change, and that really goes to the heart of what portfolio management is about. Change is the natural state of affairs, and you need to build portfolios that can cope with these transitions. When we’re looking at something as broad as decarbonisation, we’re looking at something that is not only going to affect growth and inflation, but also distribution; there will be winners and losers, there will be changes to supply chains, and there will be changes to the way that both corporates and consumers behave. So what can we do about it? First, we have to build robust, resilient portfolios, and that’s what we have always done; we build portfolios that can cope not just in the most likely scenarios but also with the extremes. Secondly, you need to think about opportunity; you want antifragile portfolios, that can take these opportunities and transform them into returns for clients.
This is also about risk management. We look through manager underlying holdings and ESG scores to understand what environmental impact and risk we are exposed to. As with any risk management metric, this is an ongoing process. When we’re choosing external managers we don’t just want to understand their current holdings, we work to assess their approach, capabilities, policies, reporting and commitment to sustainable investment. We want to know if and how they are engaging with corporate management to improve conditions, how they report to investors and what resources and commitment they’re putting behind the process. A good example is an activist manager we have just invested with, which engages with corporates on climate change risk. Most of their holdings already score highly on an ESG basis, but a couple of holdings are there because the manager specifically wants to engage with them and vote to change their policies. That’s where you see the interplay between actively managing risk, improving the overall economic system, and powering long term returns.
CT: Dimitri, what role do you think private capital has to play in the transition to a more sustainable economy?
DZ: Investors are crucial in facilitating this transition. The policy steer will help tip investment flows over the coming years, but it’s really going to be private capital that is responsible for the systemic transformation of the global economy, and it will be very capital intensive. Of course, in many cases these technologies end up running themselves, so after the initial capex they can generate electricity at close to zero marginal cost. If you think about the supply lines, you don’t need to have people burning coal and gas in industrial revolution technology power stations, nor do you have people digging things up from ever more remote locations then sticking them into pipes and trains and ships and transporting them across the world. You’re going to see systemic change, with new recharging facilities, demand side responsiveness in houses and grid interconnection. It’s a whole new world of opportunity, which of course means a rapidly changing landscape of risk.
Demand Side Response (DSR) explained
DSR is about intelligent energy use. Through DSR services, businesses and consumers can turn up, turn down, or shift demand in real-time. This helps to balance out the grid; softening peaks and filling troughs, especially at times when power is more abundant, affordable and clean. For business and consumers, DSR helps to save on total energy costs and reduce their carbon footprint.
CT: So do you need to exclude certain sectors?
DZ: This really isn’t about exclusion. A lot of these high carbon companies and sectors will continue to be used over the coming decades as part of this transition; we won’t just jump to net zero, we need to encourage a race to become best in class in terms of efficiency, resource use and emissions, and that requires active investment, because asset valuations are going to be a key incentive. So inclusion and active engagement is a far more constructive approach than exclusion.
CT: Let’s turn to valuation. Robert, we know that renewable energy companies in particular can command high prices, do you have to look past expensive valuations in this sector, or are they overpriced? Might they even be in a bubble?
RS: The thing to remember is that any asset can get too expensive. There is real risk, and real opportunity here, but as with any other kind of investment, prices can move too far in both directions. Valuation of risk is at the core of any successful investment, so when we’re trying to determine whether an investment is good or bad value, we’re working out if we will get good free cash flow from it in the future compared to the price we’re paying for it. Right now, a lot of assets are at extremely high prices off the back of ultra-low rates and lots of liquidity. Is there a risk of a bubble? Absolutely, and that’s to be expected when you see big structural changes in economies.
The key question to answer, is should you try and avoid it? Well, there are going to be winners and losers, so you do need to be discerning. Sustainable growth is really important in compounding returns, so you need to find winners that will be able to grow over the long run. Even if you’re not interested in the fundamentals behind ESG, the amount of capital flowing into ESG sectors is influencing returns in the short term. Of course, that can present problems too; an oversupply of capital into any sector can be dangerous for investors while still being positive for the underlying economy. That’s exactly what we saw in the dotcom bubble, there was a huge glut of capital poured into tech, not all of it productive, but that capital still helped fuel innovation. We could easily see the same pattern again here, so if investors don’t discriminate, and just allocate capital broadly into expensive sectors, they run a greater risk of capital loss.
Put simply, there will certainly be bubbles as we innovate our way to a zero carbon future, and while that doesn’t mean that you should sidestep the opportunity, it does mean that you need to be careful, have a highly selective approach, and always check the fundamentals. The hotter these sectors get, the more tempting it is for corporates to spin their stories and exaggerate their capabilities, as indeed we have seen recently in the case of an electric vehicle company. This is where the importance of your investment process really comes into its own; if you are rigorous in your valuation discipline, you can harness the opportunities that are out there while also taking advantage of these long term changes to the economy.
CT: Robert, how important is active management when it comes to sustainable investing?
RS: Active management shines in times of change. It works best when there is dispersion, both in valuations and in perceived economic outcomes. So do you want to be more active than usual at the moment? Absolutely, we are in a period of change on a number of fronts, and active managers are better equipped to take advantage of the resultant price distortions. But active management isn’t just about being selective in your capital allocation and then sitting back passively; it’s also about engagement. It’s about voting, and engaging with corporate management, and all investors have a part to play in this collective endeavour. The activist investor of the last 20 or 30 years was all about driving returns through calling for financial engineering like share buybacks and divesting assets. The activist investor of tomorrow is fighting for better climate change policies, greater transparency and stronger governance.
Being an active investor is not just about choosing the right assets for your own returns; it’s about being an active participant in in making the whole economy produce better and more sustainable returns in the future.
All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.
This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.