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12.06.23
From theory to practice: Real ways to think about investing sustainably
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ESG practices and performance vary across global stock markets.
It takes a lot of time – and even more smarts, research, and analysis – to successfully invest in individual stocks. So instead, many investors invest more broadly in specific countries or sectors using tools like funds. One option is to invest in funds focused on environmental, social, and governance (ESG) factors, but you could also look into exchange-traded funds (ETFs) that track the stock markets of the most sustainable countries. If you’re interested in that route, it’s important that you understand the sustainability profile of stock markets around the world.
According to the Morningstar Sustainability Atlas , continental Europe leads the way when it comes to corporate-level sustainability. The Netherlands and Finland hold the top two spots, given that both countries have a hefty weighting of sustainable companies in their main indexes. Hong Kong overtook France to nab third place, but its market does have a high “carbon intensity” score.
The US, meanwhile, sits at sixteenth out of 48 countries, and bigger Asian countries are faring even worse. China ranks close to the bottom of the fourth quartile while India, Japan, and South Korea all landed in the third quartile.
Besides sustainability scores, you’ll also want to understand countries’ “climate risk”. The journey to net zero will create new interesting investment opportunities, it’s true, but other firms may well become obsolete in this new paradigm, including ones that are doing well today. Northern European markets – the Netherlands, Switzerland, Denmark, Belgium, Sweden, Germany – and the US all carry the lowest levels of carbon risk, because their main indexes are full of technology and healthcare sectors. But on the flip side, countries like China, Pakistan, Saudi Arabia, the Czech Republic, and Qatar have poor rankings because of their disproportionate exposure to energy, utilities, and basic materials.
Bear in mind that a country’s sustainability profile is influenced by many changeable factors. For starters, how sectors are weighted in a stock market index will massively impact its overall sustainability scores and climate risks. And on a related note, an index can be disproportionately impacted by the scores of a single company, like big names Nokia in Finland and ASML in the Netherlands. So when you’re looking at published sustainability scores for individual countries, you’d do well to also understand how those scores vary from year to year depending on company and sector weightings.
Certain industries could enable – or benefit from – a low-carbon future.
The push toward a sustainable future will knock some firms out of the game, but it’ll be a wind in the sail for other industries.
Renewable energy: Plenty of countries are shifting from carbon-based fuels to renewable energy in an effort to meet emission reduction targets. And as that continues, companies that supply renewable energy like solar, wind, hydro, and geothermal power will likely reap the benefits. The US, for one, has announced a climate package that includes $10 billion in tax credits and $27 billion in a “green bank” to support clean energy projects. That’ll only bolster the International Energy Agency’s (IEA) forecast that global renewable power will become the biggest source of global electricity by 2025, doubling in the next five years.
Electric vehicles (EVs): The adoption of EVs might only be in its infancy stage, but the IEA believes the switch is crucial if we’re to meet global net-zero targets . McKinsey, meanwhile, estimates that virtually all new car sales will be EVs by 2050 . In a bid to fulfill that expected demand, Europe and US are investing heavily in their battery production capacity, and companies along the supply chain – especially ones that produce commodities like copper and lithium – could be beneficiaries of the boom.
Building and construction: To become more energy efficient, the world will need to reduce energy consumption – and using the latest technologies and practices would help. Think efficient buildings, insulation materials, appliances, and lighting systems. Companies that provide energy-efficient products and services are in a prime position to benefit from mounting demand for sustainable solutions.
Agriculture and food production: Deforestation, fertilizers, and livestock production are all major contributors to greenhouse emissions. In the future, alternative companies that provide sustainable agriculture solutions and services such as vertical farming, cover crops, lower tillage options, and soil-health products are likely to benefit from a low-carbon future.
Technology: Big tech companies might not have a direct role to play in the low-carbon transition, but they’re certainly huge enablers. As key innovations in big data, artificial intelligence, the Internet of Things, and blockchain are adopted more widely, they may well reduce the carbon footprint of many industries.
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Simple tips that could help you incorporate ESG into your investment process.
Sustainable investing might sound complex, but discovering which stocks, techniques, and sectors suit you best is achievable – it just takes time. If you’re starting to incorporate ESG into your investment process, one practical tip is to stay open-minded about which firms are sustainable to begin with. If you adopt the “best-in-class” approach, you’d only invest in companies with the top ESG scores. That might mean, though, that you miss out on companies that are on their way to being the best in their class. And bear in mind that sometimes, a current sustainability risk could actually be a mispriced opportunity, and the company could unlock new value by addressing it effectively. So don’t make the mistake of seeing ESG only as a tool to manage risks, it can also help you identify future winners.
There’s another reason to look beyond the big winners, mind you. While high-ESG-scoring companies tend to outperform lower-scoring ones, much of this success can be attributed to high investor demand with fund flows driving the outperformance of popular ESG companies. But this trend has slowed, so if you want to beat the market going forward, you’ll need to identify the best long-term performers rather than only focusing on the star names. Specifically, you might want to watch for the ones that’ll drive the shift to a low-carbon economy.
What’s more, remember that there’s more to ESG than the “E” for environmental. Social and governance issues also have a big part to play: the Covid pandemic proved the importance of strong labor and supply chains, and governance issues have been known to topple once-stellar companies.
Finally, never rely on only one metric. Generally, even if a company’s valuation looks cheap, you’ll need to factor in the context of growth and its profitability outlook. The same is true for ESG investing. You’d be wise to compare ratings and understand what’s driving scores, and even break down the differences in rankings between the rating providers. After all, sustainable investing is already changing in Europe and the US, so you’ll need to stay on your toes.