How capital markets are adjusting to the ESG transition

Financial markets are latching on to the increasing opportunities in sustainable investing, but some big gaps need to be filled.

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Globally, investors have been focusing on sustainability in a big way. Even before the United Nations COP26 meeting last year, sustainable investments accounted for US$35 trillion, or a third of all assets in the world's biggest markets.

Extreme weather events in Australia and geopolitical tensions in Europe in recent weeks have again highlighted the importance of the transition to clean energy, and the need to respond to the climate change threat.

Here is how financial markets are picking up opportunities that have opened up in sustainable investing, as well as the challenges they face in many parts of the world.

Promising value

1. Long term direction

Many countries acknowledge that the COP26 meet last year failed to achieve the target of limiting global temperature rise to 1.5 degrees Celsius. But the event was still seminal in focusing global attention on our planet's climate crisis.

Some of the long term benefits include greater clarity on carbon offsets, agreement on determining national contributions annually instead of every 5 years, and major players like China and India outlining emissions reduction ambition.

"These factors are important for the stocks in the portfolio," says Hamish Chamberlayne, Head of Global Sustainable Equities at Janus Henderson Investors.

"The direction and pace of travel is more important… The crucial point is that COP26 achieved alignment on the need to accelerate decarbonisation."

2. Change incentives

COP26 enabled progress on carbon trading markets, and institutions and businesses also agreed on transparency for accounting and reporting of targets and emissions, providing a powerful incentive for change.

Net zero pledges by various governments also resulted in significant progress in electric vehicle sales. More government initiatives and the recent surge in oil prices are expected to further boost demand for EVs this year.

3. Focus on sustainable stocks

Investors have increasingly focused on sustainable investing by excluding particular industries or companies that do not meet certain environmental, social and governance (ESG) criteria or going overweight on stocks or sectors that meet these standards.

Some of the biggest companies that are attracting ethical investors include chip designer Nvidia (NASDAQ: NVDA) which has positioned itself as a platform for next-generation computing and has attractive levels of exposure to both digitalisation and the evolving "metaverse" across various industries.

Another stock is real estate finance provider Walker & Dunlop (NYSE: WD) which has exposure to the affordable housing sector and has also positioned itself as a leader in the multi-family, green building and affordable housing lending. Evoqua Water Technologies (NYSE: AQUA) is also attracting ESG proponents, thanks to the company being a leading provider of technologies for water treatment and purification, as well as water re-use and re-circulation.

Falling short

Despite the booming growth in sustainable investments, the sector is facing 2 major challenges in terms of the recent supply chain disruptions, as well as the more enduring lack of capital market financing, particularly in emerging economies like those in South and Latin America.

1. Supply chain disruption

Most rating agencies involved in sustainable investing do not measure companies' ESG performance from the lens of the global supply chains supporting their operations. This has become particularly relevant in the last year, when supply chain issues became a problem for major sectors including semiconductors, global energy and consumer goods.

These difficulties have revealed the fragility of the global "just-in-time" supply chain architecture and highlighted the blind spot in supply chains from an ESG perspective in areas such as human rights and pollution.

Janus Henderson says the current economic and supply-chain dislocations will result in rising inflationary pressures stemming but is urging investors not to be distracted.

"A period of inflation is likely to be beneficial to the growth of many of the companies…, as it makes the economics of sustainable businesses more compelling and accelerates the level of investment into the low carbon energy transition," Mr Chamberlayne says.

Lack of private investment (the South America experience)

Emerging markets face completely different decarbonisation challenges compared to developed countries.

While COVID has been a key hurdle in the move towards net-zero emissions, better financing mechanisms and viability of renewable energy projects remains a fundamental issue.

The issue can be better highlighted through the experience of the Latin and South American region, which has seen a dearth of private investment.

The Janus Henderson Latin America Decarbonisation Report analysed decarbonisation efforts across Mexico, Central America and the Caribbean, and South America against 3 metrics: renewable energy as a percentage of total energy mix, climate bond issuance, and net zero target dates.

Of the 43 countries covered, only 8 (including Mexico and Venezuela) have not made commitments to net zero by 2050. But the broad net zero commitments have not yet translated into significant use of climate-related capital market financing instruments, such as green bonds. Only 12 countries out of the 43 included in the analysis have to date issued carbon bonds.

Many countries in the region have developed renewable energy generation for decades, prompted, for example, by the 1970s energy crisis which resulted in a boost in ethanol production in Brazil.

Rapid economic growth and higher fossil fuel demand also drove net oil importing countries such as Uruguay and Guatemala to diversify their energy sources, while hydropower alone contributes 45% of Latin America's electricity generation.

But the lack of capital market financing instruments is stunting further decarbonisation efforts. Climate bond issuance in Latin America, US$45 billion from 11 countries, is too small for the region relative to the overall US$1 trillion size of the global climate bond market.

Limited issuance has been driven by lack of government bond issuances, which hinders broader adoption of climate bonds from corporate issuers; limited private investment pool compared to other emerging regions such as Asia; and several large scale renewable energy projects funded by corporate sponsors from developed markets.

Typically, government policy is required as a supporting mechanism to capital markets but currently individual countries have different green bond policies and frameworks, resulting in market fragmentation, liquidity constraints, and obstacles to international investor participation in bond issuances.

Analysts and industry experts are now advocating a coordinated response through consistent rules by governments on issues from technical standards to regulation of carbon intensive activities, in order to accelerate decarbonisation at a pan-regional level.

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