Explore the Thinking behind our investment approach

In our final edition of the Summer Series, we turn to emerging markets. For the RBC Emerging Markets Equity team, ESG is a critical component of their investment philosophy and process. This includes a detailed assessment of climate-related risks and opportunities as part of the stock selection process, company engagement activities, and top-down thematic research. Because emerging markets are disproportionately affected by both the physical risks and financial consequences of climate change, and the substantial deficits in social infrastructure and investment have been exacerbated by the COVID-19 pandemic, RBC believes Green Infrastructure is a multi-decade growth story. In their most recent thought leadership piece, Green Infrastructure, RBC identifies three key drivers shaping the trend: global warming, health implications exacerbated by climate change, and the responsiveness of governments seeking economic solutions in pursuit of global supremacy in effectively addressing adaptation and physical climate risks. To that last point, public concern has forced climate change onto governments’ political agendas. As a result, Green Infrastructure is likely to provide a source of economic growth for many countries around the world as countries consider and announce climate-related spending packages. President Biden announced that the intended $2.5tn infrastructure plan is likely to focus on Green Infrastructure and decarbonization. China committed to a net zero carbon target by 2060 and has invested heavily in electric vehicles and renewable sources of energy. Similar announcements from other governments globally are anticipated. Exhibit 1 shows the differences in policy between the U.S., Europe and China that underpin the Green Infrastructure theme. RBC suggests that the best way to play the Green Infrastructure theme is to begin with the sources of energy consumption most responsible for man-made greenhouse gases. According to the International Energy Agency, 73% of CO2 emissions are attributed to energy consumption, specifically electricity, heating, and transportation, as noted in Exhibit 2. Within these sectors, renewable energy is set to be the fastest growing energy source over the next two decades, driven primarily by solar and wind power. Transport accounts for 25% of global CO2 emissions, mainly because the sector relies so heavily on oil. New modes of transport – such as electric passenger vehicles, buses, and trains – should make the transport sector cleaner, assuming renewables are used to generate the underlying electricity. As the cost of batteries falls there will be increasing price parity between EV and internal combustion engine (ICE) vehicles, which RBC believes could mark the inflection point for EV sales. One of the most attractive parts of the EV value chain is the component manufacturers segment. These high return businesses have strong pricing power and are not exposed to the heavy capex cycle and competitive environment that are found in other parts of the value chain (Exhibit 3). Exhibit 3: ICE versus EV Manufacturer’s Suggested Retail Price by components Delving deeper into the EV value chain of battery manufacturers, there are multiple parts of the value chain required to produce battery packs that offer economic opportunities. (Exhibit 4) Exhibit 4: Battery pack components Source: Macquarie Research. Data as of December 2020. In terms of the cost breakdown, currently the cell accounts for about 76% of the total cost of the battery pack with the module cost estimated to be around 10%.1 Significant economies of scale in battery cell production mean that the sector is largely dominated by several large players. In 2014, the top three battery manufacturers represented 56% of the total and that increased to 70% in 2020. According to RBC, “South Korean battery manufacturers have the highest market share with the scope to increase that share and are the most technologically advanced with good OEM diversification.” This explains their slight preference towards South Korean cell producers. These are but a few of the Green Infrastructure themes and opportunities presented by RBC thought leadership. You can read the full report here.

Not a week goes by without more evidence of climate change wreaking havoc across the world. From wildfires in Greece and Turkey, to Hurricane Henri hitting the East Coast of the U.S., and this week’s announcement of the climate change-exacerbated water shortages in the Colorado River,1 there’s no escaping the deleterious impacts of continued warming. The proximate impacts on communities are acute and the indirect effects on businesses and consumers are extensive: wildfires are limiting the availability of lumber and drought is hindering agricultural production of commodities like coffee, chocolate, and rice. Global supply chains and entire industries are increasingly vulnerable to severe climate-generated disruptions.2 “It’s as if the planet is putting an exclamation point on a pivot away from business as usual, as we now acknowledge the physical and economic risks of climate change accruing to all sectors of the global economy.”3 From a public sector perspective, municipalities hard hit by physical climate impacts may find it increasingly difficult to borrow for climate-related projects and other expenditures. The drought conditions in the Western U.S., for example, may lead to reduced “income from their water systems because there’s less to sell or they may have higher costs to provide adequate supplies.”4 Conversely, “cities need to limit development in areas prone to flooding, for example, but also need the property tax revenue from building on valuable land.”4 The situation is so serious that, climate data company, risQ, calls climate risk “an existential threat to the municipal debt ecosystem.”5 So, look out for the credit downgrades. As the Sustainability Accounting Standards Board (SASB) explains, “[i]nvestors can’t simply diversify away from climate risk; instead, they must focus on managing it….”6 Managing such far-reaching and complex risks requires a level of collaboration across the financial services industry, governments, and other stakeholders that we’ve never before attempted. As stated in a piece co-authored by Michelle Dunstan of AllianceBernstein, “[f]inding solutions to any global challenge to humanity is a marathon, not a sprint. More precisely, it’s a collective marathon, run by governments and social, cultural, and economic constituencies, sometimes in competition, but often in collaboration.”7 An important (rhetorical) question is: are we adequately prepared for this marathon? Generally speaking, people don’t just show up and run 26 miles without having first completed intensive training and planned their nutrition and hydration. AllianceBernstein is looking to help prepare the financial services industry in its collaboration with Columbia University in launching the Columbia Climate School. Gitterman Asset Management is also working to create an immersive and educational experience through our conference, The Great Repricing: Financial Advice in the Age of Climate Change. We’re partnering with an impressive lineup of expert speakers and organizations to bring you four days of climate-focused content that you can access for 12 months after the event. Join us now and be part of humanity’s most important marathon.

We are in an inflationary environment as the world adjusts to a post-lockdown world. Investors are therefore interested in knowing how their portfolios might perform in an inflationary world. Quality stocks tend to fare well versus the broad market during inflationary times and paying attention to valuation alongside quality has delivered even better results. According to recent research from GMO, “in historic bouts of inflation… cheaper high-quality stocks beat the S&P 500 in 7 of the 8 inflationary periods.”¹ Quality companies are generally lower risk from an environmental impact perspective, owing to the asset-light nature of their businesses. As shown below, greenhouse gas (GHG) emissions, energy consumption, water use, and waste discarded are all significantly lower than the S&P 500 and MSCI World indices. As a constituent in our SMART Fossil Fuel Free Models, the GMO Quality Strategy has a history of providing strong returns with less risk and meaningful downside protection relative to broad market equity indices. GMO integrates ESG (environmental, social, and governance) factors in both Quality assessment and valuation modelling. As of 12/31/20 – Source: Bloomberg What is the Definition of a Quality Company? A Quality company generates high and sustainable return on capital. Key attributes include: Identifiable, high returning assets Long-term durability of the business model Management that invests prudently with a long horizon The GMO ESG Dashboard: Quality Strategy The Quality Strategy has an overall ESG score that is better than the benchmark, particularly with respect to environmental criteria. GMO’s final ESG score for the Quality Strategy is derived from MSCI’s ESG ratings data. It considers the industry-adjusted weighted-average key indicator scores, along with a set of portfolio adjustments that account for ratings momentum (the percent of companies trending positive/negative) and the overall ratings quality (the percent of laggards in the portfolio). The above charts are based on a representative account in the Strategy that was selected because it has the fewest restrictions and best represents the implementation of the Strategy.

On Monday, Working Group 1 (WG1), which focuses on physical climate change, released its portion of the sixth assessment report (AR6) of the Intergovernmental Panel on Climate Change (IPCC). The IPCC was created in 1988 by the United Nations Environment Programme and the World Meteorological Organization (WMO) and has 195 member countries.[1] The first assessment report of the IPCC was published back in 1990, when climate models were much less advanced. It that human-caused climate change would soon become evident but could not yet confirm that it was already happening.”[2] This week’s publication emphatically states that “climate models can only reproduce the observed warming when including the effects of human activities, in particular the increasing concentrations of greenhouse gases.”2 Essentially, the 234 scientists found that climate change is unequivocally driven by human’s greenhouse-gas emissions. In contrasting current warming with historical climate change, the report states that: The world is now warming almost everywhere Warming is occurring rapidly Warming has reversed a long-term cooling trend Such warming has not been seen for thousands of years2 The message of the IPCC further underpins why we are so focused on climate. Advisors must understand climate science and climate risk, along with the opportunities for mitigation and adaptation, in order to optimally serve their clients across all their investment and wealth management needs. Owing to existing global warming limiting warming to the 1.5°C goal of the Paris Agreement is looking less-and-less achievable. In fact, the authors of AR6 “believe that 1.5°C will be reached by 2040 in all scenarios.”[3] But even though the prognosis is poor, “warming is likely to more or less stop once CO2 emissions reach net-zero, while net-zero GHGs would actually cause global temperatures to fall slightly.”[4] The scientific community is “hopeful that if we can cut global emissions in half by 2030 and reach net-zero by the middle of this century, we can halt and possibly reverse the rise in temperatures.”[5] We have technologies and practices at our disposal, but “is truly our last chance.”[6]

We are in the midst of a global water crisis, owing to climate change, irresponsible extraction, pollution, and lack of equitable access…[1] Less than 1% of the earth’s water is potable and global demand is rapidly rising. In fact, the World Resources Institute has projected a 56% deficit in water supply by 2030, putting millions at risk. Water.org estimates that 785 million people lack access to safe water and six times the population of the United States lives without a household water connection! Water is facing unprecedented demand across agriculture, industry, and domestic uses: by 2050 food-related demand is expected to increase by 60%, demand from manufacturing is expected to increase by 400%, and domestic demand is expected to increase by 300% in Africa and Asia, and by 200% in Central and South America by 2050. [2]. Changing global demographics including population growth, urbanization, and rising living standards are all conspiring to exponentially grow demand for water at a time when water resource issues are on the rise. As a result, companies addressing supply, efficiency, and quality may be timely investment opportunities with the potential to generate financial, environmental, and social alpha. This is exactly what the Virtus AllianzGI Water Fund does as one of our model managers. For example, the fund invests in Lindsay Corp. and Valmont Industries, companies that offer center pivot irrigation technology, an irrigation solution that results in a 95% improvement in water efficiency. Not only do these companies provide a meaningful solution to water scarcity, but they are also two of only three companies in the world that offer this solution. This is especially essential during periods of prolonged drought, such as the current megadrought in California. Given that California is responsible for two-thirds of fruit and nut supply and one-third of the vegetable supply in the nation, water efficiency technologies are essential. KEY FUND FEATURES Precision exposure to sustainable water Targets and invests only in pure-play companies, committed to solving water scarcity, increasing water quality, and enhancing water efficiency. A resilient portfolio in ever-changing market conditions The Fund focuses on high-quality water stocks backed by strong structural drivers, seeking to deliver stability in difficult market environments while generating attractive long-term growth. Time-tested experience in water investing The investment team has over a decade of experience in water investing and engages in a recurring dialogue with global water leaders. The Virtus AllianzGI Water Fund is included in the SMART Fossil Fuel Free / ESG Mutual Fund Models. To learn more about our SMART Investing Solutions and the managers we work with, schedule a strategy session with Penelope Jackson.

"Once mainstream market participants wake up to the risks and opportunities posed by the physical environment and our attempts to manage it, it will become one of the common lenses through which risk is evaluated.” – Alicia Karspeck, Ph.D.[1] At Gitterman Asset Management, we believe that climate change is our most critical systemic challenge. To that end, as well as being the biggest trend in the investment management industry, sustainable investing is also our highest purpose. We’re therefore committed to educating advisors so that they can participate in this shift and contribute to the purposeful direction of capital. In April, Cerulli Associates found that, notwithstanding client interest, “many advisors are still reluctant to offer ESG strategies in client portfolios.”[2] This is at a time when ESG strategies have been growing in availability, showing no signs of slowing. This only steepens the learning curve for advisors, especially as quality is not a given under rapid proliferation. Climate-specific investing, and, especially that which leads to tangible outcomes, such as the transition to net zero carbon emissions to align with the Paris Agreement, or adaptation to the myriad physical risks we are facing given just existing global warming, requires another leap in technical understanding. If advisors are not yet able to authentically serve clients with a general ESG interest, how will they serve clients who are specifically attentive to, and perhaps more knowledgeable about, climate? Certainly, in the numerous events we’ve held in partnership with RIA Channel, we see many of the same foundational questions showing up in the Q&A. A significant portion of our audience comes from large firms, which begs the question as to whether those organizations are prioritizing the necessary investments in advisor education? Without sufficient technical understanding, discerning between greenwashing and truly intentional investment products is tough. Marketing language, especially that propagated by big budgets (yet sometimes built on small ambitions!), may set off endorphins, but after that initial warm feeling, what are you left with? Tariq Fancy, former CIO of sustainable investing at BlackRock, recently shared that he was “rebuked…for going off script” when asked by a client what the impact of investing in low-carbon funds would be. His colleague, “told him that he should have stuck to the talking points by simply saying the funds are a way for clients to contribute to the fight against climate change, even though there wasn’t an explanation of how.”[3] Interestingly, sustainable investments recently “shrunk” in Europe, going from $14 trillion to $12 trillion from 2018 to 2020. This is not due to waning interest, instead it’s a result of more stringent definitions on what constitutes a sustainable investment under the E.U.’s SFDR. That’s not to say E.U. regulation has got it all right, but the subsequent change in assets does point to the wider problem of definitions and intentions. Put simply, voluminous data and elegant marketing do not automatically lead to a decarbonized world any more than a shelf full of unread books increases one’s intellect. We’re not saying this is easy – in fact, quite the opposite. In our industry conversations, experts who’ve been working in this space for years comment on how the level of information and new insights can be overwhelming. Prioritizing time to learn can also be a challenge for a busy advisor. Moreover, the trade-offs and complexities associated with mitigating and adapting to climate change should not be underestimated: as an industry and as a global society, we are going to make mistakes along the way. Learning is always a continual process and not an end. We can, though, avoid certain missteps, such as naively piling assets into inadequate products with cool monikers rather than diverting capital towards products with robust philosophies, demonstrable intentionality, and verifiable outcomes. Immersion in the subject matter, asking lots of questions, and retaining healthy skepticism in the face of clever marketing are three ways to mitigate this. Our upcoming event, The Great Repricing: Financial Advice in the Age of Climate Change, is aimed at helping advisors and other financial professionals achieve the former. We’re convening climate scientists, data providers, leading asset managers, and private companies, all of whom are focused on climate change from risks to opportunities. Join us for an immersive online experience, during Climate Week, from September 21 – September 24. For $99.95 you get four half-days (10am – 2pm ET of climate-focused content, opportunities to interact live with sponsors and select speakers, as well as access to the videos for 12 months.