Make no mistake, the global economy is repositioning itself for a carbon neutral future. The rapid adoption of sustainable investing strategies has been both a driver and beneficiary of this movement. Yet, despite best intentions, carbon neutrality is not going to happen overnight. Even the most ambitious global efforts, such as The European Commission’s Green Deal, are earmarking a 30-year glidepath before net-zero emissions become a reality. It raises a question in the meantime of how investors can capitalize on an obvious value opportunity, while still incentivizing change as the pendulum swings away from the so called “dirty” industries.
In case any lingering doubts remain, it has become abundantly clear ESG factors do indeed influence financial performance. This is true even within the sectors most often targeted by activists and policy makers, as the disparities between the good actors actively minimizing their carbon footprint and their more egregious peers are becoming more pronounced every day, particularly as the latter contends with an increasingly higher cost of capital. This, in and of itself, creates a value opportunity by identifying issuers who can move the needle in this area.
The more immediate value play, however, can be found in recognizing that the ESG-driven selloff in certain sectors is occurring in spite of the short- and medium-term opportunities that still exist as the global economy slowly transitions toward a carbon-neutral future.
An Emergent “ESG Risk”
Beyond the opportunity amid a protracted transition, the accelerated divestment activity in areas such as fossil fuel or metals and mining is creating new risks currently being overlooked. For instance, renewable energy—where capital is flowing—doesn’t have nearly enough capacity to meet even the existing demand. In the U.S., renewable energy accounted for only 12% of all energy consumption last year. And energy demand is only expected to increase. While the pandemic certainly complicated the supply/demand picture, the base-case projection from the International Energy Agency is that demand for oil will resume previous growth trends.
At a time when global investors are already bracing for inflationary pressures, the potential “negative supply shock,” in which climate change externalities further increase energy costs, could create upheaval in a market already subjected to extreme volatility. Deutsche Bank analysts, in research published in June (“Inflation: the Defining Macro Story of this Decade”), highlighted that historical precedent should serve as a warning for those ignoring the “supposed transitory sources” of inflation. In particular, the research noted, it was the oil shocks in the 1970s that helped push inflation to more than three times the historical averages of the previous two decades.
If the supply of oil and natural gas is compromised, creating shortages that translate into surging prices, it will come at the expense of other Sustainable Development Goals outlined by the United Nations, from no poverty and zero hunger to economic growth and industry, innovation and infrastructure objectives.
From an investment perspective, diversification into a select group of upstream oil and gas producers could provide an advantage. Earnings performance should further benefit as the supply/demand imbalances become more pronounced, although capital discipline will distinguish the winners against a volatile backdrop.
Metals: A Contrarian Path to “Go Green”
Another overlooked knock-on effect is that the race to adopt sustainable energy is creating other imbalances. Certain metals such as lithium, nickel, copper, and aluminum are essential for modern power grids, charging stations, EV batteries and other critical infrastructure that will one day enable a green future. Capital investments in these areas may make some dyed-in-the-wool environmentalists bristle, but the abrupt shift to sustainable technologies is stimulating demand in other “unsustainable” areas.
The growing adoption of electric vehicles, for instance, is stimulating demand for battery metals. Lithium, for instance, would need to see production more than triple to reach the anticipated demand that Fitch has projected for 2030. Fitch also forecasts that nickel demand stemming from EV battery manufacturing will experience an average annual growth rate of approximately 29% over the same period.
A nuance in the broader natural resources space is that in many markets, the governments will take on more of the underlying economics when commodity prices rise. This creates an inflationary structural underpinning that also favors companies with demonstrated capital discipline and can operate more efficiently and sustainably than their peers. Given these long-term tailwinds, companies like Metso Outotec and Siemens are positioned to benefit.
Other value plays are more closely aligned to the supply constraints posed by ESG efforts. The aluminum space represents one example. From a production standpoint, the metal has historically had an extremely high carbon to marginal cost ratio. According to Goldman Sachs, aluminum production accounts for 3% of global emissions and is only expected to grow without wholesale changes to production technology or policy.
Citi analysts, meanwhile, highlighted in a separate research note that emissions intensity in the sector will ultimately create a governor on aluminum supply over the medium- to long-term time horizons as ESG adoption grows. This will eliminate capacity that had previously been met by low-cost, carbon-intensive producers using coal-powered smelters.
Anecdotally, the largest global integrated producers of aluminum are already beginning to realize a “green premium” that equates to approximately a $5-20/t according to Goldman analysts. While this may seem immaterial, the premium is expected to grow as technology allows for even “greener” production, at reduced operating costs.
The global integrated producers that are today investing in sustainability are positioned to benefit. Norsk Hydro ASA, for instance, already has a significantly lower cost structure than its peers when carbon emissions are included as a cost – about 1/10th the industry average, according to Goldman research. Norsk also has the second lowest emission intensity in the industry at more than 4x below the global average, attributable to renewables that make up approximately 70% of its energy sources. Norsk is also initiating wind and solar projects to augment its current renewables portfolio; replacing heavy fuel oil with liquid natural gas; and plans to electrify its remaining coal-powered boilers with power from renewable sources. It’s not merely about extracting a green premium. Goldman Sachs underscored that these initiatives will mitigate the ESG risk, as the markets will “likely penalize companies” who do not reduce absolute emissions.
These are not a contrarian bets on the prospects of ESG. It’s merely an acknowledgment that policy makers and investors remain in the early stages of an ambitious, far-reaching journey. And while the growth of ESG has raised the cost of capital for most constituents across the energy and natural resources sectors, the incumbents who can improve their sustainability will emerge as market leaders when capital flows are channeled to the most sustainable operators in these sectors.
