Sustainable investing and generating returns go hand-in-hand

Sustainable investing has a problem. Accusations of greenwashing are growing louder, and too often, says Hubert Keller, Lombard Odier’s Senior Managing Partner, they are justified.

At the University of Oxford’s World Forum on Enterprise and the Environment, he told an audience of world-leaders in policy, academia and business that the financial industry’s approach to sustainable investing needs a radical overhaul.

Disrupting the universe

“The sustainability transformation is likely to disrupt between 90% and 95% of our investment universe,” Hubert Keller said, in opening. “We see it as unfolding largely across three key chapters: the electrification of our energy systems, the return of 20% of agricultural land to nature, and a reduction of primary materials use by about a third by 2030.”

For investors and the financial industry these dramatic shifts pose two key, overlapping questions, he explained. The first – impact – seeks to deploy capital into those companies that will accelerate the transition, and avoid those that will lag behind. The second – investment returns – must anticipate the effect of systems changes on financial markets, and position portfolios to capture the upside as the economy transforms.

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Aligning for impact

“We have to be honest with ourselves. As an industry the framework we’ve been working with, what we call the ESG 1.0 framework, is absolutely not fit for purpose,” he acknowledged. Traditional ESG assessments give a snapshot of a company’s environmental footprint, but they are “failing to assess whether a company is active in the right or wrong activities.”

“Under this framework most companies are deemed sustainable,” he added. “So it’s very convenient for the financial industry. We can build lots of so-called sustainable portfolios, and you can see that the industry is under severe attack over greenwashing issues, and quite rightly.”

Regulators are now pushing for change. Under ESG 2.0, “companies will be considered sustainable only if they are making a meaningful contribution to the transition.” And asset managers and banks that promote sustainable investment products will be forced to own a minimum number of truly sustainable companies, he explained.

While this is good news, it brings a new problem: “Given the supply chains, and the unsustainable nature of the wider economy they operate in, very few companies will be deemed truly sustainable. So how are we expected to deploy capital at scale in such a narrow investment universe? For Lombard Odier this is a USD 300 billion problem. For the wider industry it’s a USD 130 trillion problem.”

Even companies committed to the sustainability transition may fall on the wrong side of this new equation, Hubert Keller said. “A manufacturer of plant-based proteins may have an issue of water consumption. A battery manufacturer may face issues in its supply chain. And a company leading the way in recycling may have damaging landfill activities which it is still in the process of resolving.”

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The solution, he concluded, is to adopt a forward-looking assessment framework that takes into account both a company’s current activities and its future sustainability trajectory. “This will broaden our investment universe because many more companies actually do have a credible plan. This approach will deploy capital where it is most needed.”

Investment returns amid systems change

An effective financial sector requires industry agreement on this alignment framework. To put an end to greenwashing, a robust and transparent framework must apply to all market participants.

Within the question of investment returns, however, there is room for disagreement, Hubert Keller said. “This is actually a far more complicated question than the alignment framework. It is a matter of judgement. It will create healthy divergence between investment firms.”

Here, analysts must take into account both a company’s specific working practices and the wider view of “how value chains will be disrupted and how profit pools might shift.” For instance, the car industry’s roadmap to net zero involves a rapid shift to electric vehicles, but as materials extraction reduces, and as car ownership and usage change, it likely also involves a drop in overall car numbers.

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“As the value chain is transformed there will be new opportunities in EV charging infrastructure, or in power generation, or in battery technology. There will also be opportunities in operating fleets of vehicles – we might produce fewer cars but we will use them more.”
“This,” he said, “might explain the wild divergence of valuation of companies such as Tesla and Toyota. While Toyota may sell ten times more cars than Tesla does, Tesla is well-positioned to capture new profits pools emerging in EV charging infrastructure, battery storage, power distribution and data.”

“Understanding these systems changes is essential to generating returns for clients,” he added.

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