investment insights
Sustainable investments in a fractured world
Key takeaways
- Our approach seeks investment opportunities arising from the transition to a net-zero, nature-positive and inclusive economy
- Profound economic transformations such as the sustainability transition are bound to unfold in a non-linear fashion across multiple business cycles. Disruptions created by a fractured geopolitical world and the changing priorities of policymakers are one example
- Sector, geographic and style biases, together with changes in interest rates, explain much of the recent performance gap between sustainable and broader equity investments
- We expect structural support from capital expenditures and lower financing costs to be tailwinds for sustainable investments in 2024, but geopolitical risks are here to stay. Selectivity, thematic diversification and active management remain key.
While some sustainable equity strategies struggled in 2023, system changes are progressing at an accelerated pace. Regulation and (geo)politics still play a key role. Green bonds should remain supported in the context of falling yields. Active management of risks and adequate diversification remain crucial in equity markets.
The wealth management industry has taken multiple approaches to sustainable investing. We are convinced that the transition to a sustainable economy is driving a transformation at least equal to the scale of the industrial revolution – and it is unfolding at the speed of the digital revolution. Government policy, technological innovations and the limits of our physical environment are driving system changes as the economy shifts to more efficient business models offering superior functionality and accessibility at lower costs. This is profoundly reconfiguring value chains and shifting profit sources across economic activities and geographies. As a result, dozens of ‘hotspots’ are emerging in areas as diverse as semiconductor materials, precision farming and digital healthcare.
Our sustainable investment approach
In equities, we seek to identify the companies leading this economic transformation. In fixed income, we focus on assets such as labelled bonds (green, social or sustainability bonds, where the proceeds have a clear environmental or social impact), or debt issued to fund specific systems transformations. Environmental, social and governance (ESG) or other traditional approaches to sustainable investing concentrate on a firm’s practices. Instead, our approach focuses on financial returns driven by companies set to provide the solutions to achieve this transition.
Clearly, systemic changes to create a sustainable economy are both long-term and structural. They are bound to unfold in a sometimes disorderly fashion through multiple business cycles. The gap between the energy transition’s growing momentum in the real economy and the dismal financial market performance of cleantech in 2023 is one illustration of this phenomenon. Disruptions created by our fractured geopolitical world and the changing priorities of policymakers in the face of these changes offer another example.
An accelerated transition in the face of geopolitical tensions
After the pandemic and in the face of geopolitical rivalry and conflict, policymakers have accelerated the transition agenda. They have implemented near-shoring and reshoring policies aimed at controlling value chains, promoting domestic innovation, creating high-paying jobs and claiming a share of new markets. Policy support for the transition is now at an all-time high. This decade, between the European Union, the US and China, close to USD 1 trillion per year of government support will be directed at spurring innovation, accelerating the adoption of transition technologies, and defending national and supra-national interests.
Such unprecedented government support is de-risking private-sector investments. Private capital is now seeking solutions at speed, and scale. In 2023, USD 1.77 trillion was invested in the energy transition, compared with USD 1 trillion in the coal, oil and gas sectors. Energy transition investment was 17% higher compared with the previous year.
Importantly, and in a development that is sometimes overlooked, China is taking a leading role in a range of transition technologies. China accounted for 38% of the 2023 transition spending total, well ahead of investments in Europe and the US of 19% and 17%, respectively. For the first time, electrified transport became the largest recipient of investment, ahead of renewable energy, which grew at a modest 8% year on year. Sales of electric vehicles (EVs) now account for close to a fifth of the automotive market as the energy transition continues to accelerate. By the end of this decade, we expect EVs to make up almost two-thirds of the global vehicle market. Worldwide, renewable capacity rose 50% in 2023 compared with 2022 – the fastest growth rate in two decades. Here again, China led the way; the country commissioned as much photovoltaic panel capacity as the entire world a year earlier.
The world is now on course to add more renewable capacity over the next five years than over the last century. For the first time in history, the 2023 edition of the UN Climate Change Conference (COP28) delivered an agreement to transition away from fossil fuels. With renewables already beating fossil fuels on cost in most geographies, the International Energy Agency (IEA), a traditionally conservative forecaster, expects fossil fuel demand to peak this decade.
Read also: Oil, gas, changing energy dynamics
The pressure to transition to net-zero and nature-positive economies keeps mounting and is felt beyond the energy system. But the investment benefits demand patience and thorough screening if they are to enjoy the financial returns that will accompany the transition. The level of change underway is profound. New regulatory initiatives saw European carbon prices trade close to EUR 100 per tonne in 2022 and 2023; at these prices, the cost of cement might rise by as much as one-sixth, high enough to tip the economics of building construction in favour of other materials, such as timber.
In addition, the EU’s new Deforestation Regulation could impose corporate fines as high as 4% of their European turnover if businesses trade in specific commodities without appropriate due diligence. Such regulatory pressures are enough to shift value chains, product pricing and mixes as well as firms’ strategic positioning in sectors such as construction or the agri-food chain.
Sustainable investment performance
The performance of sustainable fixed-income assets and sustainable equity investments were quite different in 2023. The corporate labelled bond market (green, social, sustainability and sustainability-linked bonds) delivered performance in line with the mainstream bond market in the first nine months of 2023. These bonds have comparable durations, credit quality and yields to the mainstream market. They then outperformed in the fourth quarter, largely due to the spread compression witnessed in the utilities sector, a large portion of the green bond market. This compression was driven by clearer signalling from developed-market central banks of falling interest rates ahead, and persisted in Q1 2024 until more resilient than expected US inflation data temporarily put the trend on hold.
In equities, 2023 and the start of 2024 were marked by much better-than-expected equity market performance. The MSCI World index rose 21% over 2023, driven by a very narrow group of sectors and stocks. The information technology and communications sectors were key US market drivers, creating an historic level of concentration in equity performance. The share prices of the ‘Magnificent Seven’ (Tesla, Meta, Amazon, Alphabet, Microsoft, Nvidia and Apple) rose more than 100% in 2023, compared with 26% for the S&P 500 and 17% for the equal-weighted MSCI USA.
Our exposure to system changes including electrification and low-carbon energy did not fully benefit from this equity rally. More generally, clean energy, water, timber and sustainable food indices all lagged behind the US IT sector and megacaps, partly due to their overexposure to small, European, interest rate-sensitive companies. In addition, what has become clear in 2023 is that among idiosyncratic factors affecting the performance of clean technology, China has built a dominant position in the hardware part of the energy transition. The cost structure of Chinese leaders in the field is very difficult to compete with. They dominate most value chains and have built overcapacity. Today, Chinese companies account for more than 9% of standard clean energy indices. As such, passive investment strategies focusing on clean energy companies from developed markets have not only been penalised by the effects of higher capital costs over the past two years but have also ended up being the wrong focus considering market shifts in favour of Chinese competitors. Hence the need for a selective investment approach that seeks to identify not only the tipping point in an innovation but also the technology leaders capable of maintaining strong margins and defending market shares as the transition unfolds.
Moreover, exposures to technology companies in our sustainable themes (clean energy, sustainable food, materials) and in our sustainable stock selections – which we call our ‘CLIC® Leaders1’ – were limited. During the first six months following their launch in June 2023, this underweight in communications and technology weighed on the performance of our CLIC® Leaders. Yet since the beginning of the year, we observe greater investor discrimination and our selection has recovered its lag compared to the MSCI World, in the wake of a decent earnings season. Over a longer, five-year timeframe, the picture looks much more favourable. We remain convinced of the value of our framework but acknowledge that there is higher volatility and potentially short-term divergence from market benchmarks. This requires monitoring in actively managed portfolios.
Another key factor in the performance of sustainable strategies in 2023 was the impact of yield movements. Last year was marked by rising financing costs and high interest rate volatility. The latter contributed to higher-than-usual return dispersion and a much lower percentage of companies outperforming the index. Capital expenditure-intensive companies, typically found in climate transition themes, and small capitalisation stocks with a growth style bias including many sustainable solution providers, tend to be highly sensitive to interest rate increases and volatility. This proved detrimental in 2023. Moreover, with interest rates at multi-year highs, concerns over evolving government policies triggered outflows as investors questioned the economic viability of some infrastructure projects and cleantech solutions. As global yields rose, these stocks experienced a substantial decrease in their valuations. Conversely, as yields fall later in 2024, this may turn into a tailwind, as seen in the last two months of 2023.
Outlook 2024: regulatory support remains key, central banks offer some relief
We continue to expect structural support from capital directed to sustainable investments in 2024. Last year, the IEA tripled its projections for the total amount of renewable capacity to be deployed in China by 2030. That would make China one of the few economies to achieve its clean energy targets as much as five years early.
Read also: The countries leading the energy transition
The economics also bodes well for photovoltaic and onshore wind power; more than 90% of the electricity produced using these technologies is cheaper than fossil-fuel alternatives, according to the IEA. Effective policy support however remains key to minimise bottlenecks and inefficiencies while accelerating implementation. This is especially true in Europe where new project permits and grid and storage investments are needed. The Net-Zero Industry Act is expected to facilitate developments on this front.
The EU’s proposed revisions to its Energy Performance of Buildings Directive (EPBD) include requirements for vehicle-charging infrastructure around buildings and homes. Revisions to the directive will likely require assessments of buildings’ emissions footprints over their life cycle, which will in turn support the gradual replacement of energy-intensive structures with more carbon-efficient alternatives.
Carbon markets may also provide a boost. The EU has been at the forefront of the introduction and trading of carbon allowances. Free allowances for industries such as cement, aluminium, fertilisers, electricity, hydrogen, iron and steel will all be phased out from 2027 under the Emissions Trading Scheme (ETS). China is also expected to expand the coverage of its own carbon market to four of the most polluting industries by 2025, namely steel, cement, chemicals and aluminium.
In terms of risks, US tax credits and disbursements available under the Inflation Reduction Act (IRA) may be threatened later this year if a second Trump administration is elected. This is one reason to expect clean energy sectors to see some volatility as the US elections approach. 2024 also sees elections in Europe and in countries including India, Indonesia and Mexico. Policy change is of course possible in the aftermath of any change of government. As inflation has dented households’ purchasing power, issues of affordability and energy autonomy, among others, have triggered popular protests in several European countries. This may become politically important if election winners shift regulatory priorities.
Read also: 2024 elections: the environmental implications
In this context, lower financing costs would offer a welcome tailwind for companies closely linked to the residential, building, and utilities industries. The disinflationary trend will allow central banks to cut interest rates. The Swiss National Bank (SNB) was the first central bank to do so in March, delivering a powerful signal to financial markets that a new interest rate cycle has started. We expect other G10 central banks, including the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE), to follow suit this year. The Fed should make cuts totalling around 75 basis points (bps) this year, with the ECB and BoE cutting by 100 bps and the SNB by a further 50 bps. This should translate into broadly lower yields. Our year-end forecasts for 10-year yields in the US, eurozone, UK and Switzerland are 4.0%, 2.0%, 4.0% and 0.75% respectively. This could remove one source of return divergence across equity sectors and regions and usher in less dispersion.
A more constructive macro backdrop ahead, but risks remain
While global sustainable equity flows slowed in 2023, they remained net positive, driven by Europe, with modest outflows in the US. Valuations are now back to more reasonable levels after a post-Covid ‘green bubble’, and closer to mainstream index valuations. A more mature market environment, combined with lower rates, should see a more normal year for stock picking in 2024. We also expect more supportive fund flows. We are generally positive on fixed income in 2024, including corporate green bonds, amid declining yields. Regulatory support nevertheless remains an important driver for selected sustainability investment themes. Therefore, any policy changes or priority shifts by newly elected governments in a busy electoral year will have to be carefully monitored and risks in actively managed portfolios mitigated using appropriate diversification.
In the current fractured geopolitical context, investment strategies require selectivity and agility more than ever. We believe that sustainable investments will continue to gain in importance over the coming decade. However, geopolitics, economic growth and employment will continue to dominate the political agenda, with national and energy security sometimes taking priority over a cleaner long-term future. To manage these risks and catalysts, investors will need to be well diversified across the different sectors on which the transition depends. We will fully reflect this in our CLIC® Leader stock selections and in our portfolios.
1 The CLIC® Leaders’ list is a proprietary list of companies launched in June 2023 selected by our Equity Research team in the investment universe defined by our Sustainability Research team. It seeks to identify companies that are well positioned to capture value in the transition and contribute significantly to the environmental transition, whilst exhibiting sound financial fundamentals and attractive valuations.
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This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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