Social justice requires emerging market countries to continue economic growth. Technology will evolve to help us grow with minimal use of natural capital. Investment opportunities abound in such technologies and in adapting to extreme weather events and to a world where we use natural capital more effectively.
Just before Christmas, I participated in a stimulating conversation about sustainability in emerging markets with Tirthankar Patnaik (TP), the Chief Economist of the National Stock Exchange (NSE) of India. The conversation was streamed to the members of the NSE, who are primarily brokers and investors. Excerpts from the conversation in a Q&A format follow.
Is sustainability anti-growth in emerging markets?
TP: It’s being argued that if every person were to consume like an average person from the developed world, we’d need many Earths’ worth of resources. Sustainability in that sense also means aversion against consumerism. How do you think this would incorporate into value for a sustainability investor who’s looking for growth?
SR: There are several questions here. Let’s start with the hypothesis that sustainability is averse to consumerism. Indulge me with a digression for a second. We often talk about four factors of production (materials, labor, capital, and managerial talent) but have ignored a discussion of the last factor of production, namely natural capital such as water, carbon, mineral resources, and so on. We, by and large, assign a cost of zero to natural capital, while calculating corporate income and GDP. We may have a hard time figuring out the true social cost of natural capital, but it is certainly not zero!
So, does sustainability mean anti-consumerism? It does not have to be. Growth can also mean GDP improvement per unit of natural capital consumed. The idea of de-growth, pushed in certain circles, is a non-starter in emerging markets. We cannot sell sustainability to folks in India and Africa by telling them that we are about to conserve our natural capital and will hence not aim to grow in the future.
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My hope is that technology will evolve such that we can produce GDP and corporate net income with a lower investment of natural capital consumed. If I were an engineer at the fabled IITs (Indian Institute of Technology), regional engineering colleges and so on, I would work on coming up with ways to increase our growth without expanding our carbon footprint or consumption of natural capital in general, cheaper and better ways to storage energy in batteries, and work on adaptation strategies as extreme weather events become more common and hurt populated coastal regions in India.
There is a lot of room for optimism. Recall that until around the early 20th century, gasoline was considered a nuisance byproduct as opposed to an invaluable asset. Rare earth minerals until the age of the smart phone was not considered to be of much value. Human ingenuity will hopefully find a way to maintain or increase growth with minimal consumption of natural capital.
Let us turn to what this means for your investors. Apart from the obvious strategy of investing in green technology or adaptation strategies, I would keep an eye on “sustainable,” “eco-friendly,” or “green” or “carbon-neutral” consumer products. As prosperity increases in the developing and developed world, the demand for sustainable products will likely increase. The Economist Intelligence Unit surprisingly found a large public shift, post Covid lockdowns, in favor of sustainable products in emerging markets, especially in India, Pakistan and Indonesia, as people in emerging markets are most likely to experience the devastating impact of the loss of nature.
Why invest in sustainable companies?
TP: What do you think is the principal motivating factor for someone to invest in sustainability? Is it the inevitability of environmental shocks or that society would turnaround and cooperate towards building a sustainable planet? What timespans are we looking at?
SR: Isn’t a focus on sustainability somewhat of an inevitability in India? Consider the impact of climate change. India is subject to increasing weather-related disasters. At some level, in the short-run, adaptation is the only option. Air quality indices (AQI) in Delhi and Mumbai of 300 plus, as all of us know, is a concern. We have also experienced waste management problems, which suggest that local environmental challenges can affect economic productivity. RAND estimates air pollution related health costs reduced China’s labor productivity equivalent to 6.5% of GDP. I would be surprised if the health and productivity costs of air pollution in India are not as large, if not larger. The good news is that policy makers here are moving away from coal-based fuel.
The relative scarcity of natural capital is another concern. India’s population expected to increase to 1.527 billion in 2030, from 1.311 billion now. Mumbai, my home city, is expected to have 26 million people by 2025 and 42 million by 2050! Are urban planners prepared for such scenarios? The global demand for energy, food, and water is expected to be up by 25-40% as per McKinsey. Water-related crises are projected to be the number one risk for the world as per the World Economic Forum. Moreover, Asia produces 85% of the world’s output and hence emissions. Hence, climate is a local concern in India and the rest of Asia. At the current rate of production, our global carbon budget will last 10 years at best if we do not want to breach the 2 centigrade threshold for warming. I cite these data not to scare investors but for them to view solutions to these problems as investment opportunities.
A few firms are actively working to reduce negative externalities that they impose. Philips Morris International (PMI), for instance, generates around a 1/4th of its revenue from smoke-free products. New Zealand just banned the sale of cigarettes to anyone born after 2008. Such companies that have placed sustainability at the heart of their business transformation strategy are best positioned for higher returns. India Tobacco Company might want to consider PMI’s strategy.
You can consider the “who invests” question by positing three segments of investors. The most aggressive segment, that is driven by ethics and emotion, is the new generation of investors in the West. Our students are deeply committed to environmental issues. Let us not forget that the students of today are tomorrow’s investors, voters, and politicians. The second set of investors are indexers like Blackrock who own all of the market and hence pay for negative externalities, either by suffering losses in another segment of the market say via insurance firms, or across time in the future. The third segment is latching onto the green wave, maybe even a bubble, that we are in the middle of. The likes of Tesla, electric vehicle (EV) makers, battery makers, and renewable energy firms. Attracting capital to these technologies will hopefully spur innovation here. Some of this segment is obviously also encouraged by governmental subsidies.
Ultimately, the pressure to invest in sustainability will come from the citizenry in the democratic world. To some extent, investing in sustainability in the developing world is a moral imperative as well as a commercially viable venture. It is good to see awareness and dialog around who pays the price for environmental calamities or the negative externalities that a company imposes. For now, these costs are socialized via higher health care costs due to pollution, or by individual families in their living expenses, or by the state via deficit financing to repair infrastructure hurt by extreme weather events. It is a matter of time before taxes go up to pay for these deficits or firms are required to compensate the citizenry for the negative externalities that private and state enterprises generate.
You ask about investing timespans. The horizon or payback periods are much more rapid for investments in green tech. Adaptation strategies will require more patient capital. For instance, the replacement cycle of a car is, say, 15 years. Even if we hypothetically decide to replace all of our gas guzzlers with electric vehicles, that move will not happen for the next 15 years or longer. As an aside, consider the net zero promises committed by Western oil majors by 2050. That date is at least 3-4 CEOs and 3-4 generations of boards away. Who will hold these firms to those promises? Do we need something like a Federal Reserve or a similar relatively apolitical multi-generational institution to oversee climate promises and spending?
Will ESG shares outperform in the long run? What catalysts do we need to make that happen? Perhaps tougher governmental regulation to make firms internalize negative externalities or a massive outflow of capital from the asset management industry in favor of pro ESG companies or a big shift in consumer preferences in favor of sustainable products. The investing skill, as you know, lies in forecasting both trends and more important the timing of those trends. The directional trends in favor of ESG shares and products, to me, are quite clear. I am less sure about the timing, meaning when will these forces begin to have real bite. Is it 3 years, 5 years or is it a generation?
How is investing in resources different?
TP: How does sustainability investing differ from investing in resources? There is a view that, say, investing in beverage industry with access to water is valuable (even if the practices of such firms are unsustainable). What do you think are the risks of such investments as compared to ESG investing?
SR: If you mean, should an investor buy up water supplies and so on, if it can, as a price of water goes up in the future, you may be right. Look at the race to mine and identify lithium and cobalt for instance. These involve geopolitical implications as well, if a country or two were to say corner the market on lithium or cobalt. Having said that, the forces of innovation in a free market might find ways to make batteries for electric vehicles with material other than lithium or cobalt. Hence, a resource-based investor will have to forecast the period of time until lithium or cobalt will be relatively scarce and hence benefit from investing in those commodities.
Another perspective on this is that many current companies, such as your example of beverages, may be profitable only if we ignore the price of natural capital. In fact, I just posted a piece on Forbes using Coca Cola as a case study. It turns out that fairly modest social values assigned to water, carbon emissions, plastic bottles that are not recycled, and the incremental diabetes cases that Coca Cola’s product will erase net income for Coca Cola many times over. For instance, Coca Cola says that is a water-neutral company. It is hard to assess what means as it might involve withdrawing water in Kerala and replenishing it in Vietnam. The million-dollar question, of course, whether and when will shareholders of firms have to internalize the cost of negative externalities they impose? That question is tough as the investor has to forecast how regulation, investor induced pressure, and entrepreneurial energy to internally disrupt old ways of doing things will evolve inside companies and in countries.
What are the risks of investments in resources or in stocks in general? That depends on your horizon. In the long run, if you believe these negative externalities will be priced into the stock, either by other investors or regulators, cost of capital might go up or stock prices fall for, say, a Coca Cola. If the firm or the sector is excluded by asset managers, the cost of capital can go up. For instance, oil producers state that their cost of capital is now 20% in a world where the T-bill rate for 10 years is around 1.5% and the risk premium is about 5% in the U.S. One of the unknowns here is whether the easy money policy we have seen in the Western world will be reversed and if so, how much like cost of capital go up by. Turning to resources, my worry is that states, not companies, will try to corner lithium, cobalt, or what might become the new “oil” or resources to power the green economy of the future. At the very least, countries need to consider how they will find these resources that power the green economy as they consider transition strategies.
Sustainability as a product differentiator
TP: Sustainability has mostly been a way for firms to differentiate their products. Would higher incidence of sustainability-conscious investing shift this dynamic in any fundamental way for good?
SR: Sure. Organic food, green vehicles, and chemical free virtually everything is a big market now and will only become bigger. But the sustainability credentials of the brand have to be seen as authentic or as “walking the talk.” For instance, Starbucks claims it sells fair trade coffee except the standards for how fair that coffee really is has come under much scrutiny.
How to measure sustainable practices?
TP: What do you think are the mechanisms by which investors (especially retail investors) can make sure a firm is investing in more sustainable practices? Are firm disclosures enough? Is a third-party ESG ratings model (similar to Moody’s) a good direction?
SR: ESG ratings are under scrutiny. In general, ESG ratings try to be everything to everyone. They are nowhere close as of now to the quality of credit ratings. The fault lies both with companies and rating agencies. Companies would do well to focus on one or two stakeholders and not try to be everything to everyone. Rating agencies would do well to be transparent with what they actually do, what they can measure and what they cannot. Most use simple flags or natural language processing (NLP) to identify news sources that is ESG unfriendly for a firm. Or ESG ratings rely on simple filters such as does the firm have a human rights policy/environment policy or something relatively simplistic. Deeper work is necessary.
Credit rating agencies have a clear objective function, which is predicting a firm’s default related to credit risk. I am not sure what a parallel objective function for ESG rating agencies is. Without a clear objective function, falsifiability is a concern. How would I falsify credit ratings? I would look for untimely downgrades of credit ratings, say, after a company files for Chapter 11. What falsifiable test should I look for to assess the quality of ESG ratings?
At the end of the day, quant- based equity and bonds funds need a score or a rating to construct portfolios of sustainable firms. Hence, there will be a demand for ESG ratings, but buyers have to beware of what they are actually getting when they rely on ESG ratings. I am not sure other sophisticated investors over-rely on ESG ratings. They use ratings as an initial data point to minimize their own information search costs.
You ask about a firm’s primary disclosures. Firms increasingly put out sustainability reports that have more pages than the proxy statement sometimes for companies. A couple of tips on what to look for of you look at these reports. First, start with the risk factors in the 10-K or the list of reasons why a firm may be sued. Look for data points from the sustainability report that will help you quantify these risk factors. One of the missing variables in ESG ratings is the “P” factor, or the impact of negative and positive externalities imposed by the firm’s products and services on society.
Second, you may ask how to navigate the sustainability report. Consider the following questions: (i) is the company’s ESG program integrated with the core business strategy? (ii) is the ESG spending material or peripheral to the business; (iii) are senior executives compensation plans tied to sustainability (iv) are ESG metrics discussed in investor meetings/conference calls (v) can the ESG metrics be meaningfully benchmarked with competition and (vi) how confident are we about the credibility of the ESG data presented? I had written a piece on PMI’s integrated report as an interesting role model for firms to follow and for investors to study.
Related to the missing “P” in ESG ratings, ultimately ESG rating agencies will evolve to address the P or specialized intermediaries such as Consumer Reports type agencies will emerge to rate more responsible brands of products to facilitate consumer’s purchase decisions.
Private or public financing
TP: Do you think private financing in sustainability to be as potent (or more) than public financing? Would a government impetuous reduce the risk of such investments or would it be as risky?
SR: Private and public financing have to work hand in hand. There is a conceptual difficulty in designing government subsidies to hasten the transition as well. For instance, Tesla has received at least $2 billion in subsidies from the taxpayers of the states of California and Nevada, but I am not sure what these taxpayers got. One could argue the state got many jobs and taxes but why did taxpayers or the politicians, on their behalf, fail to demand a warrant or an option on Tesla for these subsidies? And, can we get an accounting of the approximate taxes and jobs that these subsidies generated. What about Tesla’s move to Texas? How should inter-state settling up of green subsidies work?
As I mentioned earlier, governments have been paying for replacement of roads and infrastructure that get destroyed by extreme weather events via state bonds and deficit financing. Eventually we have to account for these deficits. We need a major conversation about how to allocate and finance the huge new green capex/adaptation spending between the private and public sector.
We also need to build institutions that monitor sustainability metrics and plan for transition. The EPA, OSHA, and the legal system in the U.S., despite the press chatter these days, are interesting role models for India to consider. Urban planners have to deal with extensive migration to cities, the provision of resources in cities without compromising much of our natural capital, and with questions surrounding how to get people to move from gas vehicles to EVs and so on.
How do activist hedge funds view sustainability?
TP: Do you think activist hedge funds are a threat to the sustainability practices of firms?
SR: Danone’s CEO was ousted in an activist attack because of allegations that he over-emphasized sustainability at the cost of financial performance. What was the true cause of Unilever’s excellent stock return and operating performance? Is it sustainability or shareholder value orientation? As I have written before, one can plausibly argue that stock price of Unilever took off after an attempt by an activist to intervene into the affairs of Unilever, which is of course, class shareholder capitalism. Elliott just released a statement saying SSE plc, British utility, should spin off its renewables unit to exploit higher valuations for alternate energy firms. Perhaps spin-offs of green tech embedded in traditional low multiple firms will be pursued by traditional activists in the short run till green valuations are favorable. My guess is that the activist hedge funds are still trying to come up with a strategy to deal with the emerging ESG movement.
TP: Is there space for “activist” activist hedge funds, which push firms towards sustainable practices than against them?
SR: Engine no.1’s campaign to place climate friendly directors on Exxon’s board despite owning only 0.02% of Exxon’s stock is clearly the exemplar here. Engine No.1 bought General Motors. We have not seen much since. Engine No.1 managed to get Blackrock and Vanguard to vote with them but their case relied on traditional arguments such as poor capital allocation by Exxon. I see two conceptual roadblocks here. First, the investment horizon. Will the socially active hedge funds stay with the firm for decades to see through the firm’s response to climate change? Second, how does one culturally transform an oil and gas firm to a Silicon-valley type venture capitalist interested in green or climate friendly technology?
Impact of Covid
TP: How do you think COVID-19 experience has affected the market’s perception of sustainability?
SR: If you look at the data, Covid appears to have massively boosted demand for sustainability-linked funds in the U.S. However, the trading strategy of these funds deserves comment. Most of these ESG funds are long in tech and short on energy. However, energy has tripled in the last year. It would be interesting to see how ESG funds explain staying away from energy and hence missing standard indexes and benchmarks this year. Another aspect of Covid is, of course, work from home. Some version of work from home, reliant on great broadband technology, may be necessary to reduce commute related emissions.
Covid has clearly highlighted the fragile state of our natural capital. One can argue that fixing the fragile state of our natural capital is both a moral and a profit-making imperative. Sustainability investing is the future. Some in the audience have asked whether investments in sustainability will fall once interest rates go up in the developed world. For sure, the multiples on all stocks, especially on green investments, will fall. And many of the new green start-ups and ventures will fail. If you go back in history and ask a simple question such as what portion of a firm’s IPO offer price is recovered via some fundamentals-based payoff such as earnings or free cash flows, the answer is barely 30%. For instance, Tesla’s market capitalization now seems to assume that they will sell every vehicle in the United States in steady state! However, I think the sustainability movement has legs, is reasonably organic, and will “sustain” for a long time.
In closing, thank you Tirthankar for providing a forum to encourage conversations about (i) natural capital; (ii) investing in processes and systems to better measure our consumption of such natural capital; (iii) plan better for inevitable extreme weather contingencies; and (iv) invest in transition strategies, both for companies and the state. I am on Linked In in case your audience has questions or comments. Thanks again.