Mainstreaming Sustainability

J. JASON MITCHELL, MAN GLG

Despite its steady progress into mainstream public investing, sustainability continues to elude singular definition. A recent, large-profile conference on sustainable investment illustrates this point. Asked during the opening panel how they defined and applied sustainability, no consensus could be reached among the four accomplished panellists.

The definitional pluralism of sustainability has undoubtedly helped to create an area rich in interpretations. However, it also throws a still-developing discipline onto a self-reflexively ontological sidetrack that both distracts from the material significance of underlying sustainability themes and subdivides what still can be considered a niche albeit growing asset allocation. For sustainable investing strategies to permeate a wider investor base, they must compete head-on with global equity funds and benchmarks proving that sustainability themes and styles are capable of providing above-index returns and not simply exacting a feel-good performance tax.

Historically speaking, ambiguities such as these shouldn’t come as a total surprise. To understand sustainable public markets investing calls for an appreciation for its transformation from early, environmental-based interests to broader social connotations. The notion of sustainability hasn’t so much transformed by a Kuhnian-style paradigm shift so much as it has undergone a circuitous course of ideational framing, producing at times quite divergent interpretations of sustainable development over the last 50 years. In the 1960s and 1970s, eco-development and works like the Club of Rome’s Limits to Growth directly linked sustainability to anti-growth agendas which, using extrapolative econometrics, warned of resource shortages and an impending Malthusian crisis. The 1980s brought about a reversal through early, OECD-driven epistemic reframing to produce a reformed definition of sustainable development critically compatible with the economic growth of developed and developing countries, alike. But sustainability owes the greatest part of its institutionalism to the 1987 Brundtland Commission and the World Bank’s World 1992 Development Report, both recognizing economic growth as a vital funding mechanism for future environmental protection and resource management.

In effect, sustainability evolved from the early debates of how much to grow to the more complex, systemic issues governing the management of growth. Its institutionalism through normative frameworks like the UN PRI has meant that the traditional, resource management-centric axiom of sustainable development — doing more with less without sacrificing future generations — is increasingly matched by the inclusion of social, environmental and governance (ESG) considerations. Nonetheless, inherent problems persist. One explanation may in fact be this pluralism, the near-universal application of sustainability that conjures responses as obliquely personal as they are institutionally grounded. Sustainability represents the use of renewable energy sources as much as it does a company’s de-carbonizing sustainability plan around exogenous risks like climate change or to mitigate potential stress points in global supply chains. In short, sustainability is expected to be all things to everyone.

New approaches to sustainability
Despite the pluralism in investing strategies, sustainability continues to be overwhelmingly represented in public markets investing by two dominant modalities, generally characterized as normative or ethical, and its technology-driven, green counterpart. This is a dialectical relationship between the role of ideas and the role of material causality. In short, the normative side supports in the primacy of ideas as chief investment driver while the material approach focuses on economic and environmental efficiencies. Both, however, face the inherent challenges in representing the kind of scalable, performance-oriented and non-indexed public equities investment fund needed to help normalize and address the wider breadth of sustainability themes.

The normative approach — traditionally operating as ethical and socially responsible investing (SRI) — represents equations based on subjective values. Critically, though, these norms or shared beliefs are social constructions without perfectly uniform application, and are continually being reshaped against cultural, historical and social phenomena. Though there is universal agreement on many issues like human rights and military arms, other norms are uniquely regional. Norms do not abide by falsifiability or the logic of consequences. Instead, they produce contradictions like the diametrically opposing French and German views on nuclear energy. While the recent Fukushima nuclear accident in April has unequivocally galvanized German public and political opinion towards a non-nuclear future, France continues to support nuclear as a pragmatic, non-fossil bridging energy alternative. Similarly, the recent ban in Wisconsin, USA around collective bargaining by public workers runs counter to many European labour rights norms, not to mention violating the UN Global Compact labour principles.

Risks of normative approaches
Beyond generally accepted areas of irresponsible investing (alcohol, arms and tobacco), normative approaches bear the risk of projecting a procrustean worldview that potentially operates at the lowest common normative denominator or remains culturally and regionally tailored. Moreover, these funds often remain limited in their ability to engage with companies or countries outside this screen, placing performance as a secondary interest. Imagine attempting to reconcile the normative divisions between ethical codes as diverse as the UN Global Compact, religious codes like the Church of Sweden, shariah law and the Methodist Church ethical investing policy, and secular codes like the Friends Provident Stewardship policy into one fund. To further complicate it, try taking a cross section of these codes and test it against other rules-based systems like best-in-class, green filters and corporate governance. The sum of the inputs for this exercise may represent what everyone wants, but they do not necessarily constitute a universe of stocks that is coherently investable, much less demonstrate the fundamental capacity for sustainability to drive competitive returns against global equities funds and benchmarks.

The second modality — often distilled in purist strategies like cleantech (clean technology) or green funds — carries its own unique issues. Ascribing primacy to technological innovation and economic efficiencies, these funds concentrate on single themes or the environmental factor in ESG while omitting social and governance considerations. More problematic is their highdependency on regulatory regimes, typified by country-specific feed-in tariff mechanisms across Europe or US Department of Energy funding grants and tax incentives. In only the last year, changes to solar energy feed-in tariff regimes by France, Czech Republic and the UK — with potential changes in Italy and Germany expected — have exposed the weaknesses or lack of sustainability in these strategies by illustrating the short-term, problematic nature of subsidised renewable energy tariffs. Moreover, these strategies have a tendency to focus on the extreme poles of technology, seeking out the lowest cost per watt or high load factor solar and wind technologies. This has often led to portfolios populated with small-capitalization stocks, constrained by illiquidity issues and compounded by the hyper-cyclical regulatory nature of the cleantech industry. This may make for a compelling venture capital or private equity portfolio, but it produces significant limitations to funds looking to participate in sustainability themes under greater liquidity freedom.

From time to time, declarations also appear proclaiming the arrival of the next version of ESG or SRI. There is some truth in this: the emergence of third-party providers and the wider delivery of ESG data via platforms like Bloomberg and Thomson-Reuters is a welcome move towards more transparent, standardized metrics. But it is a mistake to expect uniform application of ESG/SRI as a style. Funds probably bear little resemblance to one another outside of recognizing framework principles like UN PRI and the fundamental acceptance that environmental, socio-political and governance factors are meaningful constituents to investing. Funds naturally build stronger competencies within factors, and understandably weigh their efforts according to this competitive advantage.

Unappreciated breadth of sustainability
Why, then, do themes matter so much in the wider context of sustainability? More to the point, how does a greater concentration on these themes help not only to mainstream sustainable investing as a style but to offer more competitive investment returns against global equities fund who haven’t integrated sustainability?

One explanation is that sustainability continues to expand ontologically, outreaching any one specific stylistic or thematic classification. And ultimately, ESG factors are only parts of a larger, variegated ‘configuration’ of sustainability that ties together process, themes, actors and socio-political phenomena in a systemic narrative. Sustainability is compelled as a discipline to consider longer-run issues, from the earth’s carrying capacity and Kuznets’ curve models to transboundary environmental externalities and the role of multilateral institutions toward corporate governance relative to thematic investment opportunities. In other words, its capacity to be applied as broadly as possible is one of its greatest advantages, affording it a unique, panoptical lens to examine interrelated linkages in resource scarcity or healthcare, to understand potential outcomes on a social and economic scale and to correlate this back to public markets investing.

Deconstructing modalities
Similarly, our approach to sustainability begins by deconstructing the uneven coexistence between the existing modalities, reducing the pluralism of definitions down to its fundamental, empirical core. When we do that, we find that sustainability represents the investment necessary to address demographic, environmental and social change, and it is manifested long-run secular trends, regulatory regime change, product innovation and a revaluation of old-economy efficiencies like recycling.

This may appear self-evident, but this point is often missed by investors who practice sustainability as style alone, or focusing narrowly on specific sub-themes like cleantech. It one sense, this approach expects more out of sustainability strategies. Consider how renewable and alternative energy is reduced to solar and wind technologies. For capacity building in areas like wind to happen, it means capital and services investment across a much wider food chain involving power generation infrastructure, grid connections and expansion with ultra-high voltage cable regardless if it is UK offshore wind builds or green field grid capacity in China or India. The US healthcare reform in 2010 carries similar reverberations, driving investment into insurance and affordable care provisioning where, for example, 30 million more diabetic Americans will have access to insulin and treatment. Or, imagine how the effects of urbanization refract through sustainability: investment in mass transit systems, education, healthcare, water and sanitation services to name a few.

Ironically, global equities funds are often the first to recognize the investment opportunities in these themes, while sustainability funds choose instead to concentrate either on normative screening or on the smaller cleantech universe. This is unfortunate. Not only does it forfeit broader environmental and demographic investment themes, but it ignores the potential to offer investors a public equities strategy that maximizes exposure to global, generalist sustainability themes within an integrated ESG framework. The secular trend of tightening emissions standards, for instance, extends far wider than the electric vehicle (EV) product cycle it is frequently reduced to. The more powerful investment driver is through the phasing of current global emissions regimes through gas and diesel efficiencies until EV volumes reach commercial scale. Purists may call this a brown as opposed to a green approach, but existing engine efficiencies have and will make greater near and medium-term differences to the carbon emissions than EV. Besides the benefit of their greater liquidity, mid-cap companies like Cummins better accurately reflect the efficiency gains and investment going into emissions regulatory change. Our approach — using an ESG style but with primary emphasis on sustainability’s constituent themes within a global equities mandate — carries several advantages. Not only does it highlight thematic efficiencies capable of driving positive earnings revisions, but it organically omits areas that run antithetical to sustainability like alcohol, arms and tobacco. Sustainability is also about managing for growth, but growth that is becoming increasingly multipolar in nature. Inefficacy in multilateral environmental policy setting is resulting in traditionally held ideas like global environmental governance being replaced by more private forms of environmental governance at the national and subnational level.

German, Chinese policy redesigns
Countries like Germany and China are recognizing the social and environmental imperative in unilaterally redesigning domestic policy and reinvesting in areas like environmental conservation and energy efficiencies. The consequences of private environmental governance initiatives have already spelled powerful dislocations in industries like Germany’s decision to retire its nuclear generation capacity, or China’s regulation on coal-powered inefficiencies coordinated with $35 billion of new energy initiatives in 2009, twice the amount invested by the United States. The upshot in these private governance initiatives has led to greater commercial innovation, economics of scale and even the formation of infant industries. In a recent speech, President Hu Jintao reiterated China’s objective towards a circular economy model through investment in resource conservation and environmental protection.

Sustainability-driven investment is already producing a number of other powerful implications. Few current examples better illustrate large-scale material investment being made to address demographic and environmental change than China’s 12th Five Year Plan. It outlines spending directives according to seven efficiency themes ranging from energy savings and non-fossil alternative sources to new materials, all whoseaggregate value-added output is estimated to equate to as much as 15% of China’s GDP in 2020. Over the next three years, China’s growth in healthcare infrastructure investment will run at more than a 25% compounded annual growth rate while the construction of 36 million low cost, social housing units will potentially add more than $1.5 trillion of investment. From a public equities perspective, these themes represent interconnected industrial value chains that range from higher margin, upstream companies to downstream distributors each uniquely reflecting in differing degrees sustainability-linked investment. In the case of China’s low cost and social housing, its publicly-listed value chain extends from banks positioned as social housing funding mechanisms to the concatenated points of building aggregates and services reflecting this sustainability investment through positive earnings revisions.

Conclusion
Sustainability as a style has undoubtedly helped create more rigorous modes of analysis with the recognition that environmental and socio-political externalities are important valuation drivers. But for sustainability to become more integrated into mainstream investing and compete against global equities funds, the diversity of its themes and its materiality — expressed as the underlying capital and services investment streams in industries that most reflect streams — need to be emphasized as a compelling advantage to compliment its stylistically driven process. This approach could ultimately popularize more performance-oriented, global strategies over traditionally index-bound SRI and small-cap cleantech funds, and in the process help to mainstream sustainability.

J. Jason Mitchell oversees sustainable investment strategies at Man GLG and runs the Global Sustainability Fund