This article is sponsored by Wellington Management

This article was written by Alan Hsu, Portfolio Manager, Wellington Management; Nathan Risko, Investment Director, Wellington Management; Eric Krusell, CFA, Investment Specialist, Wellington Management

From devastating floods in Australia — tragically, in many of the same areas hit by fires in recent years — to wildfires in Europe and the US, widespread disasters bring into stark reality the consequences today of a changing climate. The human toll of these events has become an unfortunate yet familiar part of the news cycle, but the second-order impacts of climate change on financial markets are sometimes less well understood. Many traditional approaches to climate investing have rightly focused on these risks, but we believe both their approach and their scope are often incomplete and lacking nuance, thereby creating inefficiencies in the climate-investing landscape.

In this piece, we outline our views on the climate opportunity set as climate change increasingly has the potential to disrupt entire industries.

Properly defining the climate opportunity
The wall of capital pursuing ESG opportunities has been important in tackling these issues to date but also has had unintended outcomes for markets. This influx of capital is “good” in that it finances companies that we believe are already positively contributing to the mitigation of or adaptation to climate change. However, it mostly affects companies that currently meet materiality thresholds for inclusion in today’s ESG-mandated strategies and ETFs. Crucially, these approaches typically exclude companies that do not meet those metrics today, even if they are actively moving us toward a greener world by making investments in R&D, changing product lines, and transforming business models. For example, metals producers often score poorly from a carbon emissions/ESG perspective and are therefore excluded. However, we believe some metals producers, like those for aluminum, may require a more nuanced lens. Aluminum has key uses in electric vehicles (EVs), solar power generation, climate-resilient physical infrastructure, electric grid infrastructure, and other renewable technologies. There are many potential decarbonization winners in areas such as these that we believe are not properly reflected in today’s metrics.

In our view, the backward-looking nature of most of these approaches ignores the future, resulting in a large segment of the market being underappreciated. This creates an unusual situation, as one of the basic tenets of investing is valuing a company based on its future prospects. By placing such a high value on a company’s ESG credentials today, including using them as the basis for negative screens, investors may be ignoring the ESG winners of tomorrow.

In our view, this market dynamic has generated a significant inefficiency (and opportunity) for more dynamic approaches in the form of “false negatives” and “false positives.”

Understanding the market inefficiencies in climate investing
“False negatives” include companies that, in our view, are successfully transitioning their business models to be greener, have compelling fundamentals, and are trading at attractive valuations, in part due to the fact that they do not meet the current bar for inclusion in ESG-mandated approaches today. For example, consider an automotive company that is successfully pivoting to the production and sale of EVs, but whose EV revenues do not meet the common 50% or greater threshold for inclusion in an impact fund, even if it will likely meet those thresholds within an investable time horizon.

In contrast, “false positives” include companies that currently appear to be climate advantaged, but that we believe may not be in the future. For instance, some may have poor or deteriorating fundamentals, may not have sustainable competitive advantages, or may trade at elevated valuations, in part because they meet materiality thresholds for inclusion in ESG-mandated approaches. An example of a company with this “halo effect” could be an EV-focused SPAC that we believe does not have a durable competitive advantage in a space that is ripe with competition from both legacy companies and new entrants.

Bottom line on climate investing
The climate opportunity set is, in our view, much broader and more dynamic than that of traditional climate strategies. Moreover, we believe today’s environment and existing strategies create a growing dispersion between relative price and value, meaning a more nuanced approach to climate investing is likely to be increasingly critical in the years ahead.

To learn more about our efforts in climate-investing, please see our 2021 Climate Report and visit the climate leadership section of our website.

This material is intended for informational purposes only and does not constitute investment advice or a recommendation or an offer or solicitation to purchase or sell any securities. The views expressed are those of the author at the date of publication and are subject to change. Other teams may hold different views and make different investment decisions.