4 global challenges and the investment themes helping solve them

The recent catastrophic floods across Australia’s eastern seaboard and the devastating bushfires of 2019 have elevated the topic of climate change like never before. In the more than two decades since UK-based Impax Asset Management launched, there’s been a step-change in the recognition of global sustainability challenges.  Alongside climate change, some of the topics that have become increasingly prevalent include:

• environmental pollution, 
• natural resource shortages, and 
• issues around diversity and gender equality.

As part of Livewire’s Decarbonisation series Hubert Aarts, co-portfolio manager of the global Impax Sustainable Leaders Fund, recently discussed how its asset allocation has evolved since its inception in 2008.

In the following Q&A, Aarts outlines five long-term macro themes his team considers as part of its stock selection process. He also details some sectors that have become greater areas of focus as the fund has gradually reduced exposure to Utilities firms. And he reveals which one of the following themes his team is most excited about:

• Energy, 
• Water, 
• Food, 
• Transport, 
• Smart environment, and
• The circular economy.

Edited transcript

Who is Impax Asset Management and how do you approach the decarbonisation space?

Founded in 1998, Impax is a specialist asset manager, with around $67 billion in both listed and real asset strategies, investing opportunities arising from the transition to a more sustainable global economy.

Our investment philosophy is based on the idea that capital markets will be shaped profoundly by global sustainability challenges, particularly:

• climate change,
  
• environmental pollution,
• natural resource constraints, and
• demographic and human capital issues such as diversity, inclusion, and gender equity.

We believe these trends will drive growth for well-positioned companies and create risks for those unable or unwilling to adapt. We use fundamental analysis with a focus on financial, management and business assessment which incorporates long-term risks, including environmental, social and governance (ESG) factors, which we believe enhance our investment decisions.

Every Impax strategy is, therefore, designed to intentionally allocate clients’ capital towards those companies we expect to flourish as the global economy transitions to a more sustainable model, and to reduce or eliminate exposure to those unable or unwilling to adapt to this transition.

You launched the Leaders Strategy in 2008. How has your asset allocation evolved since then?

The Leaders strategy seeks to achieve sustainable, above-market returns over the longer term by investing in companies active in the growing Resource Efficiency and Environmental Markets. These markets address several long term macro-economic themes:

• growing populations,
• rising living standards,
• increasing urbanisation,
• rising consumption, and
• depletion of limited natural resources.

Investments are made in companies that generate more than 20% of their underlying revenue from selling products or services that fall within environmental markets.

Over time, the portfolio’s exposure to the Utilities sector has fallen as additional areas of opportunity within environmental markets have emerged and matured.

A decade ago, sustainable food and agriculture were added to our environmental markets classification system. Why? Because growing environmental and resource pressures, changing consumer demands, technological innovation, and ever-tightening regulatory interventions were increasingly changing the business models of incumbent firms and creating compelling investment opportunities for active investors within the sector. As a result, Consumer Staples and Materials have become a larger feature of the portfolio.

More recently, as the role of energy efficiency in the transition to a sustainable economy has grown, the strategy has been positioned to capture emerging opportunities in IT. We have also adopted an approach to balance the cyclical and defensive characteristics of the portfolio. Consequently, the portfolio’s Industrials weight has been reduced.

The Impax team considers macroeconomic events, including the economic cycle, in deciding how much of our portfolio to invest in various sectors. We also weigh up individual companies’ growth prospects and their stock valuations in identifying opportunities.

Drivers, risks and opportunities

What are the catalysts to drive long term change in decarbonisation?

The UN COP26 climate summit last November demonstrated that the transition to a net-zero economy should create enormous opportunities for investors.

One of the most obvious areas where market growth should continue to accelerate is power generation. Clean power initiatives should provide tailwinds for renewables, which already out-compete fossil fuel generation on cost in many markets. The focus on energy security following the war in Ukraine should also increase the trend towards renewables.

We also believe there will be significant new opportunities in energy efficiency, particularly to improve industrial processes, reduce losses during the transmission and distribution of electricity, and to improve the performance of buildings. More broadly, engineering solutions that advance resource efficiency and address carbon dioxide and methane emissions will also be in rising demand.

Investors are also rightly increasingly focusing on the role of biodiversity and the role of the agricultural sector to climate change. Alongside environmental pressures and the prospect of tighter regulations, consumers are also pushing for more sustainable food production and supply chains. We expect greater scrutiny of investments in this space, with promising opportunities arising from technological innovation that will disrupt this sector.

What are the key risks investors should be aware of when investing in this space?

Investors must look carefully at both the physical and transition risks arising from climate change. On a practical level, there is a clear need for much more granular information based on satellite observation, embedded sensing, more transparent asset registers and established methodologies for translating environmental hazard into financial risk. We are actively engaging with our investee companies on this issue. In addition, investors should be aware that environmental investing doesn’t include all sectors of the global economy and thus the strategy will have a high tracking error and performance can significantly deviate from the broader market

You’ve said you expect new technologies and industries will emerge as the sustainable economy emerges and that some companies will fail to adapt. What areas of the market are you most excited about?

We believe that companies that are contributing to, or benefiting from, the shift to a sustainable economy will deliver solid returns over the long term. The strategy focuses on growth in the markets for cleaner or more efficient delivery of services of energy, water, food, transport, smart environment, and the circular economy.

Of these, we’d pick out circular economy and within it, the emerging theme of the sharing economy, in which an increasing number of products are formally rented out. Equipment rental has huge potential to improve resource efficiency across swathes of the modern economy, including resource-intensive sectors like construction and we believe it has significant long term growth prospects as the concept becomes more widely adopted.

There are business models in certain equipment niches that should deliver particularly strong long term investment returns. One example is uniform rental services businesses, which can provide companies with clean and repaired uniforms for their employees while also ensuring that clothes are re-used efficiently and waste in textile production is reduced. This kind of innovation can play a material role in building the foundations for a sustainable, circular model that is aligned with global net zero whilst also delivering value for investors and customers alike.

How well set up are these businesses to weather macroeconomic conditions like rising rates and inflation?

Investors should be aware that environmental investing doesn’t include all sectors of the global economy. Companies held by the strategy generally have lower debt and better cash flow than the market overall and therefore should be able to service their debt relatively easily.

Generally, the strategy does well in inflationary periods due to the overweight to industrials, as industrials tend to perform well in periods of good economic growth and modest inflation. At the time of writing, markets are responding to rising yields by favouring Cyclicals and Financials in the expectation of higher economic growth. But inflation is currently being driven by geopolitical factors and supply constraints and there is a risk of slowing economic momentum.

Under these circumstances, we expect Quality companies with better pricing power to perform better than lower quality “value” companies. Such companies are more likely to be able to pass on higher input prices, albeit sometimes with a time lag.

How do you weigh up stocks and decide what makes it into your portfolio?

Since 1999, Impax has developed a proprietary universe of environmental stocks, with ideas sourced both through internal research of the sector and geographical developments as well as via a wide and deep network of contacts.

The portfolio invests globally in companies that are developing innovative solutions to resource challenges in environmental markets. Inclusion in the universe depends on resource efficiency, and environmental markets businesses typically comprise more than 20% of any single company’s group revenue, profitability or invested capital.

Once a company is identified as being of potential interest, we undertake a 10-step analysis. This includes an in-depth ESG analysis followed by a peer review before the company is able to join the “A-list” of investable stocks.

Are there any tools that investors can use, or that you use, to measure the impact companies are having?

Our annual Impax @ Impact report discloses impacts including carbon emissions avoided, renewable energy generated, water treated, saved or provided, materials recovered and waste treated for our strategies.

We also use the Sustainable Development Goals framework to put current and potential portfolio companies’ impact into context. However, we view the Goals as a positive by-product and outcome of our investment process and engagement efforts, rather than a specific target.

Identifying true performers

How do you decide between blacklisting sectors or companies, and engaging with them to try change behaviours?

The companies in Impax’s listed equity portfolios have been identified as offering solutions to sustainability challenges, with financial returns generated by durable business models which we believe will benefit from the transition to a more sustainable economy.

This is an inherently positive group of companies to work with. As active managers focused on distinctive investment philosophy, we don’t need to work as activists to change the fundamental business models of the companies in which we invest.

Within this context, engagement is an important tool in managing risk and building relationships with investee companies. If material concerns or anomalies at an investee company are identified, we escalate matters to mitigate risks and preserve shareholder value and ultimately, if necessary, exit the stock.

It feels like we are only now at the end of the beginning of our decarbonisation journey. What is your one key takeaway for investors about the opportunities that lie ahead?

The direction of travel towards achieving global net-zero is clear and irreversible. Identifying the corporate winners and losers will not be easy, however. It will require expertise and investment discipline. We would argue that specialism and our years of experience investing in the transition to a more sustainable help give us that edge, both in terms of decarbonisation and other opportunities relating to environmental markets.

Managed Fund

Impax Sustainable Leaders Fund

Global Shares

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Impax Asset Management is one of the largest and longest established investors dedicated to investing in the transition to a more sustainable economy. Click on their fund profile below, or visit their website to learn more.