Sustainable Investing Perspectives

Our latest monthly issue of UBS Sustainable Investing Perspectives discusses implications of energy rally for SI investors, the momentum to build on diversity and equality and breakthroughs in the carbon market.

10 Feb 2021

Perspective 1

Implications of energy rally for SI investors

Global energy stocks have lagged for several years, and were particularly sensitive to the COVID-19 pandemic as severe lockdowns resulted in plummeting oil demand and oil prices. Since 4Q20, with the anticipation of vaccines and a rebound in global economic activity, as well as supply restraint, we have seen a recovery in oil prices, and as of 3 February, the price of Brent crude oil has climbed to pre-pandemic levels. Despite our longterm view of a continued energy transition out of fossil fuels into renewables, we acknowledge that this cyclical rotation may continue and further support oil prices through the year ahead.

What are the performance implications for SI strategies of a rally in traditional energy stocks? SI strategies take different approaches. Some investors opt to exclude fossil fuels from their SI strategies, and could therefore be negatively impacted from a rally in the energy sector. However, many SI strategies integrate environmental, social, and governance (ESG) factors in the investment decision-making to identify companies that are ESG leaders because they are the best among their peers in managing ESG risks and opportunities. These integrated approaches may not exclude the energy sector entirely, but instead might tilt a portfolio toward the oil and gas majors that are best prepared for the energy transition.

For example, as of 29 January, the energy sector made up 2.31% of the MSCI All Country World Index (ACWI) ESG Leaders, compared to 3.02% of its parent index, the MSCI ACWI.1 The ESG Leaders index outperformed its broad market equivalent by 80 basis points year-to-date as of 4 February, and by 166 basis points in 2020.2 Despite the energy sector being somewhat underweight in general, we think that ESG leader and diversified SI strategies will hold up if higher oil prices support better performance of fossil fuel stocks.

Finally, higher oil and gas prices should also support the economics of switching to alternative sources of energy, so the potential recovery of the energy sector should not detract from the performance of renewables. Improving economics, as well as ongoing innovation, should continue to support outperformance in the alternative energy sector, which may offset opportunity costs from underexposure to fossil fuels.

Investor takeaways

  • ESG leader strategies select companies that are the best among their peers in managing ESG risks, and provide a way for investors to be exposed to the subset of energy companies that are best prepared for the energy transition.
  • For investors looking to drive a measurable, positive impact across industries, including in the energy sector, we recommend considering ESG engagement equity and fixed income strategies, which engage with companies to drive improvement on material ESG factors such as including their climate change policies.
  • Increased investor and government awareness of the risks of climate change will continue to support “green” themes such as CIO's "Renewable energy," "Clean air and carbon reduction," "Energy transition," and "Smart mobility" themes. For more, read about Long term investments.

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Perspective 2

Momentum continues to build on diversity and equality

Social inequalities are increasingly in the spotlight as asset managers, investor groups, and governments worldwide raise their demand for additional corporate focus on diversity and inclusion—both action and transparency. US President Joe Biden has indicated that diversity and racial equity will be a priority of his new administration, and it soon demonstrated this intent with executive orders mandating an increased focus on anti-discrimination efforts, such as reversing the ban on transgender people serving in the military.

These recent developments are only the latest in a long-term societal shift, which we think creates long-term investment opportunities around the theme of diversity and equality. There is evidence that organizational diversity correlates with innovation and profitability, and we see four key drivers of the growing relevance of the topic to investors: 1) increasing regulation and stakeholder pressure for workforce diversity and more transparent corporate disclosure; 2) growing evidence of the benefits to companies; 3) growing evidence of the economic benefits of a more equal and inclusive society, and the potential risks rising inequalities pose; and 4) a societal and generational mind-shift as social movements addressing inequalities gather steam, with younger generations adopting a different attitude toward—and expectation of —global social diversity.

Corporations are starting to respond. As the topic of racial equity came into the spotlight in 2020 in the United States, companies started to direct capital toward efforts advancing racial equity. Data from UBS Evidence Lab indicates that mentions of words related to gender, race, or ethnicity in global investor calls increased by 400% between 2010 and 2020. Yet, most corporations lag. In the UK, there are currently zero Black people at the top of the top 100 listed companies (FTSE 100), as concluded in a report by diversity consultancy Green Park. Only 10 of the 297 top leaders in the FTSE 100 companies had an ethnic minority background, the same number as in 2014.1

Investor takeaways

  • Governments and investors increasingly demand disclosure and progress on diverse representation on senior leadership and governance positions, creating an opportunity for companies that are ahead of the trend and increasing noncompliance risks to laggards.
  • Companies are responding to market demands and data on gender diversity are more widely available, while reporting on racial, ethnic, or other types of diversity has opportunity to catch up.
  • We think companies that are leaders in promoting diversity and equality throughout their value chains and processes can deliver outperformance in the long run thanks to a higher degree of innovation and higher sales growth and profitability. For more, we recommend our "Diversity and Equality" Longer Term Investments theme.

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Perspective 3

Breakthroughs in the carbon market

China announced the long-anticipated national rollout of its emissions trading scheme (ETS) in January, extending the efforts of pilot programs in seven regions over the past seven years. The rollout will be conducted in phases, with the first phase spanning seven sectors including utilities, petrochemicals, paper, and airlines. The Ministry for Ecology and Environment already allocated quotas covering 2,225 utility companies in January, with trading commencing in February and mandatory compliance by year-end.

Even within this initial phase, the scope of this rollout already sets China up to overtake the European Union as the world’s largest carbon market. At the moment, the allocation of free carbon credits implies 1% efficiency gains on average for the sector, and 3–5% of payable credits. This means that companies that fail to achieve emissions reduction of 4–6% would have to purchase credits in the market. Over time, the allocation of free credits would decrease, which would further boost trading volumes in the market. For this initial phase, the largest earnings impact would be for the power sector, from an estimated –9% for inefficient thermal power plants, to +7% for hydropower plants, based on the current carbon price of CNY 30 per ton. Outside of the power sector, we expect a low-single-digit earnings impact on heavy power usage industries such as aluminum, steel, and cement. While this may seem manageable in the near term, sensitivities could arise significantly should carbon pricing in the official national ETS rise higher than that in the pilot, or if credit allocations are tightened more aggressively in the coming years.

Carbon pricing has been an area of extensive research and policy study for decades, and have gradually gained prominence as a policy tool in climate mitigation globally. Emissions systems provide a market-based, two-way reward and penalty system to incentivize companies to reduce emissions, and is more progressive than simple carbon taxation. Furthermore, they can develop to become additional sources of fiscal revenue—estimated to already exceed USD 45 billion in 2019, based on World Bank data. The full potential of carbon pricing as a policy tool hinges on the establishment of a liquid, functional market. Currently, the global carbon market remains nascent and fragmented, with over 60 carbon pricing initiatives at local, national, and regional levels. According to the World Bank, market volume makes up just over 20% of total global emissions, and even in the most developed market, the EU ETS, market volumes still only meet 40–45% of total emissions in the region.

More important, current carbon price levels remain too low in most parts of the world. As mentioned earlier, carbon prices have averaged CNY 30/t (USD 4.6/t) in China, and even in Europe, estimated 2021 prices of USD 30–35/t still fall short of the EPA's estimate of USD 41/t carbon cost to society. Furthermore, the High-Level Commission on Carbon Prices targets carbon prices of USD 50–100/t by 2030 to achieve Paris Agreement outcomes.

Apart from financial alignment and incentives, a welcome byproduct of China’s ETS is increased data transparency in related issues. As part of the infrastructure build, there are now legal liabilities and fines that force Chinese corporates to accurately report emissions data, based on official standards, which would also be made public.

Investor takeaways

  • The launch of China’s national ETS will have a material earnings impact across sectors. The renewable energy sector is the immediate beneficiary based on potential monetization of existing capacity, as well as growing demand for low-carbon energy solutions. We see further support to our long-term bull case on greentech.
  • The China ETS is an essential tool in China’s goal to carbon neutrality by 2060.We expect domestic carbon prices to trend up as the market infrastructure matures, with further boosts from ongoing regulatory tightening. ESG leaders with appropriate disclosure and transition policies in place should be better positioned to manage or capitalize on these developments.
  • Greater data transparency will also benefit SI investors in the meantime.

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