Semiconductors, three reasons to invest in people, and transition risk for real estate

With reports of increased emissions from Microsoft (up 30% since 2020) and Alphabet (up 13% y/y) due to investments in artificial intelligence (AI) and data center infrastructure, we see increased questions around the sustainability of the semiconductor companies that are powering this growth.

What sustainability factors are considered for semiconductor companies?

Fabrication facilities, where chips are manufactured, are capital- and resource-intensive and the manufacturing process requires significant water consumption and generates harmful waste. Given the heavy competition on intellectual property and talent, social factors are significant as well. With the financial potential presented by the transition to a low-carbon economy, assessing the sustainability of semiconductor companies is not just a risk, but also an opportunity story. Applications for semiconductor companies across energy efficiency and other greentech products are wide, meaning the impact of products and services should not be understated. So, CIO's sustainability scores methodology assigns relatively even weights across the various sustainability topics, and we see ESG rating providers like MSCI and S&P assign relatively equal weights to the E/S/G pillars for semiconductor companies, too (Table 1).

However, the sustainability factors investors may want to consider could vary depending on whether the semiconductor company is a manufacturer or a “fabless” semiconductor company (also known as designers). Semiconductor design companies (like NVIDIA) avoid insourcing the manufacturing process, making topics like carbon emissions and water consumption less material. For example, TSMC (a semiconductor manufacturer) has Scope 1 (direct) and Scope 2 (indirect) carbon intensity of 170 tCO2/USDmn and water intensity of 444 m3/USDmn, compared to NVIDIA’s 5 tCO2/USDm and 15 m3/USDmn based on data from S&P Trucost. Putting it into context, for every USD 1mn of revenue, TSMC emits the equivalent carbon as 20 residential homes in the US over a year (per the EPA GHG Calculator). This is comparable to the weighted average of the MSCI AC World Index.

While most sustainability assessments treat semiconductor manufacturers and designers the same, greater materiality considerations could be granted to the downstream value chains and human capital of fabless semiconductor companies. Additionally, the power demand of AI, part of chip manufacturers’ scope 3 emissions (category 11—use of sold products), remains a key consideration.

How does the market view the sustainability characteristics of NVIDIA and semi companies?

NVIDIA, the name most in the spotlight in the industry, receives positive scores from most sustainability ratings (i.e., assessments of a company's operational sustainability). MSCI rates NVIDIA AAA and ranks it in the top 1% in its industry, S&P scores NVIDIA at 59/100, above the industry average of 25, and Sustainalytics assigns a low-risk rating of 13.2 (where lower is better), in the 97th percentile in the industry. Using the proprietary CIO sustainability scores, NVIDIA scores a 6.8/10, in the 99th percentile of the semiconductor industry.

Beyond NVIDIA, the semiconductor industry's median headline score is 4.0, compared to 3.5 for the broader covered universe. Beyond the median, we see a number of names scoring above average in the sector, while we are mindful of longer-term risks and opportunities (see Figure 1). Investors should use sustainability data and scores in conjunction with fundamental investment analysis, and not use sustainability data in isolation to make investment decisions. Sustainability scores and data may be used as a starting point, but not a conclusion.

Despite high sustainability ratings, sustainable funds are underweight NVIDIA, with an average weight of 3.7% compared to the stock's 4.2% weight in the MSCI AC World Index, according to research by Goldman Sachs. As the focus on the enablers of the AI investment opportunity continues, we expect sustainability-focused investors to look for better relative performance—and transparency—in managing human capital as well as energy and water consumption. We also expect additional engagement efforts on these topics to continue. See the June 2024 SI Perspectives report for a view on climate risk and AI, and the proxy season.

Takeaways for investors:

• As investors position to take advantage of the opportunity related to AI enablers, we see sufficient opportunities among companies in the semiconductor industry that are leading on sustainability factors.
• Sustainability issues are many and varied, affecting companies, people, and geographies differently. Being “sustainable” is a spectrum, not a binary assessment, and depends on the underlying investment strategy's intent.
• We consider ESG leader strategies to be those that invest in companies that manage sustainability risks and opportunities better than peers.

In 2022, about a third of IKEA’s US workforce quit, and half of its new hires in the UK and Ireland left within a year, according to Bloomberg and company reports. Each departure cost IKEA at least USD 5,000 to replace. To tackle this, the company raised wages, made shift schedules flexible, and adopted new technologies. These changes led to a 44% drop in voluntary turnover in Ireland and a 25% drop in the US within only eight months.

This example shows that investing in employees can lead to operational success and meaningful financial impact. With labor strikes and shortages on the rise, effective human capital management—including diversity, inclusion, and employee health and safety—is crucial for long-term value creation. It has the potential for both companies and investors to unlock additional long-term value from improved labor productivity.

Here are three reasons why effective human capital management is increasingly important:

1. Climate Change Impacts Productivity: Extreme heat affects sectors requiring outdoor physical labor, like agriculture, mining, and construction. The Federal Reserve Bank of San Francisco notes that decreased productivity can slow capital accumulation and consumption. Heat exposure has caused up to 2,000 worker fatalities and 170,000 workplace injuries in the US,[1] based on a report from Public Citizen. Companies must consider climate risks for employees exposed to heat stress.
2. Emerging Technologies and AI: AI and other technologies can boost efficiency and productivity if employees are properly trained. An MIT study found AI too expensive to replace humans in most jobs,[2] but it will impact nearly every job according to the Harvard Business Review.[3] As emerging technologies and AI manifest their potential, sufficient ethics and data security policies are necessary, and the shift toward a new era of digital transformation will be one that reduces learning friction toward building a more equitable and inclusive workforce.
3. Employee Engagement Drives Customer Engagement: Engaged employees provide better customer service[4]—a key competitive advantage. In an experience-driven economy, quality customer service is more important than ever. A Forbes survey found 48% of consumers are willing to pay more for quality service, leading to customer loyalty and better pricing strategies.

Takeaways for investors:

• Investing in human capital benefits both employees and companies through increased productivity and lower turnover rates, crucial for long-term performance.
• Climate change, AI, and an experience-driven economy are key factors for effective workforce management.
• ESG leaders excelling in human capital management may better handle near-term challenges and extract long-term value from improved labor productivity. Investing in themes like "Diversity and Equality" can also be a way to identify companies focused on employee retention and productivity.

Financing risks are emerging for commercial real estate in Europe, responding to the adoption of EU Energy Performance of Buildings Directive (EPBD) this quarter, which requires all buildings to achieve “zero emissions” by 2030, and the use of fossil fuels for building heat systems to be phased out by 2040. Banks and insurers are beginning to factor in the feasibility of relevant assets’ delivery of these targets into their investment assessments, as EPBD spells a sharpening of timelines for transition risk assessments.

According to Bruegel, a European think tank, meeting these requirements would require an estimated EUR 297 billion in spending every year, or an implied doubling of current renovation rates. This investment need may not be matched by funding appetite. Of course, the commercial real estate (CRE) sector has already been suffering substantial valuation challenges in recent times, in Europe as well as globally, but the EPBD is just an example of how transition risk has become a tangible incremental issue.

Transition risk refers to those arising from the socioeconomic shift toward a more sustainable economy, as opposed to physical risk, which refers to the impact of climate change itself, whether direct or indirect, chronic or acute (e.g., asset valuation sensitivity to more frequent and severe flooding).

And while there is broad consensus on the risk assessment framework for physical risk—which overlay geospatial data, climate models, and asset valuation models—transition risk can be sector- and country-specific, depending on how policy, infrastructure, and market dynamics shift in accordance to both physical risk and transition ambitions.

For EU real estate, however, this outlook is now somewhat sealed, and financing risk is already materializing. Already, banks have introduced targets for financed emissions in their commercial real estate (CRE) portfolios, responding to tightening demands and threats of European Central Bank (ECB) fines for mismanagement of climate risk. A recent survey of 250 CRE asset managers by Deepki, a sustainability data company, suggests that over 30% of their portfolios can be considered “stranded,”—i.e., the investment hurdle to meet required sustainability standards may not be commercially viable, and may face additional valuation discounts.

This creates strong incentives alignment for real estate developers and landlords alike to chase sustainability standards. This focus on real estate reflects the fact that buildings represent 37% of total greenhouse gas emissions globally, according to UNEP data. Of this, 75% are operational—heating, cooling, and lighting—and this is also where energy-efficiency products already exist and are commercially viable, leading the UN to project this share dropping to 50% in the coming years. Longer term, technologies such as new building materials would be required to address lifecycle emissions and embodied carbon, which make up the balance.

Takeaways for investors:

• Transition risk is becoming increasingly apparent for the commercial real estate sector, with potential impact on both funding availability and pricing.
• Within the commercial real estate sector, companies with leading sustainability management practices, especially on emissions control and energy management, may see both strategic advantage as regulations escalate, as well as operational advantages e.g. lower energy bills.
• This provides strong tailwinds for Energy efficiency as well as Circular economy.