Sustainable Investing Perspectives

On 16 August 2022, President Biden signed the Inflation Reduction Act of 2022 (IRA ‘22) into law. With USD 369bn dedicated to energy security and climate change, and an additional USD 4bn for drought resiliency, the bill contains a wide variety of spending plans that should provide a tailwind for select companies. We see our Energy efficiency, Smart mobility and Clean air and carbon reduction themes as particularly well positioned. Below we discuss three key components of the policy and the investment implications.

What’s in the bill?

Energy efficiency: a variety of incentives to improve energy efficiency are embedded throughout the policy. Ten years of consumer tax credits and USD 9bn in consumer rebate programs were slated for home efficiency projects, including heat pumps, electric HVAC, and rooftop solar. USD 1bn was set aside to improve energy efficiency in affordable housing.

Transport: a consumer tax credit of USD 4,000 and USD 7,500 is included for used and new "green" vehicles respectively (subject to income restrictions), and the tax credit for building EV charging stations was increased and extended. Further, USD 1bn was laid out for "green" heavy-duty vehicles like garbage trucks, and USD 3bn for the US Postal Service to purchase zero emission vehicles. Beyond EV, the Act creates a new tax credit for sustainable aviation fuel.

Energy security: the bill increases the investment tax credit (ITC) for solar and wind, includes a nuclear credit for existing facilities, and attempts to make green hydrogen more economical through a new production tax credit for clean hydrogen.

Where we see opportunity

We see a number of opportunities across sectors, but encourage investors to be selective. Index-level valuations for US companies are beginning to look rich (Fig. 1 and 2), as companies face supply constraints, tariff threats, potential of an economic slowdown and higher interest rates which are a headwind to expansion for growth companies. Currently, we are focused on relatively larger cap companies with diversified revenue streams, solid earnings, and robust balance sheets.

With the above considerations in mind, we see short term and longer-term opportunities across multiple sectors. We recommend diversification across energy efficiency tools, the electric vehicle supply chain, energy transition including transmission, offshore wind, solar, battery storage, industrial gases necessary for the hydrogen supply chain, emissions trading markets, and companies providing environmental consulting services that can aid in adaptation projects.

Within the energy transition, we prefer utility scale alternative energy providers that tend to enjoy relatively stable earnings compared to pureplay alternative energy stocks. Similarly, within electric vehicles we take a selective approach, limiting manufacturers to those with a competitive advantage or vertically integrated supply chains, and high voltage components makers that serve several end markets. Pureplay US charging companies could see a boost from the bill, but without knowing which companies will receive the funding allocations, we see these as higher risk ways to position.

Investor takeaways

• The Inflation Reduction Act of 22 is one of the largest climate spending plans ever passed in the United States.
• For investors interested in tapping into these trends on a tactical basis, please see our Greentech goes global theme for more information. We recommend being selective, and prefer larger cap companies with diversified revenue sources, solid earnings and robust balance sheets.
• For investors with a longer-term time horizon, we see opportunity in broad exposure to the Energy efficiency, Smart mobility, Clean air and carbon reduction themes.

Japan is reportedly preparing to launch new initiatives to boost the size of its domestic circular economy from its current JPY 50tr to JPY 80tr by 2030, according to Kyodo news. Potential measures include a promotion of imports of waste home appliances from countries which lack the technology to recycle, and legal measures on solar panel reuse and recycling, and financial aid for companies to invest and boost recycling capacity. Apart from Japan, accelerating initiatives have been rolled out in the EU, US and China, to include a few. Rising commitment and implementation by policymakers is just one of the four key secular drivers we have identified as catalysts to accelerate circular economy development in the coming years.

A circular economy — one that aims to reduce resource dependency through design, recycling and reuse — is a focus solution for delivering UN Sustainable Development Goal 12: Responsible Consumption and Production. Current consumption requires the environmental resources of 2.3 planets, according to the World Business Council for Sustainable Development, and the World Resources Institute estimates that we could potentially reduce global greenhouse gas (GHG) emissions by 39% by doubling circularity from the current 8.6% of the global economy.

But the benefits are not confined to environmental ones. According to studies by the Ellen MacArthur Foundation, increased reuse and recycling of materials could translate into savings of up to USD 630bn for the EU consumer electronics market alone, or up to USD 700bn for the global fast-moving consumer goods (FMCG) market. This economic benefit is especially relevant to sectors and industries that are influenced by two other secular drivers: firstly, customers’ rising demand for circularity, and secondly, cost escalation as a result of resource scarcity. These drivers can directly drive revenue upside, through new product lines and markets, or cost savings, especially in the context of escalating commodity prices.

The fourth and final secular driver is that of technological developments and innovation. Advances in relevant technologies are at the cusp of commercialization, including metal recycling; chemical recycling and pyrolysis of industrial waste; and bioplastics. Successful commercialization would translate into a step-jump progress in achieving circularity, circumventing challenging and uncertain behavioral change. Of course, robust solutions would require not only innovative technology, but also systems redesign and infrastructure, especially in supply chains.

The combination of these four drivers lead us to believe that the integration of circular economy principles will be rapid across various industries in the coming years. Implementation remains challenging, and further accentuated by increased regulator, investor and consumer scrutiny. For example, Hennes & Mauritz is facing a class action lawsuit in New York for greenwashing in its attempt to demonstrate product circularity, from the production footprint of its products to its recyclability at end of life. Successful transition to circularity would require thoughtful collaboration between both solution providers and incumbent manufacturers.

For more, please refer to Longer-term investment: Circular economy. Note that with the launch of this theme we closed our Waste management and recycling theme, which is an important subcomponent of the opportunity set related to the circular economy.

Investor takeaways:

• Regulations, consumer demand, resource scarcity and technological innovations are driving accelerated progress in the development of a circular economy.
• While the top-down drivers are clear, implementation records differ across industry and companies. A robust investment strategy must match thematic alignment with bottom-up analysis.
• Investors seeking exposure should consider both enablers — solution providers to promote reduce, recycle or reuse strategies — and adopters — incumbents who are adopting or acquiring such solutions. We highlight opportunities in waste management and the plastics supply chain.

Water may seem like an abundant resource on our planet. Yet, freshwater used for human activity, makes up only 2.5% of global water resources, of that only 1% is available for consumption.¹

Water impacts large swaths of the economy, cutting across apparel, food and beverage, energy, chemicals, pharmaceuticals, and mining. In 2016, these sectors accounted for about 70% of global water use, and they continue to rely on it as an input.² Even technology companies intersect with water security; data centers consume significant water for cooling purposes. In the US, data centers rank among the top 10 consumers of water, and a mid-sized center uses up as much water as about 1,000 households, according to research from the University of California, Berkeley.³

Water use is a critical societal question, and one which has come sharply into focus last month with droughts ravaging the United States, large parts of Europe and the Horn of Africa. It is also a financially relevant issue across sectors. According to a CDP survey of 2000 global companies, the total projected cost of inaction to water risk might be 5x higher than expected cost of managing this risk.⁴

In our view, there are two ways in which investors can consider water risk in their portfolios. They can look to understand the water intensity—measured in cubic tons of water per USD million dollars of revenue—for companies where water is financially material, and position in names that are better at managing their consumption. Innovation is underway on this front, as investors increase pressure and companies commit to acting. In August, a group of investors representing nearly USD 10 trillion AUM launched the Valuing Water Finance Initiative, aiming to engage with 72 companies to act on water as a financial risk.

The second way to position is by investing in the companies exposed to the Water Scarcity Longer Term Investment theme. This market comprises several subsectors, and broadly is exposed across industrials and utilities. According to RBC Capital Markets, the value of the market is more than USD 655bn as of 2021, and the largest category at 29% is wastewater treatment. The rest consists of water equipment suppliers that provide equipment for water exploration, distribution, and treatment.

Investor takeaways:

• Water scarcity presents a societal and a business risk, cutting across multiple sectors and geographies.
• Investors can gain exposure to solution providing companies related to the Water scarcity theme. The value of this market is estimated at USD 655bn, and it’s composed of utilities and industrials.
• Another way to position is to look for companies across sectors which score well on how they manage their water intensity, implying they are relatively better than their peers at managing water risk.¹