Future Performance Relies On Sustainability

When we founded Generation Investment Management in 2004, our intention was to show how integrating sustainability research into a long-term investment strategy could strengthen fundamental investment analysis.

Four years on, our conviction on the importance of sustainability in delivering long-term performance has increased. We are encouraged to see many investors now agree that sustainability issues do materially affect a company’s ability to generate returns. Sustainability is increasingly mainstream, which makes sense given its impact on profitability.

At Generation, thinking “sustainably” means embracing a systems view of the world – a perspective that focuses on inter-relationships.

To understand the investment implications of climate change, you must consider implications for water and resource scarcity, poverty and development, consumption and economic growth, pandemics and disease, demographics and urbanisation. Solutions should not just treat symptoms; they need to address causes.

It is time for markets to recognise the magnitude, and urgency of the climate crisis. We are convinced that the transition from a high-carbon to low-carbon economy will be the most significant process in modern economic history – matching the Industrial Revolution in scale, and the technological revolution in pace.

Despite the materiality of this transition for business and investors, the response is impaired by a fundamental market distortion – the absence of a global price for carbon that is commensurate with its environmental impact.

The classification of carbon as an externality results in poor capital allocation, such as the financing provided for new coal-fired power stations. A carbon tax and a cap and trade system are complementary ways to address this distortion. For an efficient carbon tax, we need to shift the burden of taxation away from employment-based taxes. Sweden, Norway, and the Canadian provinces of Quebec and British Columbia have begun this shift, with positive results.

The longer we delay the internalisation of this obviously material cost, the greater risk the economy faces from a growing bubble of sub-prime carbon investments. Such investments ignore the reality of the climate crisis and its consequences for business.

We believe investors are increasingly aware of the implications of the scientific consensus.

To abate emissions, we need solutions from many sectors and market participants. Of the potential options, the cheapest and most logical is demand destruction – managing the demand for energy by reducing its use or improving its utilisation. This means improving the distribution and delivery of electricity through grid optimisation and smart metering, which will enhance our infrastructure while laying the framework for more decentralised, small-scale power generation.
We also must improve the built environment through sustainable design and greener buildings. Solutions for transportation and mobility are also critical.

We need scalable solutions to de-carbonise the supply-side of the energy equation. This means promoting investment in renewable technologies, including geothermal, solar and photovoltaics, wind, and waste-to-power. We must also improve the environmental footprint of fossil-fuelled industries and of coal-fired power plants. We must invest in carbon capture and sequestration and improving efficiency.

With all these potential investments, we need to focus on the entire spectrum of implications. True sustainability means judging solutions on a life-cycle basis and considering the complete set of inputs, costs, and externalities. This is particularly important when assessing the potential for bio-based material – from crops, forests, waste – as potential alternative feedstocks for transport fuels and plastics.

Just as there is a growing gap between where emissions are heading and where scientists say they need to go, there is a yawning gap between the capital deployed and the capital needed to address the climate challenge.

Inaction today will significantly increase costs in the future, so investors have a clear incentive to invest now.

Of course, business alone is not going to solve this crisis. Governments must also respond. A first step is a successor to the Kyoto Protocol – one that engages the developing world in an equitable way – and transfers technology and capital for sustainable global development.

The global economy now stands on the brink of a mass mobilisation of capital towards addressing the challenges of climate change. Sustainable solutions will be the significant driver of economic development for the coming decades.