Good Environmental Investing is Hard

Investment Note #23 - 24th January 2025

Good Environmental Investing is Hard

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Synopsis

• In August, the mining giant Glencore abandoned its plans to sell its coal business after shareholder’s pressured the company to keep it in-house. 

• Per the Wall Street Journal: “The U-turn shows how environmental, social, and governance investing has lost momentum since it took off in the early days of the Covid-19 pandemic, when billions of dollars poured into funds that directed money based on sustainability credentials and chief executives flaunted their ethical bona fides”

• In the heyday of environmental investing companies could, in theory, generate additional shareholder value by making less money rather than more. If you had a business that was say 90% clean and 10% dirty, by selling the dirty business you suddenly became investable to these large ESG funds. As these funds needed to deploy significant amounts of capital quickly, a company could end up being more valuable (via a higher p/e multiple) by doing less.  What happened to the dirty business was typically it went into the private market where transparency is lower and shareholder votes or engagements on environmental matters aren’t possible.

• In its announcement, Glencore’s CEO noted that the “ESG pendulum has swung back (against ESG) over the last nine or 12 months” blaming politicalisation of the issue in the US.

• Given this swing, is there a way for an environmentally focused investor to deploy capital in an efficient way that is genuinely good for the environment?

What are the options?

• At the most basic level investors have three options to deploy capital; debt, equity or derivatives.

• As we’ve seen with Glencore traditional public equity investing is not ideal for this purpose, many CEOs are prone to making short-term decisions based on what is currently popular. It is also the case that, from an impact perspective, buying the equity of a public company does not give that company any additional capital and also without control, public equity is not an ideal route for the green investor.

• Private equity and specifically venture can be a better choice given it involves getting additional money into a company to finance growth and expand operations. It also usually gives the investor control of the company, allowing them to ensure that management don’t stray off course. However, the investor outcomes from venture capital are highly uncertain. 

• We are also making the major assumption that either our hypothetical investor is capable of investing this capital directly, i.e. buying and managing companies themselves, or is able to access environmentally focused private equity and venture capital funds. The former is incredibly difficult and time consuming, the latter is also difficult and allows the market to limit the amount of capital that can be deployed.

• Debt investing generally is better in that it is again directly impacting companies by financing green projects, ideally at a lower cost than would otherwise be available. However, these projects come with a couple of hurdles; firstly, they take a long time to build (remember efficient deployment of capital is one of our goals) and secondly, are subject to other uncertainties like government permitting and NIMBYism.

Is there a better way?

• The options outlined above are ultimately limited in that they impact only a specific company or project. If we assume the goal for environmentally focused investors is to reduce the overall amount of carbon dioxide emitted into the atmosphere, is there a way to do this across industries?

• In theory, Yes. Thanks to emissions trading markets.

• Emissions trading markets were developed in the 1970s in the United States to tackle the acid rain crisis targeting sulphur dioxide and were, broadly speaking, successful. President Obama attempted to create a similar trading market for carbon dioxide in 2009 but was blocked by conservative lawmakers and the idea did not progress.

• Thankfully, carbon markets fall squarely within the EU’s unique brand of regulatory zealotry and the bloc created the first large greenhouse gas emission trading market in the world in 2005. In addition to the EU; China, the UK, Germany, New Zealand and some US States have all launched similar systems. By 2023, roughly €900 billion was traded across these markets, 87% within the EU system (source: Reuters).

• These markets work on a cap-and-trade basis. They require companies to buy carbon allowances from an authority for each ton of their greenhouse gas emissions. Typically, some allowances are given for free, while additional allowances are auctioned to the highest bidder. The total amount of allowances in a jurisdiction is capped, so the authority has total control over the aggregate level of emissions. By controlling the number of allowances, the authority can set a path to lowering emissions by issuing fewer and fewer allowances.

• An investor could then step into the shoes of an emitter and buy carbon dioxide allowances directly from the emission trading market which would have a direct impact on emissions across all industries in the jurisdiction covered by the markets.

• By buying up the supply-constrained physical carbon allowances an investor could increase the price of carbon for all other actors. This has the double benefit of directly preventing carbon emissions and also by driving up the cost of emitting. Therefore, the benefits for emitters across all industries to innovate and lower their carbon footprint become greater.

• Within the EU’s system, it is also the case that when allowances go unused, the future supply of allowances decreases so our hypothetical buyer is getting even more bang for their buck.

The Catch

• The catch, and why investors are not following this approach, is that there is no return on invested capital. The purchase of allowances is a pure cost, making the practical application of this strategy difficult.

• Like other commodities, carbon does have a futures market where investors can buy derivatives, which can have an indirect effect by increasing the price of carbon allowances and therefore the cost of emitting, but it does not reduce emissions in the same manner as physical purchases do.

Summary

• Last March, Netflix released an adaptation of The Three-Body Problem, one of the most successful Chinese novels of the 21st century by author Liu Cixin. Without spoiling what is a great novel and reasonable adaptation, one of the major antagonists is a radical environmentalist with unlimited funds.

• As it’s a piece of fiction, the character in question combines their wealth and radicalism into a Bond villain type doomsday plan to ‘save’ the planet which the heroes must stop.

• For radicals both fictional and real, physical carbon hoarding might be a legitimate strategy but for those interested in helping the planet and earning a reasonable return there is no panacea when it comes to ESG investing. While many approaches exist, none are without their challenges.