By Dáire Dunne, Portfolio Manager, Wellington Management
In emerging markets (EMs), climate-related risks could hamper economic development, jeopardise human health and devalue capital assets. Physical climate risks such as heat, droughts, supernormal rain events, water scarcity and poor air quality have already created systemic problems for many EMs. At the same time, transition risks stemming from changing policy and regulations can pose financial headwinds, particularly for carbon-intensive industries.
Many innovative EM companies are developing products that help society adapt to climate change, or by shifting business models and corporate policies to mitigate the risks. Here, I outline investment opportunities and challenges and provide a framework for incorporating climate-related themes into an EM portfolio.
Why climate is a concern for EMs
Wellington’s work with Woodwell Climate Research Center (WCRC), the world’s leading climate-research institute, confirms that EMs face significant risks from increasing temperatures which exacerbate weather volatility, water scarcity and droughts. According to WCRC projections, within the next few decades, many developing countries will experience multiple additional months with average daytime temperatures over 35° C (95° F). Our work shows that major agricultural-production regions in China, India and Brazil will contend with lethal heat waves as well as greater potential for floods, droughts, and year-over-year rainfall variability.
To make matters worse, across EMs, low income levels and ageing infrastructure can exacerbate — or accelerate — the physical effects of climate change. Low levels of air conditioning penetration, hot, crowded cities, prevalence of outdoor labor and agriculture and construction, the use of paving and rail materials that are vulnerable to extreme heat are all risk factors.
Positive change creates investment opportunities
As daunting as these issues are from a macro perspective, we believe it is a mistake to assume that EMs will be poor investments over the next decade because of climate change. On the contrary, we believe EMs may be fertile ground for active managers willing to do the work of understanding climate change and identifying potential opportunities and challenges. Policies, regulation, and incentives are in place to lower carbon emissions, improve energy efficiency and energy security and build sustainable, climate-ready infrastructure. While these may present financial hurdles, they can also encourage innovation, and they will almost certainly result in dispersion.
- China is expected to account for over 40% of the total clean energy mix by 2022 and is currently the global market leader in hydropower, bioenergy for electricity and heat and electric vehicles.
- In 2018, Vietnam, South Africa, Mexico and Morocco had a combined clean energy investment of US$16 billion, accounting for almost half of EMs’ total investment — excluding China, India and Brazil.
- India has reduced its annual C02 emissions by 38 million tonnes, mainly with energy-efficient appliances and the provision of clean cooking fuel to 80 million households.
Framework for investing: climate adaptation and mitigation
As active managers, we aim to invest in companies we believe will outperform EM benchmarks and avoid those we believe will lag. Traditional EM indices are still heavily weighted towards carbon-intensive industries, which may be tested as priorities shift to ensure a sustainable, lower-carbon future. At the same time, companies addressing climate change (or are carbon-advantaged) and thus may be relative outperformers remain underrepresented in EM indices.
We see two groups of potential climate beneficiaries: companies that help society adapt to physical changes, and those that help mitigate transition risks. Two adaptation themes that interest us are smart agriculture and cooling solutions.
Smart agriculture
Amid land loss, water scarcity and labour-health concerns, some EMs are focused on the mechanisation of agricultural production and postharvest operations. While agriculture is 95% mechanised in the US, for example, just 40% of India’s agricultural production is done mechanically.
In my view, empowering smallholder farmers through access to agriculture technology can help enhance productivity and resource efficiency. Here, our opportunity set includes companies investing capital and developing solutions for drought-resistant crops, healthier livestock, crop-protection technology and agricultural-productivity enhancements.
A cooler future
I expect air-conditioning demand among EM households and businesses to increase. White goods and industrial-cooling systems companies that can supply affordable, energy-efficient products may do well. Building products such as low-emissivity windows and installed solar-generated cooling systems also have potential, in my view.
A company in our opportunity set develops underground cooling systems called district cooling. According to the company, approximately 70% of the energy consumed in the Middle East during summer months goes to cooling. District cooling has been found to be more energy efficient and cost effective and produce fewer carbon emissions than traditional infrastructure-cooling systems. With Middle Eastern states heavily reliant on fossil fuels, lowering the region’s energy requirements will likely have a material positive impact and significantly reduce emissions.
Mitigating transition risks
I believe companies that successfully flex and navigate regulatory and policy changes may also be relative outperformers. Reducing emissions or shrinking carbon footprints via efficient use of resources, recycling efforts and waste management may be advantageous relative to industry peers that fail to take those steps. Two themes to watch are environmental consciousness and energy efficiency.
Environmental consciousness
Social pressures to address air pollution, water scarcity and food security will require aggressive policy responses. At the same time, carbon-pricing initiatives will lead to greater focus on emissions reductions. Investment opportunities include wind and solar power generation, water and waste management, electricity infrastructure and coal-to-gas transition.
Beijing, for example, strives to be coal-free by 2020, and many Chinese provinces are looking to eliminate coal used for heating. With the government championing a transition from coal to gas cross northern China, we believe companies that can supply natural gas — a cleaner, safer alternative to coal — may be well positioned to benefit from this tailwind.
Energy efficiency
Policy is also increasingly geared towards reducing energy-use intensity. The transportation, construction and manufacturing sectors are the largest energy consumers. We believe companies that help reduce the energy intensity of products, services or processes may be secular beneficiaries. Some examples of aligned investment opportunities include battery manufacturers, electric-vehicle component manufacturers, natural-gas distributors and electric bikes.
The global market for electric scooters and bikes is 40 million units per year, with 30 million sold in China alone5. The Chinese government has lent significant policy support for lithium-ion-powered scooters, in part by mandating weight and speed limits to which all of China’s 200 million bikes need comply by 2022. Companies working to innovate and supply lithium-ion two-wheelers and batteries are squarely in our opportunity set.
5 Statistica, 2020; United Nations Department of Economic and Social Affairs, 2019.
Conclusion
While investors may assume they should avoid EM investments because of climate change, we believe a better approach incorporates considerations around climate adaptation and mitigation within the investment process. Policy and incentives may create more flexible, sustainable macro economies and encourage innovation from the private sector to help combat climate change. In my view, like every structural theme, climate change causes market dislocation and presents investment opportunities and challenges that active investors ignore to their own detriment.
For more information please visit www.wellingtonfunds.com/sustainable-investing or contact:
Dennis Kwist +44 20 7126 6107 | drkwist@wellington.com
Therese Axelsson +44 20 7126 6603 | taxelsson@wellington.com
Diana Nilausen +44 20 7126 6575 | dnilausen@wellington.com
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