Sustainability, and the US withdrawal from the Paris Agreement

Written By: Martin Grosskopf Vice-President & Portfolio Manager AGF Investments Inc

& Hyewon Kong Associate Portfolio Manager AGF Investments Inc

& Jonathan Lo Vice-President & Portfolio Specialist, North American & International Equities AGF

Martin Grosskopf, Hyewon Kong and Jonathan Lo of AGF Investments look at the issues surrounding climate change, and carbon emissions in particular

By now, there have been any number of opinions published on the topic of President Trump’s announcement to pull the US out of the Paris Climate Change Agreement. Our objective with this piece is to discuss our opinions as they relate to the investment implications that have received little focus so far.

It’s not only about carbon
To state the obvious, or perhaps not so obvious, is the significance that the Paris meeting had in reversing the pessimism that accompanied Copenhagen eight years before, though not in the national pledges themselves, which remain voluntary. As many commentators have pointed out, it is highly unlikely that these voluntary pledges will result in emissions reductions that would limit global warming to two degrees and certainly not the stretch target of 1.5 degrees.

Investors must realise that the most pressing emissions for many countries are not carbon – with its global footprint – but nitrous oxides, sulphur, particulate matter and, to some extent, mercury. When released, these emissions have a profound local and regional impact on health – an incredibly important distinction in the current political climate.

We have written and spoken before about a “tyranny of carbon” whereby investors are increasingly fixated with the long-term implications of an emission that, because it is used by plants, does not immediately seem particularly worrisome to most people. We have also highlighted that a sole focus on carbon has resulted in misguided adoptions of diesel vehicles in Europe, resulting in a decline in local air quality (witness recent bans on certain diesel vehicles in Paris and London and the Bundesrat’s proposal to ban diesel passenger vehicles in Europe by 2030). We should be aware by now that Volkswagen is a symptom of a problem, not the cause.

Investors wanting to show action on carbon have perpetuated the growth of carbon-reduced products, which often superficially provide a “win/win” scenario: reduced carbon and a reasonable deviation from the benchmark. It is highly unlikely that these products will direct capital into the solutions that will be required to actually reach the Paris Agreement’s targets, given that they are inherently riskier and often “off benchmark” at this stage of their adoption.

The politics of populism will limit concerted global action on carbon
It has become increasingly clear that the trend towards economic liberalism has, at the least, experienced a pause, and at worst is in serious retreat. When President Trump supporters speak of cosmopolitan elites or the Davos crowd, or Marine Le Pen supporters highlight the distinction between globalists and patriots, they speak of the same thing. Climate change, as the most global of environmental issues, is also most linked to measures of economic well-being. This limits its appeal within poverty-stricken countries, but we are learning it also limits its appeal within affluent countries that have emancipated middle-classes. For those who have not benefited economically by globalisation, one can expect their support to be directly related to an improvement in their situation.

Figure 1: US unemployment rate vs. how much Americans worry about global warming

Source: Gallop, U.S. BLS, Barclays Research, as of January 2017

Investors as economic actors may well be unsuited to untie this Gordian knot – self-awareness would be a first step. For 20 years a relentless focus on margin improvement has hollowed out the developed world middle-class, while benefiting the poorest in China and elsewhere (see Figure 2). Profit maximisation for the declining segment of society that owns shares, as opposed to investment in labour and capital, is a fertile bed for the growth of populism and economic nationalism. The steady progress and support for global environmental issues within Western democracies over the last 40 years may be less predictable as they mature. In juxtaposition, it is no surprise that China now seeks serious improvement in environmental quality (and leadership in clean technology) as its population has become somewhat better off economically.

Figure 2: Change in real income between 1988 and 2008 at various percentiles of global income distribution (calculated in 2005 international dollars)

Source: Stifel Nicolaus, as of December 2016

Believing that the trend in populism is an aberration is inaccurate, and its impact on climate change action may continue to be profound.

Investors need to eat their own words on materiality
In reality, investors do not gain or lose from climate change nearly as much as many other factors, such as interest rates, oil prices, currency, etc. Prices on carbon are not yet at the level or extent to dramatically reduce emissions, nor impair the business models of many companies. That many large emitters disagree with some of their shareholders on the extent of future action on carbon by pricing it highly enough to reach reductions that would result in a “two degree” scenario is, in the face of growing populism, a reasonable position. There is some irony in the efforts directed at debating the value of future reserves while stranding capital in diesel technology in the present.

The logic is only clear when one considers that the cashflow from even the highest cost carbon sources, such as the oil sands, can be attractive at current oil prices given the sunk costs. When investors speak of investing for the long term they tend to mean protecting current cashflows into the future – not investing heavily to transition an economy to cleaner sources of cashflow. This is a risk minimisation strategy and is entirely different from one that is innovation-driven. Yet from an environmental impact standpoint, what you make is as important as how you make it.

Local governments and corporate entities are the current agents of change
Companies, cities and states who view themselves as progressive will continue to drive action towards low emissions energy. From the Technology sector and Industrials through to Materials and consumer sectors, green branding is accelerating, as is the desire to hire staff who are motivated by these corporate objectives. Local governments want to maintain high standards of air quality and attract high-growth, progressive companies.

As a result, investments in renewable power or energy efficiency have as much to do with cost reduction, local air quality concerns, green branding and supply diversification than with carbon, per se. For investors it is the “trend that is your friend”. Each of these factors provide viable, profitable investment opportunities today that reduce all emissions – including carbon.

Defining opportunities
We take a pragmatic view of sustainability issues – investing in solutions in the present, but with a hopeful eye on the future. The Trump administration’s step back from the Paris Climate Change Agreement dims the prospects of its success as an agreement, but it does not in our view dim the sustainability themes underlying it. It is, however, a wake-up call for sustainability investors. Linking emissions reductions to other pollutants will be critical in making progress on carbon as they are, in much of the world, more pressing. In many cases, companies with solutions in water, waste, energy or food and healthy living have corporate drivers that are immediately investable and tied to local needs and aspirations. In other words, they have momentum to which serious global action on carbon will only be additive.

An approach of investing in solutions-providers sounds simple, but it isn’t – not when we expect the same level of returns as those from a conventional portfolio. Holdings must demonstrate an ability to generate returns in today’s economy while being equally relevant to tomorrow’s, to meet the return expectation of the average investor.

The big issue of today – linking economic profit, the health of workers and sentiment towards environmental action is one on which passive strategies will, by nature, remain silent. Whether active money can find an appropriate level of shareholder profit while ensuring economic progress for the bulk of society is really the largest of investors’ sustainability questions. Certainly serious progress on climate change will be integrally linked to the answer.

The commentaries contained herein are provided as a general source of information based on information available as of June 16, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and / or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA).

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AGF International Advisors Company Ltd., its employees, directors or related companies, may have a shareholding / be a director in the securities (or related investments/ derivatives) of certain companies covered in this report, or may provide/ solicit investment banking or other services to/ from them. It is noted that the Institutional Sales Representatives compensation is impacted upon by overall firm profitability and accordingly may be affected to some extent by revenues arising other AGF business units including AGF Investments Inc. and InstarAGF Asset Management Inc. Notwithstanding, AGF International Advisors Company Ltd. is satisfied that the objectivity of views and recommendations contained in this report has not been compromised.

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Published Date: June 16, 2017