2024 Should Be the Year of the “Transition Plan”

Simon Hallett, Head of Climate Strategy

Last year we forecast that net zero–oriented investors would shift from portfolio decarbonization toward driving real world change. As they do so, the hunt is on for data that can help them prioritize their effort, for example tracking whether companies have aligned their business plans with net zero by setting science-based targets (SBTs).

More and more companies are setting SBTs, but they may not be the right companies; it is easier to set an ambitious target if your core activities are not emissions intensive to start with. What really matters for the climate is that the most emissions-intensive companies adopt SBTs. A key portfolio metric is not what portion of companies have SBTs but what portion of emissions come from those companies.

The aggregate data are striking: 39% of MSCI ACWI market value is represented by companies that have set SBTs, but these companies represent only 19% of index emissions. The vast majority (81%) of emissions come from companies with no plans to align with net zero. We, therefore, expect to see investors increasingly prioritize persuading their highest emission holdings to adopt SBTs.

Setting targets is one thing; delivery is another. As more companies set SBTs, investors will then want to hold them accountable for executing a credible strategy—a
“transition plan”—to deliver their targets. Transition plans are not the same as SBTs but will explain how those targets will be met. The International Sustainability Standards Board, the United Kingdom’s Transition Plan Taskforce, and Glasgow Financial Alliance for Net Zero are advancing a standard for transition plans and cooperating closely with one another to ensure inter-operability. These will give investors the opportunity to judge companies by the credibility of their plans.

We expect 2024 will see more companies setting SBTs, including a growing portion of the higher emitters. This will be accompanied by those same companies starting to publish transition plans. Investors will start to evaluate those plans and incorporate them into investment decisions using good old-fashioned fundamental analysis.

California Carbon Allowances Should Outperform Global Equities in 2024

Celia Dallas, Chief Investment Strategist

In 2024, we expect supply of California carbon allowances (CCAs) to decline and demand for such allowances to recover. In late July, the California Air Resources Board (CARB) made it clear that it expects to reduce CCA supply to meet the state’s 2030 emission reduction targets. Furthermore, demand for CCAs is expected to improve in 2024. Such conditions reinforce our recommendation to overweight CCAs relative to global equities, as carbon pricing is driven by supply and demand dynamics.

Cap-and-trade programs seek to reduce carbon emissions by putting a price on carbon and requiring covered entities to purchase allowances to offset emissions. The most attractive time to invest in these markets has been as supply starts to fall short of demand, pushing up prices. The California cap-and-trade program budgets a 4% annual CCA supply reduction. CARB’s review revealed that it would need to reduce CCA supply by 7.7% annually from 2025–30 to meet its current 2030 emissions reduction target of 40% relative to 1990. Should CARB raise the bar to a 48% reduction, as some analysts think is likely, supply would need to fall by 11.1% a year.

The magnitude of proposed cuts surprised investors, propelling CCA prices 11.4% between late July and its November 16 peak. CARB expects that tightening supply will push up prices and will likely increase price containment and price ceiling levels that exist to slow down the pace of price increases. The program is expected to be in deficit this year. The expected supply cuts will also draw down the cumulative excess supply relative to demand.

Demand for CCAs is tied to economic growth and progress in transitioning the economy away from carbon. Late 2022 and early 2023 data for the state are consistent with recessionary conditions of falling employment, incomes, and consumer spending. While it is unclear when conditions will recover, weak demand will simply slow down the pace of CCA supply tightening relative to demand, not eliminate it.

Fundraising by Natural Capital Strategies Should Hit a Record High in 2024

JP Gibbons, Senior Investment Director, Sustainable & Impact Investing

Natural capital strategies support land-based investments in sustainable agriculture and forestry, oceans and fresh waters, and other ecosystem services. These investments support a healthier planet and are needed to fight climate change. We expect fundraising for natural capital investment strategies will hit a record level in 2024 due to government and public demand, which continues to strengthen the opportunity set.

Government policy, particularly in developed markets, is creating attractive investment environments. A new framework adopted by 196 countries at the 2022 United Nations Biodiversity Conference put forth several ambitious environmental commitments, complementary to the climate change goals of the 2015 Paris Agreement. Targets include the restoration and protection of 30% of the earth’s land and sea, substantial reductions in harmful subsidies for agriculture and fishing, significant financial support to developing countries, and new reporting requirements regarding corporate influence on nature. Changes in policy should follow to stimulate momentum toward the commitments and create favorable investment opportunities.

Additional momentum has come from the general public’s demand for healthier food, cleaner waters, and thriving natural landscapes. Particularly in jurisdictions where regulation is opaque, the private sector has filled the gap through market-based tools that influence business decisions toward nature-positive projects. Feeling the urgency to act, responsible corporations have bolstered mechanisms through investment in voluntary carbon and biodiversity credits, water conservation, and organic premiums.

Recognizing the value of nature is not a new concept, but until recently it wasn’t clear how to monetize that value. These are still early days for natural capital investments, and challenges (i.e., measurement and valuation) need to be navigated. However, investment in the sector—estimated at $3 billion per year in 2022 according to the United Nations Environment Programme—is realizing significant growth, boosted by tailwinds like regulation and market demand. Managers are converting more traditional strategies to nature positive and identifying new investment themes. Investors are leaning into the favorable investment environment while mitigating exposure to nature-related risks. The amount of investment dollars raised for natural capital will grow significantly from years past as the world recognizes the need and value in protecting our natural resources.

The post 2024 Outlook: Sustainability & Impact appeared first on Cambridge Associates.

Defining Stewardship and Engagement
As defined by the UK Stewardship Code, Stewardship is the responsible allocation, management, and oversight of capital to create long-term value for investors leading to sustainable benefits for the economy, the environment, and society. Engagement puts stewardship into action—it is purposeful dialogue with a specific and targeted objective, according to The Investor Forum. Engagement is a meaningful part of investment activity and a means for fiduciaries to promote accountability.

Engagement and Net Zero Policy Goals

In a net zero context, the objective of engagement is to align company business plans with the Paris Agreement objective of a 1.5-degree Celsius scenario, beginning with decarbonizing the real economy through investing in transition assets and establishing credible transition plans and science-based targets. Engagement is an essential element of a net zero investment policy, which clearly articulates net zero goals and provides framing for priorities, investment manager selection, and engagement.

An engagement policy should include setting expectations of its investment managers’ approach to engagement, proxy voting, and escalation. An escalation policy outlines general steps for increasing engagement with a manager or companies to promote behavior change and its general timeline to assess developments before determining whether to dissolve the relationship. With these policies crafted, investors have a road map to engage more deeply in net zero, both with existing and prospective investment managers (Figure 1). The Appendix lists some resources available to help asset owners on their engagement journey.

Strategies for Deeper Engagement

Investors should determine their capacity for climate engagement and decide what potential approaches best fit their team as part of their theory of change, especially as some engagements can be multiyear efforts. Investors can use various engagement methods. Figure 2 outlines the three major approaches.

To start, investors and their advisers should understand what they already own by reviewing their investment managers and portfolio holdings and evaluating whether they are aligned with a net zero pathway. This should include a review of each manager’s net zero and engagement policies and practices. Investment managers need a strong ability to assess an investment’s net zero activities to accurately price a company’s alignment. Investment managers can drive change by interacting with non-aligned investments and staying invested in high-emitting sectors as active shareholders, thus encouraging a shift toward sustainable practices. Managers with strong engagement practices will have a clear thesis on the materiality of engagement topics such as net zero, a well-equipped engagement team that contributes to the work of investment teams, a clear strategy for engagement escalation and proxy voting with associated milestones, transparent reporting to investors, and an outcomes-based focus that recognizes the long-term nature of engagements for meaningful change.

After a review, an investor can then easily prioritize investments to engage with. Examples include engaging with managers where there is the greatest exposure to non-aligned or non-transitioning assets, or engaging with managers that do not have a strategy for their portfolios to be aligned with net zero objectives by 2050.

Engage With Investment Managers

When engaging with managers about net zero, investors have an important opportunity to convey how a net zero strategy can help enhance returns given the systemic risks and rewards in a transitioning world. This communication can come in the form of written letters and meetings to discuss a manager’s plan (or lack thereof) to engage with and align portfolio companies with a net zero pathway. If managers do not show adequate action over a reasonable amount of time, an escalation policy might come into play.

Engaging with passive index providers is as important as engaging with active investment managers, particularly as systemic climate change risks materially threaten market-wide returns (i.e., beta). Index providers cannot diversify away from systemic risks and can only address systemic threats by effecting real world change. Indexes are therefore effectively “universal” owners in what protects the long-term health of the system as a whole to preserve long-term returns.

These efforts are most applicable to marketable securities. But private investments also play a significant role in achieving net zero goals, whether by funding climate solutions or funding net zero–aligned high-growth companies that will be the industry leaders of tomorrow. General partners have a high degree of influence over portfolio companies and therefore a particular responsibility to achieve positive outcomes via engagement, as part of their wider value enhancement activities. Investors should allocate capital to managers with a clear playbook to limit climate risk and reduce carbon intensity across their value chain. The Initiative Climat International’s (iCI) Decarbonisation Roadmap and the Institutional Investors Group on Climate Change (IIGCC)’s Net Zero Investment Framework for the Private Equity Industry provide a clear pathway toward assessing, setting targets, and engaging in net zero alignment. Again, making sure that an investor’s net zero objectives are clearly communicated to investment managers should help ensure better alignment across a portfolio, while sending an important signal to the wider private market community.

Engage Directly or Through Collaborative Initiatives

Direct engagement with company management, either individually or through peer coalitions, is another viable approach. If seeking to engage with companies, the IIGCC’s Net Zero Stewardship Toolkit is a useful resource to develop an approach. However, engaging with companies individually can be time consuming, and specific expertise and dedicated staff resources are required to manage and implement the engagement. Many investors find it simpler to work with collaborative investor coalitions that help coordinate, reduce duplicative efforts, and frame the engagement process on behalf of investors. Research shows that such collaborative initiatives positively contribute to the effectiveness of engagements over environmental, social, and governance (ESG) topics. By joining wider coalitions, investors can leverage collective bargaining power and create broader visibility of issues. There are a range of organizations (e.g., Interfaith Center on Corporate Responsibility, UN Principles for Responsible Investment, Climate Action 100+, IIGCC) for investors to join and take action together. Engagements through these groups can include lower touch actions such as signing onto joint letters (groups such as Nature Action 100, IIGCC Net Zero Engagement Initiative, and ShareAction facilitate these). Higher touch engagements can include leading or co-leading a deeper discussion and engagement with a company typically held over a 12-month period. Figure 3 outlines a wide range of actions an investor can pursue, including ways to leverage shares through coalitions. Investors cannot engage with every holding, so it is important to prioritize initiatives that focus on portfolio components with the highest emissions reduction potential and that may be under-engaged by other investors.

Collaborative investor groups also engage on industry-specific and national regulations in favor of policies which support systems-level net zero alignment, such as mandating emissions disclosures, removing subsidies from polluting industries, and creating set guardrails and targets consistent with net zero. Engagement here should focus on the largest cost and regulatory barriers hindering the pace of private sector action.

Employ a Third-party Service for Engagement Support

Investors can focus their engagement capabilities by hiring third-party services to perform engagement and/or voting services. Investors can specify their climate priorities, engagement preferences, and voting predisposition from the provider’s options to be executed by the overlay service that takes over responsibilities from the asset manager. Outsourcing can be simple, but expensive to execute. We instead encourage asset owners to select managers that are aligned on net zero objectives in the first instance. However, overlay services may suit investors who prefer to select and invest directly into listed equities through separately managed accounts and do not have the staff to manage engagement and voting activity, as opposed to investors who invest through selecting asset managers.

Case Studies

Asset owners can use multiple tools and approaches to engage for climate objectives. Here are three illustrative examples of global asset owners engaging in net zero in different ways and levels of engagement with multiple beneficial outcomes. Each asset owner’s effectiveness came from persistence in their multiyear efforts and a focus on accountability from their investments.

As evidenced in the case studies, climate-related engagement can yield significant positive outcomes, and there are multiple ways of engaging depending on an investor’s capacity and resources. Engagement programs and relationships with investment managers take time to establish, and meaningful outcomes can be the fruit of multi-year processes. But it can start with an action as simple as endorsing a letter through a collaborative engagement group or writing to a manager for greater insight on their net zero engagement practices. As asset owners become more comfortable, more tools can be added to a suite of actions.

Conclusion

Engagement is the opportunity for investors to bring their voices to the table and practice their fiduciary responsibility to participate actively in the global effort to reduce real world greenhouse gas emissions. If left unabated, these emissions will result in catastrophic impact born from physical and transition risks, which pose significant, underpriced dangers to the global economy, the global financial system, asset values, and, ultimately, portfolio returns.

The financial materiality of the climate crisis requires fiduciaries to protect their portfolios from the risks presented by climate change, while investing in opportunities to transition to a low-carbon economy. ² Collective participation is needed, and accountability mechanisms are important. As shown through the case studies, asset owner participation can be a powerful voice to encourage climate risk disclosures and align portfolios on the net zero pathway. Engagement is an imperative toward positively impacting the real economy and protecting portfolios. ³

Deborah Christie, Managing Director, Public Equities

Marie Ang, Investment Director, Sustainable & Impact Investing

About Cambridge Associates

Cambridge Associates is a global investment firm with 50 years of institutional investing experience. The firm aims to help pension plans, endowments & foundations, healthcare systems, and private clients implement and manage custom investment portfolios that generate outperformance and maximize their impact on the world. Cambridge Associates delivers a range of services, including outsourced CIO, non-discretionary portfolio management, staff extension and alternative asset class mandates. Contact us today.

Appendix

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post Strategic Investor Engagement: Driving Stewardship for a Net Zero Future appeared first on Cambridge Associates.

Even with some near-term headwinds, we see opportunities in private equity and venture capital (PE/VC). As with broad markets, climate tech PE/VC is facing slowing deal activity and exits in a higher rates environment. Higher financing costs and elevated valuations may weigh on future round financings and exits in the near term, particularly for earlier-stage hardware climate tech companies that have a longer runway to profitability. However, overall investment activity should gradually recover as climate tech PE/VC funds look to deploy a significant amount of dry powder, and as recent policy developments support the opportunity set. Climate tech VC funds target mid/high double-digit returns by focusing on early-stage companies in areas such as software, battery/storage technology, commercial transportation, renewable fuels, and solutions for complex industrial challenges (e.g., cement and steel production). Less crowded areas, like hardware climate technologies, offer higher scalability and potential payoffs, but require dedicated expertise in the fields of technology, engineering, manufacturing, and project finance.

Private infrastructure funds focused on the energy transition provide the largest opportunity set. Smaller infra funds will invest in areas that overlap with PE, like scaling solar developers and electric vehicle infrastructure, given double-digit return targets, while larger funds with lower, more predictable, return targets may focus on acquiring power assets with long-term revenue contracts in place (and related storage plays). Infrastructure funds benefit from the investment scale needed to meet net zero goals, but face headwinds, including rising competition for assets, higher financing costs, and difficulties with everything from supply chains (e.g., IRA requirements) to delays in grid connections. One result is that even some large infrastructure funds have broadened their focus from renewable power projects to utility-scale storage and renewable energy installation and financing for the residential sector. Investors looking at managers allocating in these markets should consider skill sets (including technical, regulatory, and financial), sourcing abilities, and public market trends, as some energy transition plays have struggled to perform (in part due to initial public offerings executed at high valuations).

Like PE, performance in public equities addressing the energy transition has been volatile and valuations for renewables, and especially tech-oriented energy transition plays, are elevated. However, public equity managers focused on the energy transition typically cover a broad array of securities in businesses ranging from renewable utilities and renewable equipment to energy efficiency, advanced materials, software, agriculture, and the circular economy. The companies themselves may participate in a mix of activities but tend to meet some threshold of green revenues. A key consideration when investing in public securities is that much of the industrial sector will need to adapt their business models over time to a low-carbon future. Managers that engage with portfolio companies to understand, support, and hold them accountable for realistic climate reduction strategies should unlock value in portfolio holdings over time.

There are also investment opportunities related to green metals (e.g., copper, cobalt, lithium) via commodity futures or mining stocks. However, there are near-term risks to consider. Many of these metals are highly sensitive to the global business cycle; demand for industrial metals may soften if China sees a secular shift from an industrial-led to a services-driven economy; secondary supplies may increase with further investments into metals and battery recycling; and higher prices may drive development and use of alternative battery technologies to reduce critical mineral dependency. As such, another way to address this idea is with investments in battery recycling, alternative battery, and mineral extraction technologies.

The investment opportunities and the disruptive forces the energy transition brings will create plenty of winners and losers that require investor focus. We expect investors with a deliberate and thoughtful plan to invest in the transition across the risk/reward spectrum will be rewarded.

Celia Dallas, Chief Investment Strategist

Wade O’Brien, Managing Director, Capital Markets Research

Vivian Gan, Associate Investment Director, Capital Markets Research

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post Is Now a Good Time to Invest in the Energy Transition? appeared first on Cambridge Associates.

Join us as we visit Joby Aviation out in Marina, California to witness their eVTOL (electric vertical take-off and landing) aircraft take flight. With plans to operate like Ubers in the sky, eVTOLs are the closest thing we have to flying cars—and they could be a commercial reality by 2025. The companies creating them promise a faster and greener mode of transportation, but who’s investing in them? Are they safe? And how will they change our transportation infrastructure?

We’ll discuss these questions and more with Eric Allison (Head of Product at Joby Aviation); Andrew Beebe (Managing Director at Obvious Ventures); and Doug Carlson and Alex Innes-Whitehouse (pilots affiliated with Cambridge Associates).

Listen now to Unseen Upside: Investments Beyond Their Returns.

Read the transcript

Please note that as of August 29, 2023, Stitcher has been discontinued.

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post eVTOLs & Flying Cars appeared first on Cambridge Associates.

That’s what the scientists and engineers at Colossal Biosciences are working towards: reversing extinction. Using CRISPR and advanced gene editing techniques, they plan to bring back the woolly mammoth and the dodo bird to help reverse the impacts of climate change and complement existing conservation efforts.

Join us for this podcast episode of Unseen Upside: Investments Beyond Their Returns, where we discuss this topic with Ben Lamm (Colossal Biosciences); Tom Chi (At One Ventures); and John Calvelli (Wildlife Conservation Society).

Listen now to uncover the Unseen Upside.

Read the transcript

Please note that as of August 29, 2023, Stitcher has been discontinued.

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post CRISPR, Dodo Birds, Woolly Mammoths, & Gene Editing appeared first on Cambridge Associates.

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post 2022 Diversity, Equity, and Inclusion (DEI) Report appeared first on Cambridge Associates.

Commonwealth Fusion Systems is on the brink of delivering commercial fusion energy thanks to their revolutionary magnet. But how does a safe, limitless, carbon-free, fusion power plant operate? What does it look like? How and when will this technology be replicated to meet the world’s energy needs?

In this episode of Unseen Upside: Investments Beyond Their Returns, we’ll learn more from Bob Mumgaard (Commonwealth Fusion Systems); Katie Rae (The Engine); and Theresa Hajer (Cambridge Associates).

Listen now to uncover the Unseen Upside.

Read the transcript

Please note that as of August 29, 2023, Stitcher has been discontinued.

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.

The post Will Fusion Power (or “Stars in a Jar”) Replace Fossil Fuels? appeared first on Cambridge Associates.

Whether we crash into a recession remains to be seen, but if history is prologue, market downturns would disproportionately harm communities already struggling to stay afloat. Now is not the time to turn back. Adopting a more disciplined approach to investing for social and environmental equity (SEE) can help investors minimize portfolio risk and maximize impact, even during flagging markets. In this paper, we review the momentum experienced in sustainable and impact investing (SII) and the historical relationship between global recessions and inequality. We then explain the rationale for staying the course during turbulent times, and introduce a framework designed to help investors produce better financial and impact outcomes in any market cycle.

Part I: Risk-Off Sentiment Threatens Momentum in Social & Environmental Equity

According to our 2022 biannual client survey, 65% of institutions had actively engaged in SII and environmental, social, and governance practices, a 29-percentage point increase relative to the 2018 response. The primary drivers of increased uptake are better education around the opportunities and risks of sustainable investing, increased clarity around clients’ mission priorities (and ways to express those views in portfolios), as well as growth of strong performing and aligned investment options. Additionally, social and/or environmental equity were among the top priorities for sustainable and impact investors surveyed, with one-third of respondents making impact investments across three or more impact themes. These results draw in sentiment from 2020, which shined a spotlight on widespread social and economic disparities impacting marginalized communities and compelled investors to focus more on the interconnectedness of social and environmental themes.

Despite this evolution and recent momentum, there’s still risk of investors pausing or even reversing course on investing for SEE amid a critical time for marginalized communities. During heightened market volatility and falling market returns, availability and recency biases tend to lead to decreased risk tolerance and a race to implied safety. Some investors might consider investing in sustainable and/or impact themes to be too risky. Worse yet, sustainable investing initiatives can be labeled as “idealistic” or “ancillary” despite the materiality of SII factors.

Economic downturns accelerate the pace of economic and social inequality, according to a recent study conducted by the Bank of International Standards (BIS), ⁴ which found that, on average, income inequality grew twice as fast during recessions. Contractionary periods exacerbate a wide variety of social indicators—from job insecurity and health outcomes to generational wealth distribution—while stoking uneasiness among the very investors that want to effect positive change at the same time. This perfect storm of macroeconomic factors and investor sentiment threatens progress made on SEE over the past several years. Still, turbulent markets are not the time to steer away, but to forge ahead.

Part II: A More Disciplined, Intersectional Approach Can Help Minimize Risk and Maximize Positive Impact

A Framework for Stable and Volatile Times

In Social Equity Investing: Righting Institutional Wrongs (2018), we define social equity investing as “investments to promote equal opportunity and access for all, regardless of background.” The SEE framework is a natural evolution of our investment approach, overlaying the following three-step process:

1. Rigorously assessing each investment manager’s alignment with SEE themes and categorizing them on a spectrum of SEE alignment; ⁵
2. Mapping managers based on their investment strategies against a five-stage thematic pyramid; and
3. Executing an engagement program designed to improve alignment of managers that are weakly aligned with SEE and explore new opportunities.

This approach addresses myriad pain points we have uncovered. These include the association of social equity investing with lower or concessionary returns, a failure to acknowledge the intersectionality ⁶ and interconnectedness of sustainability and impact issues that result in siloed portfolio approaches, and inaccurate language used to describe and define social equity—particularly the conflation of broad social and racial equity with diverse manager investing.

The SEE framework’s five-stage pyramid (Figure 1) is inspired by a well-established theory in psychology, Maslow’s Hierarchy of Needs, and offers a more disciplined, clearer, human-centered approach to investing for SEE.

Investable social and environmental themes—which we view as core to creating an equitable society—are mapped to a hierarchy of needs, rather than a primarily demographic or social lens (e.g., race and gender). The hierarchy provides a visual representation of the relative weight or impact of investing in a particular theme. For example, the base of the pyramid addresses physiological or basic existential needs of all people, regardless of race, gender, or geographic region. We all need clean water, air, food, safety, infrastructure, and affordable and reliable means of getting around to survive. It is important to note that while civil rights and justice themes are also represented at the base of the pyramid—a reflection of their fundamental importance—they are not easily actionable through market rate investable instruments. Instead, we currently see grants and program-related investments (PRIs) as the primary capital source for these themes.

Progressing up the pyramid, we approach more “psychological” or “esteem” needs, which are defined as those that foster greater feelings of acceptance, status, and independence, and go beyond the very basics of subsistence. The apex of the pyramid represents “self-fulfillment” needs that refer to the realization of a person’s highest potential and ability to seek personal growth. Its relative size on the pyramid reflects the limited, albeit growing, grant or PRI opportunities we currently see in arts and culture. Lastly, as illustrated by the arrow ascending the right flank of the pyramid, the framework fully integrates racial and gender equity into every theme and reinforces them—and myriad other forms of equity—at every step. Therefore, racial and gender themes do not lose, but instead, gain prominence in SEE investing.

All told, the approach leaves investors with a clearer way to express their values in portfolios and to visualize alignment of investment managers with portfolio goals and objectives without prescribing the order in which to invest.

Maximize Impact and Enhance Returns With a Systems Lens, Improved Investment Processes and Manager Selection

The framework is designed to help accelerate investment in SEE themes in three important ways:

First, it acknowledges the role of systems in exacerbating inequities and therefore leans into a systems approach ⁷ to support investors in reversing those inequities. It does so by purposefully building in the interconnectedness of myriad sustainability and impact issues and, critically, weaving in environmental equity and climate change as core tenets in our discussion of social equity. A more holistic portfolio approach benefits a wider group of global stakeholders and, if done well, will help to enhance long-term climate, social, and financial resilience of portfolios.

Second, in keeping with our approach to debias the investment decision-making process, the framework explicitly seeks to reframe SEE themes in terms of the universality of human needs. Mapping themes in this way, rather than social constructs (e.g., race or gender), works to reduce the cognitive barriers that trigger implicit biases, restrict fruitful discussion about the intersectionality of themes, and ultimately limit investment uptake. For example, too keen a focus on a specific “gender lens” or “racial lens” can potentially compromise investment processes. This could result in unnecessarily siloed portfolios, which threaten the overall scalability of global impact.

Finally, strong manager selection and diversification are hallmarks of this intersectional approach. Improving the classification of managers that have closer alignment with SEE and enhancing engagement practices with those that are not quite there are pivotal to better outcomes. Sample engagement questions might include:

• How does the firm consider equity and inclusion in the evaluation of prospective investment opportunities and pipeline generation?
• How specifically does your strategy incorporate and promote equitable access for women and marginalized communities within each portfolio company’s long-term strategic plan and operations?

These are challenging questions, but all responses from all managers across all strategies, regardless of an explicit SII focus, are data points that enhance our ability to better classify managers that meet our clients’ needs. The framework defines an SEE investment manager as one that intentionally targets social or environmental equity themes at the strategy level (e.g., supporting diverse entrepreneurs, thus targeting the financial inclusion theme) or through the products and services offered by their portfolio companies.

Leaning into SEE thematic investing may help buffer portfolio performance and mitigate risk, particularly in market downturns, as we believe many industries that align with high-impact SEE themes tend to be less prone to the negative effects of recession. In fact, while recession-era vintages have historically performed well (Figure 2), a deeper look at SEE-aligned sectors exposes resilience (Figure 3). We recognize that many SEE themes overlap with historically defensive sectors, but these are also areas that address fundamental human needs and are ripe for innovation. Managers with high SEE integration are intentionally focused on making better and more accessible products within these industries to address those needs.

Applying the Framework: A Foundation’s Impact Portfolio

A hypothetical scenario brings this approach to life and illustrates how the SEE framework can help improve the ability to select the most aligned managers for long-term portfolio sustainability. This case study consists of only private investments managers, given their unique ability to effect impact more directly through control and influence of underlying portfolio companies.

Applying the three-step SEE approach, each manager in the impact portfolio is initially analyzed to gauge the level of authenticity, intentionality, and materiality of focus on SEE themes. This assessment begins with a rigorous due diligence and manager landscaping process. Next, managers are classified in an easy-to-use stoplight format (red illustrating no material SEE integration and green representing the highest SEE integration) before being mapped to the thematic area in the SEE pyramid that best aligns with their primary investment strategy (Figure 4). The final step is to develop an engagement strategy in partnership with the investor. While all managers are eligible for engagement, those with less than a green classification present the greatest opportunity for engagement around these issues.

The analysis reveals an impact portfolio that is less aligned than intended with their stated racial justice/equity mission. For example, there is a dearth of managers with strong SEE integration (green), presenting an opportunity for further engagement and discussion among investment committee members around their managers’ intentions and true fit in a social equity mandate. Additionally, a concentration in sustainable real assets and climate tech venture capital managers that have minimal SEE integration (orange) is exposed. Finally, the portfolio has strong diverse manager representation, which suggests a keen focus on diversifying managers, but also a potential confluence of diverse manager investing with SEE investing (e.g., red sphere, a diverse manager with no material SEE integration). Overall, this process creates an opportunity to dig deeper into what the investor owns and to find ways to improve the portfolio’s mission alignment through improved engagement and future manager selection.

There is no “one size fits all” approach to building a resilient and impact-forward portfolio. However, leveraging the SEE framework can support discipline, rigor, and more thoughtful implementation strategies across market cycles. We believe there is an existing and growing universe of SEE-aligned managers that have the potential to outperform broad equity benchmarks and to reduce risk because of their integrated focus on improving social and environmental equity (Figure 5).

Conclusion

The SEE framework is designed to induce investment in SEE themes through an intersectional human-centered approach. While we introduce it in the context of economic downturns, it is a useful tool that is applicable in all market cycles and can help investors to reduce bias in the investment process, enhance portfolio construction and unearth new sources of alpha, and mitigate portfolio risk. Risk-averse behavior is characteristically human. Whether in calm or stormy waters, we should batten down the hatches and sail with resolve toward sustainable solutions that address and advance the fundamental needs of all human beings.

Drew Carneal and Caryn Slotsky also contributed to this publication.

Footnotes

1. Rob Bauer, Jeroen Derwall and Colin Tissen, Private Shareholder Engagements on Material ESG Issues, May 31, 2023. And Hoepner, Andreas G. F. and Oikonomou, Ioannis and Sautner, Zacharias and Starks, Laura T. and Zhou, Xiaoyan, ESG Shareholder Engagement and Downside Risk (November 2022). AFA 2018 paper, European Corporate Governance Institute – Finance Working Paper No. 671/2020; and Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015., Fox School of Business Research Paper No. 16-009.
2. See Freshfields Bruckhaus Deringer, “A Legal Framework for Impact: Sustainability Impact in Investor Decision-Making,” UN Environment Programme Finance Initiative, July 2021.
3. IPCC, Sixth Assessment Report, Climate Change 2022: Impacts, Adaptation and Vulnerability, 2023. Bank of England, 2021 Climate Biennial Exploratory Scenario, 2022.
4. Luiz Awazu Pereira da Silva et al., “Inequality Hysteresis and the Effectiveness of Macroeconomic Stabilisation Policies,” Bank for International Settlements (BIS), May 2022.
5. A manager with high SEE integration is one that intentionally targets one or more investable social or environmental equity areas: health/wellness, environmental equity/climate justice, education/workforce preparedness, affordability/physical security, and transportation/sustainable infrastructure.
6. Intersectionality describes the interconnected and overlapping systems of discrimination across social categorizations. The term intersectionality was coined by Kimberlé Williams Crenshaw in 1989. An intersectional approach to investing, similarly, acknowledges that certain risks and opportunities are interconnected and cannot be separated. Investors that pursue an intersectional approach within their portfolios may enhance the long-term climate, social, and financial resilience of their portfolios, benefiting stakeholders.
7. Systems thinking/lens or approach in the context of this discussion acknowledges the linkages of material sustainability and impact factors to one another and to portfolios. It is a way to make sense of complex systems by exploring the interrelatedness of the parts, boundaries, and perspectives within that system. It recognizes that complex systems cannot be fully understood from only one perspective, and complex problems cannot be solved by any single actor.

The post A Social & Environmental Equity Investing Framework for Better Real-World Outcomes appeared first on Cambridge Associates.