Millions of hours have been spent negotiating net-zero targets, but many human-led climate impacts are already locked in. Our credit and equities portfolio managers explain where they see opportunities in solutions providers that will help society adapt for the new reality.
Read this to understand:
- Why further climate impacts are inevitable
- How investors can seek companies that will help societies adapt to more extreme climate events
- How tapping into a broad opportunity set, including mid-sized companies, can help build portfolio resilience
The ability to adapt is a distinctive feature shared by humans, which will be tested in the coming decades. With eight billion people on the planet and the climate warming around ten times faster than ever before, there will be new challenges for the built environment and systems supplying water, food, energy, transport and communications.1
Previously, most policy conversations have concentrated on how to trim carbon dioxide (CO2) emissions. As global progress towards net zero has been disappointing (atmospheric CO2 is higher than anything Earth has experienced for 800,000 years), a pragmatic approach is needed, which anticipates future climate shocks.2,3
“Even if we stop emitting CO2 now, the world will continue to warm,” according to Professor Richard Tol, former contributor to the Intergovernmental Panel on Climate Change (IPCC). “We have set something in motion that will take at least a millennium to work through.”
More extreme temperatures in winter and summer, more frequent droughts, more intense downpours and flooding, higher sea levels and further species loss are all likely, according to the IPCC.4 That has sobering implications from a human development perspective: there are millions whose livelihoods will not be viable (see The age of climate extremes).5
Investing to speed adaptation
There are ways investors can enhance resilience by investing in companies whose products and services will help communities prepare for the future. The adaptation lens can be applied to public markets such as fixed income and equities, as set out here, and real assets too.
We need solutions to address the climate crisis, but mitigation takes time
“We need solutions to address the climate crisis, but mitigation takes time,” says Andrea Carzana, co-manager of Aviva Investors’ Global Climate Transition Equity strategy. “We must anticipate how the environment is likely to alter, and practical adaptation provides immediate benefits. Politicians are starting to appreciate this, and that’s why we are starting to see much more policy support.”
The view of Aviva Investors’ portfolio managers is that there are currently more adaptation opportunities to be found in equities than credit, but both have potential based on bottom-up, fundamental analysis today. The ideas are independent of any particular climate pathway.
Strengthening water and food supply chains
As the environment changes, ensuring water and food supplies are sufficient will become an urgent priority. “Water scarcity will become a major issue,” says Justine Vroman, co-portfolio manager of Aviva Investors’ Climate Transition Credit strategy (see Figure 1).
Figure 1: Global population living with severe water scarcity (per cent)
Note: 2050 (f): Forecast reflects lower boundary.
Source: npj Clean Water, 20196
Although water covers around 70 per cent of the planet, only a tiny fraction (0.007 per cent) is useable and accessible.7 Demand has been growing voraciously. It increased 600 per cent in the last century and is forecast to grow over 20 per cent by 2050, but poor management and pollution are impacting supplies.8 This combination is expected to drive cashflows at companies monitoring the water cycle, managing pollutants and servicing water providers.
“Water utilities have a key role to play in adapting the provision of water services for a warmer world. It’s likely to drive heavy capex and bond supply, which could induce better entry points but also rating pressures,” says Vroman.
Credit spreads in this space can be tight, reflecting the healthy demand and pricing power these companies enjoy
“We see opportunities in industrials with companies like Xylem. It’s helping build resilience through water re-use technologies, and its solutions can also reduce sewer overflow during extreme weather. Credit spreads in this space can be tight, reflecting the healthy demand and pricing power these companies enjoy; nonetheless their defensive nature is interesting from a portfolio construction standpoint.”
Opportunities flagged by co-manager of the Aviva Investors Climate Transition Credit strategy Tom Chinery touch on the same theme. They include Aliaxis, the fluid management company producing pipework and parts for water and gas networks. The company has a circular economy focus and is replacing virgin polymers with recycled plastic waste in its production chains where it can.
“Essentially, we are looking for companies operating in areas where demand is likely to be resilient, and which produce products that are less energy intensive, more efficient and more robust. These are the factors that will drive adaptation to that new lower-intensity world,” Chinery explains.
In the food chain, there are concerns the changing climate could reduce output in swathes of agricultural land, while overuse of pesticides and nutrients will disrupt biodiversity in soils and waterways. There is an urgent need for more sustainable pathways.
Areas ripe for change include traditional protein production. Cattle need around 15,000 litres of water to produce a single kilogramme of meat and generate significant amounts of methane.9 Plant-based proteins are more viable; many consumers are already making the switch. (See Figure 2 for future growth projections.)
Figure 2: Growth scenarios for global alternative protein market (per cent)
Note: H = High growth scenario. L = low growth scenario. Remainder are base case scenarios.
Source: FAIRR, October 25, 202210
While the switch to vegetarianism may be entirely voluntary today, that could change.
“If we get to a situation where global food production can no longer support us, through population growth or frequent climate-induced natural disasters, a material reduction in meat consumption will be a necessity,” says Jonathan Toub, co-manager on the Aviva Investors Natural Capital Transition Global Equity strategy. “That could benefit some of our holdings that supply ingredients and flavourings to the alternative protein industry.”
The revolution in protein production extends to cultured meat (meat grown from stem cells in the lab), but investors cannot access this theme via large caps.
The opportunities are in mid-sized companies. We can’t invest in more mature companies producing cultured meats
“The opportunities are in mid-sized companies”, explains Julie Zhuang, co-manager of Aviva Investors’ Natural Capital Transition Global Equity strategy.
“We can’t invest in more mature companies producing cultured meats, because there are no pure-play public companies to invest in at scale. We can access the theme through a broader investable universe; that framing allows us to explore some of the more exciting transition growth stories.” For Zhuang, the breadth of the investment universe is an important differentiator.
Reducing losses across the food chain is another priority. Outbreaks of rodents threatening food supplies and human health are not new, but the changing climate seems to be changing ecosystem dynamics.
“Rising temperatures appear to have lengthened the breeding season for some rodents; it’s proving a problem, particularly in countries like India,” says Carzana. He highlights the earnings potential of pest-control companies like Rentokil, while acknowledging it is hard to wholly separate climate change from other drivers in this example.
Developing resilience in the built environment
In the built environment, climate extremes will challenge those constructing and maintaining spaces to live and work. Ed Kevis, co-portfolio manager of Aviva Investors’ Climate Transition European Equity strategy, sees scope for earnings growth at Arcadis, the Dutch design and engineering company, which guides on flood management using hard and soft (i.e., nature-based) solutions. Its activities range from water management and environmental restoration to the creation of hydrogen infrastructure and sustainable transport networks.
Paints made with low VOCs are better for human health and can improve insulation as well
Other names highlighted by Kevis include Sika Group, a speciality chemicals company producing durable building materials. “The company invests heavily in R&D and has created more resilient concrete through specialist additives,” he says. “It also has industry-leading products for waterproofing and ensuring adhesives maintain their effectiveness.”
Other building products offer environmental and performance win-wins: “One example is paints made with low volatile organic compounds (VOCs), which are important in green buildings,” Zhuang says. “They cause fewer emissions and generate fewer contaminants in groundwater, so are better for human health and can improve insulation as well.”
Contributing to financial resilience
Meanwhile, as climate records are breached, the insurance industry is assessing the implications with care.
“More than half of climate disasters are uninsured,” Carzana says (see Figure 3). “The need for insurance is going up and up, especially when it comes to weather-related products. We invest in MunichRe; it’s a well-capitalised global reinsurer that can take on more risk and price it appropriately. We see a strong link between what the company is offering in adaptation benefits and the potential for financial return.”
Figure 3: Protection from extreme climate events - insured and total damages, 2000-2022 (US$bn)
Source: Environmental Research, June 28, 202211
From crisis comes opportunity
As ecozones alter, significant changes to human systems will be needed, creating opportunities for companies that might enhance society’s ability to thrive and bounce back from environmental challenges. Recent volatility has been an opportunity to increase allocations to high-conviction names.
We have increased our exposure to companies offering real benefits at reasonable valuations
“A number of them are in the industrials and materials sectors, which are inherently cyclical,” says Max Burns, head of equities research and co-manager of the Aviva Investors Climate Transition Global Equities strategy. “They began to de-rate in the middle of 2022 with the spectre of recession, and we took the opportunity to add selectively. It gave us an opportunity to increase exposure to companies offering real benefits at reasonable valuations.”
Appreciating the advantages these companies offer is important, particularly after a period in which traditional fossil-fuel and carbon-heavy stocks have outperformed.
“It is important to recognise the strengths of the technologies and approaches we are targeting,” Kevis says. “As a society, we must do better at highlighting them. Change is coming, and there will be higher costs in the future if we fail to act.”