Sustainable Alternatives

Both sustainable and alternative investments have found their respective places in investment portfolios and probably need little, if any, introduction. While the latter encapsulates idiosyncratic strategies to opportunistically exploit inefficiencies, complexities and illiquidity across asset classes, the former allows investors to profit, intentionally or indirectly from business activities geared toward positive outcomes for people and the planet. As the agents of change for people and planet i.e. businesses, policy makers, investors and others deploy all tools at their disposal and innovate to augment their efforts in seeking financially material environmental and social outcomes, it lends itself to various intriguing opportunities that merit a closer look.

The quest for newer and creative ways to monetize idiosyncratic opportunities has always spurred alternative investors to seek greener (no pun intended) pastures and it cannot be truer than today when the global investment opportunity set is being redefined by tectonic changes across multiple dimensions-macroeconomics, geopolitics, regulations, technology, demographics, environment, and society. Sustainability viewed through an alternatives’ lens could potentially offer a rich playground for those alternative investors seeking to expand their investment horizons. While still early days, it bears watching how the forces align to create attractive investment opportunities notwithstanding the inherent risks and challenges.

Some green shoots on the horizon are notable. Helped by a record-breaking start for green bond issuance in 2023 from Italy, Germany, Ireland (“green treasuries”) and EU financial and utility companies, cumulative sustainable bond issuance has crossed $4 trillion (Source: Environmental Finance), registering ~50% compounded growth over the past three and a half years. While green bonds (proceeds tied to specific climate change outcomes) represent over 60% of the sustainable bond universe, issuance has diversified since 2019 across three “S’s”-social, sustainability and sustainability-linked bonds. Sustainable bonds expand the trading universe for fixed income managers of all stripes-traditional and alternative (i.e. hedge funds) complementing ESG public equities that investors can also go both long and short.

Besides sustainable bonds as a financing channel, banks like Spanish BBVA, Credit Agricole, etc. are quite active in providing green and sustainable loans/credit facilities to companies big and small (e.g. Spanish electric utility Iberdrola) for infrastructure capex. needs as well as for general corporate purposes, at interest rates/pricing to incentivize companies to lower credit risk by adopting sustainable considerations. Similarly, banks (e.g. Barclays) provide working capital for pursuing sustainable trading activities and supply chain financing linked to reducing a quantum of greenhouse gases from a borrower’s supply chain/ product’s lifecycle within a timeframe.

As with traditional loans, sustainable loans afford securitization into sustainable collateralized loan obligations or SCLOs, which frees up banks’ balance sheets to provide additional lending thus also expanding the opportunity set for institutional asset owners and managers.

Loans for affordable housing, solar power projects etc. also allow securitization in the form of green asset-backed securities or ABS (e.g. Tesla’s securitization of its EV car leases). Similarly, financing of LEED (Leadership in Energy and Environmental Design) buildings lends itself to securitization into green commercial mortgage-backed securities or CMBS.

In emerging markets, private creditors (as in the non-sponsored direct lending markets of Asia) can potentially step in to fill the void left by traditional banks in providing supply chain finance tied to carbon reduction. Many local teams of private creditors/micro-lenders in EM are already experienced in extending credit (complementing venture capital/private equity) to reduce gender inequality, improve financial inclusion, reduce poverty, enhance resource efficiency, optimize agri-businesses, etc.

Just as the Sustainability Linked Loan Principles (SLLPs) introduced in March 2019 were key to the development of the sustainable loan (and securitization) market, changes to carbon pricing policies are afoot that can potentially energize trading opportunities. The urgency to reduce GHG emissions is now increasingly recognized globally that besides outright decarbonization efforts it is important to price carbon by establishing carbon emission limits or quotas. Carbon credits are granted only to companies that keep their emissions below a set baseline. Those carbon credits can then be traded with companies that are above the baseline as in Europe’s Emissions Trading Systems. With a slight variation, California’s Cap and Trade System sets an upper emissions limit and assigns carbon credits for emissions within those limits. Companies that don’t use up all their emissions credits can trade their excess credits to other companies that would otherwise exceed the limit. The US CFTC is also considering other regional markets in the country to facilitate greater trading of carbon credits.

ETS allows regulatory bodies to create a baseline price for carbon that increases over time, incentivizing decarbonization. If the cost of pollution/price of carbon is high enough its warrants securing the allowances (in the secondary market) by those companies exceeding limits. Consumer affordability and energy security concerns (aggravated by the Russia’s invasion of Ukraine) have so far contained carbon prices. However, EU’s proposed carbon border adjustment mechanism (CBAM), is expected to be a game changer as indicated by sustainability experts. Companies importing goods e.g. cement, steel, fertilizer, etc. outside the EU from less-stringent (on carbon emissions) countries are currently given free emissions allowances on their imports up until 2026.  Thereafter, a higher price on carbon would be placed driving the market for trading carbon credits.

Akin to getting credits for keeping within carbon emission limits, carbon offsetting credits are also given for removing and storing carbon by planting a forest or building a Carbon Capture and Storage (CCS) facility, that is promoted by the Inflation Reduction Act with a substantial increase in credit that can be traded for carbon hedging. Taking one step further, private companies and individuals can also purchase carbon offsets (to voluntarily offset their carbon footprint) directly in a decentralized voluntary carbon credit market. Singapore, Hong Kong, Australia and now India and China are driving the growth of the VCC market estimated to grow from $2 billion in 2021, to $50 billion by 2030, according to the Institute of International Finance. Recognizing its potential, demand for insurance-based solutions for carbon offset is also likely to grow. Analogous to carbon and carbon offsetting credits are nature credits for creating positive biodiversity benefits (including indigenous people and local communities) and biodiversity offsets to mitigate negative bio-diversity impacts.

And this is just the beginning of a long journey where growing awareness and recognition of sustainability considerations, and evolving taxonomies, regulations and standards are pursued to achieve environmental and social goals, opening potential opportunities for those alternative investors who are willing to stretch their imaginations and adapt their capabilities.

Kamal Suppal, CFA

Chief Investment Auditor

June 20, 2023

The above content is intended for sophisticated audiences as in institutional investors or accredited investors. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.