Sustainability is key to superior returns

These are firms that are looking towards the future and are in a position to grow and provide investors with strong long-term returns. These companies are highly attractive from a fixed income perspective where an investor’s priority is in the reliability of the coupon and receiving the principle back at the maturity of the bond.

A business that is proactive in its approach to a sustainable future clearly provides a positive investment opportunity. For example, Greater Gabbard, a UK offshore wind farm, is having a positive effect on climate change in the UK and may outperform more traditional power-generating assets over the longer term.

One hundred per cent of the energy Greater Gabbard generates stems from wind farms, significantly reducing its environmental impact. This positive effect mitigates a significant source of potential regulatory risk and may prove to be a stable investment over time.

Conversely, companies that are insular or too focused on short-term returns are at greater risk from consumer pressures, increased regulation and political legislation, which can all negatively affect cashflows and therefore a company’s ability to service and repay outstanding debt.

From an investor’s perspective, many of these risks are not widely understood or factored in to their decision-making process.

Let’s take the issue of global warming, for example. It is generally agreed that a global temperature increase of more than 2 degrees Celsius from preindustrial levels could lead to a reduction in arable land, falling crop yields and decreases in water availability, all of which could have a significant effect for current and future generations.

The importance of this has been overlooked for decades, although people are beginning to wake up to the real effect it could have more recently. There is now an awareness of the actions needed to be taken. For example, it has been calculated that if we are to prevent a 2 degrees Celsius increase in the world’s temperature, then up to 80 per cent of known fossil fuel reserves need to stay in the ground and remain unburnt.

Mark Carney, governor of the Bank of England, recently said “the vast majority of reserves are unburnable if global temperature rises are to be limited to below 2 degrees C... the tragedy on the horizons could cause market failure. We [Bank of England] will be deepening and widening our inquiry into stranded assets and I expect the Financial Policy Committee to also consider this issue as part of its regular horizon-scanning work on financial stability risks.”

From the perspective of a fixed income investor, the viability of investing in oil and gas bonds must therefore be seriously considered.

On a similar theme, companies whose products or actions significantly contribute to global emissions are at greater risk of tougher, more stringent regulation. This in turn has the possibility of significantly affecting cashflows, along with the competitive landscape for businesses.

Recent headlines about Volkswagen and the subsequent market reaction are a good example of these concerns. It could be suggested that car manufacturers as a rule are generally not investable as the products they produce are significant contributors to global carbon emissions and therefore global warming. This leaves them more susceptible to regulatory change, increasing costs and declining margins.

The fact that Volkswagen chose to install technology to allegedly ‘cheat’ emissions tests instead of investing capital in research and development to create a product that complied with increasingly tough regulations, speaks volumes. The effect of this news saw the price of Volkswagen’s debt fall significantly. In one case, the price fell roughly 20 per cent or eight times the annual coupon on the bond. With coupons and bond yields at historically low levels, investors can ill afford capital losses of this magnitude.

Investing in businesses that are avoiding risks by proactively looking at future societal demands could therefore provide a more stable environment for fixed income investors and ultimately stronger returns for fixed income funds.

Mike Appleby is an investment manager and analyst at Alliance Trust Investments