Sustainable investors have to navigate a wide range of alternative and often complementary investment approaches. Between passive and active strategies, superficially screened or deeply impactful investments, the spectrum of ESG investment channels is extremely wide.
Another factor to consider, particularly when thinking of the environmental aspect, according to Sara Bellenda and Francesco Conte, portfolio managers at J.P. Morgan Asset Management, is the difference between companies decreasing their carbon footprint and firms helping them decrease their greenhouse gas emissions.
“Solutions are key to our strategy,” Conte says, referring to J.P. Morgan Asset Management’s Climate Change Solutions strategy, which he co-manages with Bellenda.
“The aim of the strategy is to invest into companies that are helping other businesses to decrease their carbon footprint.” According to them, Heating, Ventilation, and Air Conditioning (HVAC) and electrification are two of the most promising sectors for investors to tap into these opportunities.
Why electrification and HVAC?
Conte believes that although revolutionary innovations in the pipeline offer much promise, there are plenty of exciting opportunities available for sustainable investors right now. “There are very interesting technological developments that are not yet commercially viable, such as hydrogen or carbon capture. These technologies will surely change the world, but their price needs to come down. Meanwhile, there are other solutions which are readily available at competitive prices,” Conte explains.
“Investing in solutions is not about ratings or being leaders of operational practices. It’s about the product and the outcomes, which have to genuinely provide a solution for the environment,” Bellenda explains. “Our focus is more narrow than that of the wider market that claims to look at sustainable companies. The solutions that a company provides have to be a meaningful component of that company,” Bellenda continues.
According to Conte, the theme of electrification is the bond that ties together a lot of the present and future solutions to climate change. “Electrification and HVAC are climate change solutions that are available now. Electrification taps into the trend towards the replacement of oil and gas by electricity from renewable sources, such as wind and solar farms. In the HVAC sector, newer heat pump technology enables the replacement of fossil fuels for heating and ventilation to electric based heating and ventilation. Such a technology is becoming increasingly price-competitive and governments are introducing a supportive regulatory and fiscal incentives,” he adds.
Electrification Solutions to Climate Change
From a purely financial perspective, the case for investing in electrification is clear, according to Conte. “We expect electrification businesses, a part of the wider industrials sector, to grow faster than GDP, because there is such a need for their services to help decarbonise the world,” he says.
Conte suggests there are many paths to achieving this destination. “Renewable energy companies provide a channel for asset owners wishing to support pure play efforts. Investing in incumbents moving to renewable energies can also be a channel for investors wishing to support the transition.”
“France’s Schneider Electric is a very prominent name in this sector. But it is not the sole opportunity,” Bellenda argues. “Eaton, a US-based large cap company, is another significant provider of electrification solutions. Its activities tap into many markets, including e-charging stations for electric vehicles (EVs) and the provision of electricity for datacentres. Eaton’s exposure to this type of demand in terms of growth potential and valuation and its leadership position in this market are very attractive,” she continues.
Electrification also provides other investment opportunities, according to Conte. “Aside from companies like Örsted, which focuses on off-shore energy, investors can also tap into a company such as Vestas, which makes wind turbines,” Conte says. “Renewable energy, because it is dependent on variable weather conditions, creates volatility in the electric grid, which raises the need for software solutions to manage the peaks and troughs,” he adds. These and other trends conspire to increase the burden imposed on national electric grids in the coming years. “Once EV penetration reaches 20-25%, the grid generally will need improvement to be able to withstand the increased demand imposed upon it,” he adds.
Speaking of EVs, there are also interesting investment opportunities laying beyond the most famous cases. “Although Tesla might be the most salient name in the EV industry, Volkswagen has also embarked on an interesting journey. The company’s response to the Diesel-gate scandal has driven it to improve its internal processes and strategic vision,” Conte adds. “In response to the scandal, they have become the leading automotive investor in electrification. Volkswagen has earmarked €37 billion, or half of all its planned investment expenditure between 2021 and 2025 for the development of future technologies such as electrification,” he adds.
“One of the lessons that I have learned is that, when a company makes a mistake, such as Volkswagen did, it often responds by setting up the most advanced control systems and risk management processes and adjusting its strategy. Volkswagen’s plan is for half of its vehicle sales to be electric by 2030,” Conte explains. “This investment strategy is very appealing to investors given ongoing political efforts to align regulation and fiscal policy to incentivise electric car purchases at the detriment of internal combustion vehicles,” the portfolio managers note.
The market for high voltage cables is also likely to benefit from the increased electrification of industry. “The distance between the source of the energy and industrial centres increases demand for high voltage cables to ensure efficient distribution of electricity,” according to Conte. This is pertinent in Germany where wind farms are located in the north of the country while its industrial heartland is concentrated in the south. The integration of national European electricity grids into a unified system also increases the demand for high voltage cables. “Companies such as Italy’s Prysmian and France’s Nexans, which control 70% high voltage cable market, stand to benefit from increasing scale of electricity grids,” Conte explains.
Increased demand for batteries as a consequence of the increasing prominence of EVs and renewable energy will also play a crucial role in electrification. “There are not enough batteries in the market to satisfy the demand from EVs as well as for the storage of renewable energy. Businesses such as Scatec, a Norwegian company working with renewable energy in emerging markets, can offer solar energy throughout the working day thanks to their use of batteries,” Conte says.
Last but not least, companies like Electrolux also have an important role to play in electrification, according to Conte. “Fridges are the largest energy consuming appliance in any household, so there are also energy efficiency gains to be achieved through software solutions by household appliance companies,” he adds.
Opportunities in Sustainable HVAC Solutions
According to the portfolio managers, the dominant opportunities in HVAC are heat pumps, ventilation, and air conditioning. “The key element of HVACs, is heat pumps. In a way, this theme is related to electrification. Each time a building replaces a boiler with a heat pump, heating and ventilation of the building becomes electric. Similarly to electrification companies, firms operating in this space are offering not only hardware products, but also software solutions to more efficiently operate buildings,” Conte says.
“Heating and ventilation is roughly half of the energy consumption of a building and demand for heating and ventilation is expected to grow by 50% by 2050. By modernising HVAC system companies will not only modernise their building. They will also decrease their overall energy bill therefore reducing overall greenhouse gas emissions.” Conte explains. “These companies can provide hardware and software solutions to better manage buildings’ energy needs. “The actual type of solutions that these companies provide varies depending on the clients’ needs but the competition between them is mainly focused on technology and the type of solutions provided rather than on price,” he continues.
“Trane Technology, for example, provides air conditioning solutions to residential and commercial buildings, including hardware, but also after-sale care such as customer assistance and product maintenance. It is a large American company, with a market capitalisation of US$45 billion and operations concentrated in the USA, but also covering Europe and Asia,” Bellenda says.
“The company offers a dual investment opportunity to gain exposure to the profits associated with upgrading and refreshing office buildings. Real estate assets will be adjusted to integrate post-pandemic health and safety concerns following the return to face-to-face working conditions. Concomitantly, they are also due to be upgraded to meet more stringent environmental standards,” Bellenda adds.
“The HVAC industry is characterised by significant barriers to entry. By continuously raising regulatory standards only the most technologically advanced companies can meet those standards. Global leaders such as Trane, Johnson Controls, Global Carrier and Daikin have the technology to meet these high standards and are naturally shielded against potential competitors,” she continues.
The Role of Regulation
Delving deeper into the issue of regulation, Conte is keen to highlight its positive contributions to the industry when it is appropriately designed. “Thanks to human ingenuity when faced with more demanding regulation companies can develop innovative solutions,” he says.
“Europe has the highest environmental regulations in the world, it is therefore not surprising that many global companies develop new technologies for the European market which are then sold in the rest of the world. Although many of the leading HVAC companies are based in the USA, our understanding is that they tend to develop new products in Europe because the regulations there are more stringent. Those products are then sold worldwide. European regulatory stringency is actually a fuel for technological innovation,” Conte explains.
“The same is true of environmental regulations. Companies are having to push the limits of their capacity to find new and better environmental solutions in their European activities because of all the climate change mitigation regulations coming out of Brussels,” Conte adds.
The Road Ahead
According to Bellenda, disclosures are going to remain the dominant themes for investors in climate change solutions. “From a research perspective it is both exciting and challenging to try to overcome the data difficulties in this field. It requires engagement to get access to corporates, find more about their business model, how the company works and understand the implications of their approach to environmental and social factors. ESG disclosures will play a very important role going forward, particularly for small cap corporates’ ability to access investors,” she argues.
Finally, Conte is hopeful regarding the pipeline of innovative solutions expected to become commercially viable in the future. “Asides from the interconnectedness of all these fields, one lesson I learned is to never underestimate human ingenuity. Solar power was dismissed as expensive for many year and is now a perfectly affordable technology. Today, hydrogen seems to be where solar power was a decade ago. Whether it is the technological frontier or environmental regulation, companies will find a solution,” he concludes.