Is net zero the next asset class?

By Jayson Forrest

Transitioning to net zero will be anything but smooth. John Woods (Australian Ethical) and James Kingston (iShares) talk about the challenges ahead when positioning portfolios for net zero and whether that transition offers investment opportunities.

Ask John Woods – Head of Asset Allocation at Australian Ethical – for his opinion on whether net zero will become the next asset class, and his answer might surprise you.

“The investment hurdle to reach net zero is surmountable,” he says. “Whether it will be the next asset class depends on how big it is. The International Energy Agency (IEA) talks about the trillions of dollars needed to address this challenge. So, on that basis, that would make net zero an asset class bigger than Government bonds and similar in size to global equities today.”

Looking at the investment made so far towards achieving net zero by 2050, BlackRock expects that by 2030, around $2.2 trillion will have been actually invested in renewable energy, which increases to $2.8 trillion when pledges made to renewables are included. However, that figure is still short of the estimated $4.4 trillion in investments needed to reach net zero by 2050.

Speaking at the 2023 IMAP Portfolio Management Conference in Sydney, John believes that to suggest calling net zero an asset class, however, misses some of the finer details. That’s because the impacts of net zero are much broader than an asset class, and touches all parts of a portfolio. 

The process that Australian Ethical takes when thinking about how to get to net zero in 2050, is to run two scenarios – a negative climate scenario and a positive climate scenario.

The first scenario (negative climate scenario) maps what will happen if the world fails to meet the net zero challenge, which includes climate change, resource scarcity, and elevated conflict between nations. But the positive climate scenario of achieving net zero shows an actual lower cost of energy and greater human progress by achieving more with less costs.

“If we can address climate change successfully, investors can actually get similar returns to what they’ve been accustomed to over the last decade,” says John. “In order to transition to net zero, we’re now asking investors to invest in catalytic and renewable technologies to drive the economic environment. We have to allocate capital efficiently, so that it’s productive and addresses the problems we have. It’s not easy to do, but it can be done.”

He acknowledges that this transition is a significant change from how investors have been investing and believes that the key to success will be delivering the types of returns investors are used to.

So, in answering the question, ‘Is net zero an asset class?’, John is of the opinion it’s not an asset class, but an investment thematic that touches all asset classes and sectors in portfolios. As an example, he points to a net zero investment being anything from investing in a trend that switches from the use of private transport to public transport, or something more direct, like renewable energy, by investing in the likes of Tesla, Vestas, MGA Thermal, and Evergreen. 

John concedes that addressing the challenges of net zero isn’t easy, and is one of the reasons why he thinks venture capital is an interesting way to play this thematic, due to the various options it offers investors.

“There is venture capital funding for new types of batteries, alternative proteins (plant-based and food-technology alternatives to animal protein), and sequestering carbon. Then there are small cap companies in emerging technologies like hydrogen, as well as a range of industrial companies involved in electric vehicles, wind power and solar energy. The reach of net zero also extends to corporate bonds for large scale wind and solar projects,” he says.

“Net zero is not so much an asset class, but like ESG integration, it’s a risk you need to be aware of in your portfolio. The way to manage that risk is through some of the smaller investments currently available that are driven by this catalytic change.”

Importantly, the move to net zero is happening across both emerging and developed markets. And while many countries have committed to the Paris Agreement to reach net zero by 2050, China has extended its own target date for decarbonisation to 2060.

But China has already shown its appetite for net zero, by being one of the biggest investors in solar and renewable assets last year. It was also responsible for more than half of renewable electricity generation growth in 2021, which was mostly due to record wind and solar photovoltaic (PV) capacity additions in 2020.

“China is well aware of what’s required for this net zero transition. At the end of 2009, China embarked on a significant infrastructure investment with transport to support its economy. I expect to see something similar happen with net zero, with a commitment by China to invest far more significantly in renewables,” says John.

“If you start thinking about net zero from a value investment perspective, the expected returns on renewables in emerging markets are higher than developed markets,” he says. “This provides an opportunity for both value and growth investors to play the same thematic.”

James Kingston – Head of Product, Practice and Portfolio Solutions for Wealth Portfolio Construction at iShares – agrees with John’s view that net zero is not an asset class. He acknowledges that the transition to net zero is a risk that needs to be managed across an investor’s whole portfolio.

In 2021, BlackRock introduced a new framework for its capital market assumptions (i.e. the long-term assumptions on asset returns). This framework builds the manager’s assumptions on how climate is going to affect the returns on investments over the long-term into the portfolio construction process.

According to James, when building portfolios, advisers typically look at a range of factors, like risk and return, the macro environment, and monetary policy. But moving forward, portfolio managers and advisers will also need to look at carbon emissions and how companies are transitioning to net zero.

He also accepts there will be macro volatility as part of this transition, as well as supply-side inflation that will impact asset classes. So, when building portfolios, those factors need to be considered, as supply shocks and mismatches between supply, demand and energy will continue.

“How you manage these risks and how you manage this transition is going to play out in your portfolio,” says James. “If you decarbonise too quickly and you then encounter these supply shocks, you may be potentially left with underperformance. Conversely, if the market decarbonises faster than you are decarbonising your portfolio, you could be left with assets that underperform.”

Greenwashing continues to be an issue for the industry, and despite ASIC cracking down on the incidence of ‘greenwashing’, John doesn’t believe it will derail the uptake of net zero assets, like renewables, by investors.

“I don’t think ‘greenwashing’ will curb the appetite of investors and portfolio managers for net zero assets,” he says. “Investment managers have always needed to be careful about communicating what they are trying to achieve for clients. Net zero does make that a much more complex discussion now for advisers and managers, but I don’t believe it will stop the money flowing to the assets to achieve the outcome they’re looking for.”

James agrees: “There’s been a lot of confusion by investors with the product labelling of investments. So, we support anything that is more transparent and easier for clients to understand, while ensuring that products are true to label. With the regulator’s focus on ‘greenwashing’ and the availability of solid research and ratings in the market, I don’t believe ‘greenwashing’ will derail the investment into net zero assets. Inevitably, we still need to transition to the target of 2050.”

James does acknowledge there are still risks associated with the transition to net zero, which could hurt some of the emerging renewable investments. He says net zero is a polarising topic in the U.S., but is encouraged by the Biden administration’s commitment to investing heavily in renewables. He also applauds the European Union’s united move to transition away from carbon-heavy fuels, and at a faster rate than the United States.

“There’s still a long way to go before achieving net zero, but what we’re seeing through regulatory changes in the U.S. and Europe is a lot more expenditure and investments being made into renewable energy, which will push investment forward and hopefully, help us to reach net zero by 2050,” says James.

“Ultimately, the amount of global momentum behind this transition means we need to embrace it. It won’t be a smooth journey, with debates and arguments on how we get there, but we need to understand that doing nothing is going to cause more harm than doing something now.”

It’s a sentiment supported by John who adds that every investment Australian Ethical makes needs to stack-up on a risk-reward basis – and that includes net zero assets.

“When we take a long-term view at the types of returns that are possible in a lot of these net zero assets, they just stack-up,” says John. “So, there shouldn’t be anything to actually derail this transition. There are going to be challenges, but the rewards of achieving net zero will be immeasurable.” 

John Woods CFA is Head of Asset Allocation at Australian Ethical; and

James Kingston is Head of Product, Practice and Portfolio Solutions for Wealth Portfolio Construction at iShares.

The session, ‘Is net zero the next asset class?’, was moderated by Kieran Rooney – Senior Consultant at Evergreen Consultants.