Sustainable development funding

• Do livestock companies include the physical risk they are facing in their forecasts?
• Sustainable water solutions – are there investment opportunities?
• Can country debt conversions for sustainable development funding tackle the tension between high sovereign debt and the need for sustainable investment

Investor view: Physical risks in the food sector not accurately priced

Climate change poses numerous risks for companies, with livestock companies being particularly vulnerable. According to a FAIRR analysis published last year, climate risks could potentially eliminate 2020-level profits for half of the world’s 40 largest listed livestock companies unless new strategies are urgently implemented.[1] For investors, the critical question is whether these climate risks are accurately reflected in company valuations. Some climate risks – such as litigation or transition risks – are difficult to quantify or predict, though. However, one type of risk that is relatively straightforward to assess is physical risk. For instance, company assets such as factories and buildings can be damaged or destroyed by floods, wildfires, or other extreme weather events that are becoming more frequent and intense due to climate change.

In recent years, various models have been developed using geospatial data to determine the exposure of corporate assets to extreme events. Investors can utilise these models to evaluate the physical risks to company assets. Nevertheless, it appears that risks are not adequately priced for large meat producers. According to a Bloomberg model, an average of 72% of the assets of the world’s six largest meat producers by market cap are exposed to high levels of physical risk, with heatwaves being the primary risk factor for almost all of them.

These assets are crucial for the companies’ operating business. Their average property, plant, and equipment (PP&E) turnover ratio is around 4, meaning that one unit of PP&E can generate four units of revenue. Effective use of assets is an important company valuation metric and is reflected in costs of capital. If companies’ PP&E are damaged or rendered unusable by extreme events, these assets cannot generate revenue, negatively impacting the company’s valuation.

However, consensus forecasts for the next 3 to 6 years for these companies do not show a noticeable decline in net PP&E or revenues, indicating that physical risks are not currently reflected in stock prices.

Investors can mitigate their risks by investing in companies that are actively reallocating their assets or taking measures to protect them from risks such as heatwaves.

While this will initially increase costs and reduce profitability, these investments should pay off in the long term given the magnitude of the risks involved.

Our View: Tapping into water – the growing demand for sustainable water solutions

Water is vital to the global economy and its estimated value in 2021 was USD58tn, according to the WWF. However, water is increasingly under threat due to overconsumption, poor management, and climate change. Agriculture consumes 70% of global freshwater, while industry and domestic use account for 30%. As water scarcity intensifies, it poses significant risks to economic growth, potentially reducing GDP in water-stressed regions by up to 6% by 2050, according to the World Bank.

Industries such as agriculture, energy, and technology are particularly vulnerable. In agriculture-dependent regions, water shortages could lead to food insecurity and economic instability. The UN estimates that two in five jobs in low-income countries are reliant on water. Developed nations face risks as well. For instance, France’s nuclear energy production was curtailed in 2022 due to low water levels, worsening Europe’s energy crisis. Semiconductor manufacturing, vital for modern technologies such as AI, is also highly water-intensive, with production facilities often located in water-stressed regions.

Recognising these risks, global investment in water infrastructure needs to reach USD6.7tn by 2030, potentially rising to USD22.6tn by 2050. Despite this, less than 1% of Europe’s USD53bn climate technology investment in 2021 went toward water tech, highlighting the underinvestment in this area. Investment opportunities lie in upgrading aging infrastructure and developing innovative water technologies like smart irrigation, wastewater recycling, and desalination.

Several sectors stand to benefit from increased investment in water-related technologies, including Industrials, Utilities, Technology, and Agriculture. Water utility stocks have historically been stable, defensive investments due to their monopolistic control over water distribution and the essential nature of their services. Indices such as the S&P Global Water Index and the MSCI World Water Index track the performance of companies involved in water utilities, infrastructure, and technology. These indices have seen solid performance, with the MSCI Global Sustainable Water Index delivering a 12.3% annualised return over the past decade, outperforming the MSCI World Index (10.65% annualised return).

Investors can gain exposure to water-related opportunities through water-themed ETFs, funds, and green bonds. As the water crisis intensifies, we think water will increasingly emerge as a key investment theme, offering both sustainability and financial growth opportunities for investors.

Under debate: Country debt conversions for sustainable funding – a way forward to protect ecosystems?

The nature finance gap remains in excess of USD700bn per year and finding ways for governments to invest in projects to protect the vital ecosystems will be essential in transitioning towards a more sustainable and nature positive future.[2]

A working paper from the IMF says that states with particularly elevated climate vulnerabilities are also more likely to be facing greater fiscal risks, because climate change can exacerbate debt vulnerabilities leading to further discrepancy between the needs for Investments and the decreased fiscal flexibility.[3]

One way to tackle this ambivalence are debt conversions for sustainable funding that reduce a country’s debt in exchange for financial commitments to protect and invest in the environment and their ecosystems. These transactions are still small in volume compared to the overall debt burden of the countries, yet recent transactions highlight their potential to play an increasing role in future.

The most recent and largest by financing volume is the “Galapagos Bond”, that refinanced USD1.6bn of Ecuador’s debt at a 60% discount. After subtracting the investments that Ecuador is obligated to make to protect the Galapagos Islands over the coming years its debt will be reduced by USD1bn.[4] Other deals in Belize and the Seychelles have raised USD200m to protect more than 150,000 square miles.[5], [6]

Critics have warned that these transactions are too costly to implement while they fail to provide sufficient funding to tackle the problems they want to address, with some even going as far as to calling it greenwashing. Structuring these debt conversions to with the aim to fund sustainable projects properly is highly complex, and they must include clear and ambitious targets that must be properly monitored to effectively protect ecosystems. They could then contribute towards a more sustainable, nature-positive future.[7]