Green Transition Remains on Track Despite Disappointing COP27

The United Nations climate summit ended without making a big change in how fossil fuels are used. At the COP27 conference, it was decided to set up a new fund to help pay for climate-related damage in the most vulnerable countries. However, there wasn't much progress made on lowering carbon emissions since the COP26 meeting last year.

Frans Timmermans, who leads the European Commission’s climate initiatives, said that the world was in a “make-or-break decade,” adding that the COP27 agreement was “not enough of a step forward.”

Even though there hasn't been much progress, we expect that governments and businesses will invest more in the move to a zero-carbon economy. Governments have made significant capital commitments toward long-term goals, such as the EUR 300 billion REPowerEU and the USD 370 billion US Inflation Reduction Act.

Because of the crisis in Ukraine, these kinds of measures should be strengthened by putting more emphasis on the reliability of food and energy supplies. This also makes people more likely to invest in green energy that is made locally instead of fossil fuels that are traded around the world. It also makes people more likely to take steps to increase the local food supply.

In the meantime, we still think that companies that make products and offer services to help solve environmental and social problems will do well in the long run.

But going forward, investors need to pay attention to diversification by sector, style, and asset class.

Investors shouldn’t neglect value-oriented companies in the sustainability space

Some sustainability-linked themes with exposure to high-growth technologies did poorly in 2022 as investors exited growth-oriented sectors in favour of value. We expect volatility among growth companies to continue into 2023. This highlights why investors should ensure portfolio diversification and not neglect more value-oriented long-term ideas in the sustainability space. For instance, we see many opportunities to add value to the food supply chain, waste management, and recycling.

Focus on sustainability improvers as well as leaders

Environmental, social, and governance (ESG) leaders had done better than traditional indexes for several years, but they did worse in 2022, mostly because they didn't put enough money into traditional energy companies. We think this shows how important it is to look at both ESG leaders and ESG improvers. ESG improvers are companies that keep getting better at ESG issues that affect their financial performance. At the index level, ESG improver equities have outperformed broad equity markets by nearly 2 percentage points a year over the past five years.

Asset class diversification is also important for a balanced sustainability strategy

In 2022, high correlations between bonds and stocks made it hard to diversify. This was a problem for portfolios that were managed traditionally as well. Nonetheless, we believe diversification across sustainable investing asset classes should help improve risk-adjusted returns. In addition to the chances to diversify across equities, we stress the need to take an active approach to make sure that fixed-income allocations are sustainable. We see a lot of opportunity in sustainable bonds, like green, social, sustainability, and sustainability-linked bonds, that have shorter terms and a little more credit risk than benchmark indexes. We think such positioning should result in lower volatility and higher total returns during periods of slower economic growth.

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Source: UBS