Why ESG Investors Need to Rethink Capital Intensity
Author: Martin Grosskopf
March 10, 2020
Of the financial market trends since the Great Recession, arguably none has been stronger than the shift in investor sentiment towards businesses that have low capital intensity. These businesses tend to have a significant portion of their market value attributed to intangibles, with resulting high margins and returns on capital, and they comprise large weights within global equity benchmarks. The primary economic trend that benefits these companies is the shift toward services within developed economies. Many economic commentators view this as a sign of improving efficiency; some go so far as to suggest a decoupling from the capital intensity of previous economic cycles.
Investors concerned with environmental, social and governance (ESG) issues might see these market and economic trends as a double benefit. “Asset-light” business models are perceived to have lower emissions intensity, and financial markets reward them handsomely. Within the context of sustainability and climate change, it looks like low capital intensity can help ESG investors enjoy the best of both worlds.
Unfortunately, appearances can be deceiving. To focus on asset-light businesses in support of sustainability goals is to ignore the broader realities of global production networks, as well as the material flows required to support current economic growth and future population increases. It also diverts financial market support away from more capital-intensive industries where emissions reduction can potentially have greater impact. How can this gap between perception and reality be bridged?
First, we must separate fact from hypothesis. If economic growth is decoupling from capital intensity, we should be seeing a decline in inputs as well as outputs such as emissions and solid waste. This is clearly not occurring. In fact, raw material use continues to increase, as shown by the rise in copper consumption per capita, a fair proxy for overall consumption. On the output side, CO2 emissions per capita are increasing; so are waste volumes, not just in emerging economies but in developed countries as well.
Part of the reason behind the idea of decoupling might be the optimization of supply chains. Capital-intensive resource extraction and manufacturing have been moving to emerging markets – effectively offshoring capex, waste and emissions intensity. In some cases, as little as 5% of supply chain emissions might reside in the country of product origin, with local capex tending to target cloud infrastructure. On the other hand, waste flows provide a window into actual local consumption intensity. As the market most benefiting from asset-light business models, the United States leads in per capita waste generation – at three times the global average, according to Verisk Maplecroft’s Waste Generate and Recycling Indices 2019 report, and at levels higher than other industrialized nations with higher GDP per capita.
In this regard, the market is a poor arbiter of the actual intensity of a business model even as it begins to push for emissions reductions. One only need look to the increased urban congestion and pollution associated with the rise in ride-sharing services or same-day delivery – industries attracting plenty of investor support – to understand that “decoupling” is often more promise than reality.
This background is critical to understanding the so-called energy transition needed to meet carbon reduction ambitions. Instead of being asset-light, it is exceedingly capital-intensive, and it will depend on market support for endeavours as diverse as lithium mining and wind turbine manufacturing. Or consider a hugely capital-intensive sector: automotive. Original equipment manufacturers (OEMs) are ramping up investment in electric vehicle (EV) technology; One prominent German automaker, for example, has earmarked US$60 billion for a program that could have a significant impact towards emissions reduction.
The returns in such industries often pale in comparison with those in software or payments, however, creating a high barrier to the flow of capital. Consider, again, the auto industry and its investment in EV. Margins are likely to suffer for years until volumes can offset costs. Equity investors are rightfully wary of this phase, during which returns on capital are uncertain. With exception, OEMs must rely on internal cash flow, and will require a considerable transition time during which customers will need to be encouraged to purchase both internal-combustion and EV technologies, as the former funds the latter.
While stock investors may not be inclined to reward companies for their high capital intensity, many bond investors have a different perspective. Demand for green bonds in fixed income markets is strong, and they may become the vehicle of choice to fund capital-intensive projects. Importantly, these instruments have the potential to be ring-fenced (having a defined use of proceeds), timely (duration can be limited) and behavioral (rewards can be embedded for improving environmental performance).
For the financial industry to contribute meaningfully to an energy transition, accelerating the flows to capital-intensive industries is critical. Government incentives and subsidies have a role in this, despite the free-market criticism they often encounter; markets need mechanisms and feedback loops that incentivize both equity and credit investors to fund greener business models. Just as importantly, real progress towards carbon targets will require a rethink of the idea that sustainability and low capital intensity go hand in hand. In reality, there is no free lunch, and we urgently need to alter the incentives driving asset allocation in global markets.
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Written by
Martin Grosskopf, MBA, MES
Vice-President and Portfolio Manager
AGF Investments Inc.
Andy Kochar, CFA®
Vice-President, Portfolio Manager and Head of Global Credit
AGF Investments LLC
