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ESG Focus: The Little Big Things – 27-07-2023

ESG Focus | Jul 27 2023

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: The Little Big Things

In today’s edition of The Little Big Things, FNArena examines the Green Capital Expenditure Theme, pent up critical metals and minerals demand, the US Inflation Reduction Act one year on, and the floundering sustainability-linked bond market.

-Goldman Sachs checks out green capex goldmine
-Critical metals and minerals ready to blow
-US Inflation Reduction now promising trillions
-What to do about sustainability-linked bonds?

Compiled by Sarah Mills

Green Capital Expenditure Theme Hot To Trot

Goldman Sachs believes green capital expenditure will be a multi-year secular theme this decade, and expects annual green capital expenditure should hit US$6trn, buoyed in part by government incentives.

The analyst expects green capital expenditure will drive greater ESG weightings going forward given it offers exposure to: secular growth themes; attractive returns; and growing "discovery" value (given 60% of green capital expenditure stocks in the broker’s coverage are underweight in ESG funds, relative to their benchmark weightings).

Goldman Sachs says private sector green capital expenditure is currently on track to deploy an extra US$0.9trn per year through the decade. About US$0.6trn of this should come from listed companies and $0.3trn from private companies.

The analyst expects a reward factor may also come into play.

The broker nominates nine sectors that it expects will demonstrate resilient returns, strength and/or momentum from the green capex theme (with Machinery hitting all three). 

These include Airlines, Diversified Telecom, Independent Power Producers and Renewables; Machinery; Electronic Equipment and Software; Energy Equipment and Services; Transportation Infrastructure and Electrical Equipment.

Goldman Sachs also observes green revenue beneficiaries have outperformed green re-investors and green-ablers.

The broker highlights 109 favoured stocks in the report, but no ASX-listed companies.

All up, the broker expects investors will favour critical sectors that offer a combination of resilient returns with good momentum, most of which are listed below.

Goldman Sachs says the sectors that recorded the bulk of capital expenditure via reinvestment rates, straight capital expenditure and cash flow investment included: construction materials; independent power and renewable electricity producers; automobile components; water utilities; energy equipment and services; oil, gas and consumable fuels; and multi utilities (the latter two demonstrating a sharp fall in cash flow investment).

Modest increases were forecast for metals and mining; building products; electronic equipment instrument and components; and automobiles.

When it comes to individual companies, Goldman Sachs expects ESG funds will favour revenue beneficiaries; those that are increasing reinvestment or have high investment already; and green-ablers.

The analyst advises that stocks screening under its green capital expenditure themes have broadly outperformed market benchmarks during 2021 but were mixed in 2022.

Goldman Sachs nominates IGO ((IGO)) and Allkem ((AKE)) as likely Australian green revenue beneficiaries.

The broker also expects green-ablers in copper/aluminium; electricity transmission; semiconductors; and cybersecurity will receive funding to help drive companies’ decarbonisation, clean water and infrastructure goals.

Critical Metals Demand To Ignore Slowdown

All this capital expenditure has to go somewhere and critical minerals and metals are among the more obvious targets.

ANZ Bank’s July Commodity Call says critical minerals demand is about to be unleashed from its inflationary binds, and will likely sweep all obstacles in its path. 

While higher interest rates, a faltering covid recovery and weak demand from China has hit the broader base metals market, demand for transition minerals is solid, observes ANZ.

Copper and nickel volumes are approaching critical demand levels, and the analyst expects volumes will continue to rise sharply over the next three years.

So strong is demand that even an economic slowdown and a retreat in traditional sectors such as manufacturing and construction will not dampen it, says ANZ.

The main drivers of demand will be growth in electric vehicles (turnover jumped to 14% of all cars sold in 2022 according to the International Energy Agency) and renewable energy (investment hit US$600bn last year).

US Inflation Reduction Act’s First Birthday

Ninety One reviews the US Inflation Reduction Act (IRA) year on from its inception.

The analyst observes much of the last year revolved around sorting out issues with the Internal Revenue Service (IRS) to determine which projects and products will receive the full benefit of the Act’s tax credits.

Now the process is being finalised, Ninety One considers the outcome to be broadly positive for climate solutions companies.

The domestic content label was also expanded to ensure that green global supply chains also qualify (Australian green projects now also qualifying for US tax credits).

As a result, the broker believes there are under-appreciated investment opportunities in non-US-listed companies that could prove beneficiaries of the Act.

The analyst is particularly excited about the EV market and the battery market and expects this should generate opportunities for US factory-automation firms.

A major benefit of the IRA, posits the analyst, is the resilience it lends green industries during tough times.

The analyst also welcomes recent IRS guidance on transferability, which will make it easier to monetise tax credits up front, saying this should boost the number of projects generated at lower cost.

Meanwhile, estimates on the size of IRA subsidies vary widely, observes Ninety One. The Congressional Budget Office pegged US$391m between 2023-2032.

But Goldman Sachs believes the total outlay could be three times that, pegging a figure of US$1.2trn as new low-carbon technologies and products steal market share and capital.

Princeton University’s Zero Lab’s REPEAT analysis reckons US$1.7trn.

Sustainability-Linked Bonds (SLBs) under microscope

While subsidies are massive suppliers of capital, there are those who would like to see other financial structures thrive in the mix.

Green capital expenditure relies heavily on green finance, even for companies decarbonising in non-core transition businesses, for which sustainability-linked bonds (SLBs) were the great white hope.

But supply of SLBs, which offer investors unrestricted use of proceeds, fell -18% year-on-year as interest rates rose, faring worse than other forms of green finance such as use of proceeds (UOP) bonds (which recovered in 2023).

Morgan Stanley reports issuance of $3bn, compared to peak issuance of roughly $18bn in November 2021.

Morgan Stanley sheets this back to continuing technical concern about the asset’s structure.

Morgan Stanley says weak targets, and the fact that they can be called before maturity and insufficient penalties have all combined to build the asset’s reputation as a greenwashing exercise. 

Nevertheless, Morgan Stanley cites a persistent level of global appetite and asks what needs to change, and suggests the following areas of examination: coupon step-downs, approved issuers, target benchmarks, addition of social KPIs, target misses, third party verification, and lack of advantages relative to vanilla bonds.

So I guess it’s a matter of watch this space.

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