Social justice requires emerging market countries to continue economic growth. Technology will evolve to help us grow with minimal use of natural capital. Investment opportunities abound in such technologies and in adapting to extreme weather events and to a world where we use natural capital more effectively.
Just before Christmas, I participated in a stimulating conversation about sustainability in emerging markets with Tirthankar Patnaik (TP), the Chief Economist of the National Stock Exchange (NSE) of India. The conversation was streamed to the members of the NSE, who are primarily brokers and investors. Excerpts from the conversation in a Q&A format follow.
Is sustainability anti-growth in emerging markets?
TP: It’s being argued that if every person were to consume like an average person from the developed world, we’d need many Earths’ worth of resources. Sustainability in that sense also means aversion against consumerism. How do you think this would incorporate into value for a sustainability investor who’s looking for growth?
SR: There are several questions here. Let’s start with the hypothesis that sustainability is averse to consumerism. Indulge me with a digression for a second. We often talk about four factors of production (materials, labor, capital, and managerial talent) but have ignored a discussion of the last factor of production, namely natural capital such as water, carbon, mineral resources, and so on. We, by and large, assign a cost of zero to natural capital, while calculating corporate income and GDP. We may have a hard time figuring out the true social cost of natural capital, but it is certainly not zero!
So, does sustainability mean anti-consumerism? It does not have to be. Growth can also mean GDP improvement per unit of natural capital consumed. The idea of de-growth, pushed in certain circles, is a non-starter in emerging markets. We cannot sell sustainability to folks in India and Africa by telling them that we are about to conserve our natural capital and will hence not aim to grow in the future.
My hope is that technology will evolve such that we can produce GDP and corporate net income with a lower investment of natural capital consumed. If I were an engineer at the fabled IITs (Indian Institute of Technology), regional engineering colleges and so on, I would work on coming up with ways to increase our growth without expanding our carbon footprint or consumption of natural capital in general, cheaper and better ways to storage energy in batteries, and work on adaptation strategies as extreme weather events become more common and hurt populated coastal regions in India.
There is a lot of room for optimism. Recall that until around the early 20th century, gasoline was considered a nuisance byproduct as opposed to an invaluable asset. Rare earth minerals until the age of the smart phone was not considered to be of much value. Human ingenuity will hopefully find a way to maintain or increase growth with minimal consumption of natural capital.
Let us turn to what this means for your investors. Apart from the obvious strategy of investing in green technology or adaptation strategies, I would keep an eye on “sustainable,” “eco-friendly,” or “green” or “carbon-neutral” consumer products. As prosperity increases in the developing and developed world, the demand for sustainable products will likely increase. The Economist Intelligence Unit surprisingly found a large public shift, post Covid lockdowns, in favor of sustainable products in emerging markets, especially in India, Pakistan and Indonesia, as people in emerging markets are most likely to experience the devastating impact of the loss of nature.
Why invest in sustainable companies?
TP: What do you think is the principal motivating factor for someone to invest in sustainability? Is it the inevitability of environmental shocks or that society would turnaround and cooperate towards building a sustainable planet? What timespans are we looking at?
SR: Isn’t a focus on sustainability somewhat of an inevitability in India? Consider the impact of climate change. India is subject to increasing weather-related disasters. At some level, in the short-run, adaptation is the only option. Air quality indices (AQI) in Delhi and Mumbai of 300 plus, as all of us know, is a concern. We have also experienced waste management problems, which suggest that local environmental challenges can affect economic productivity. RAND estimates air pollution related health costs reduced China’s labor productivity equivalent to 6.5% of GDP. I would be surprised if the health and productivity costs of air pollution in India are not as large, if not larger. The good news is that policy makers here are moving away from coal-based fuel.
The relative scarcity of natural capital is another concern. India’s population expected to increase to 1.527 billion in 2030, from 1.311 billion now. Mumbai, my home city, is expected to have 26 million people by 2025 and 42 million by 2050! Are urban planners prepared for such scenarios? The global demand for energy, food, and water is expected to be up by 25-40% as per McKinsey. Water-related crises are projected to be the number one risk for the world as per the World Economic Forum. Moreover, Asia produces 85% of the world’s output and hence emissions. Hence, climate is a local concern in India and the rest of Asia. At the current rate of production, our global carbon budget will last 10 years at best if we do not want to breach the 2 centigrade threshold for warming. I cite these data not to scare investors but for them to view solutions to these problems as investment opportunities.
A few firms are actively working to reduce negative externalities that they impose. Philips Morris International (PMI), for instance, generates around a 1/4th of its revenue from smoke-free products. New Zealand just banned the sale of cigarettes to anyone born after 2008. Such companies that have placed sustainability at the heart of their business transformation strategy are best positioned for higher returns. India Tobacco Company might want to consider PMI’s strategy.
You can consider the “who invests” question by positing three segments of investors. The most aggressive segment, that is driven by ethics and emotion, is the new generation of investors in the West. Our students are deeply committed to environmental issues. Let us not forget that the students of today are tomorrow’s investors, voters, and politicians. The second set of investors are indexers like Blackrock who own all of the market and hence pay for negative externalities, either by suffering losses in another segment of the market say via insurance firms, or across time in the future. The third segment is latching onto the green wave, maybe even a bubble, that we are in the middle of. The likes of Tesla, electric vehicle (EV) makers, battery makers, and renewable energy firms. Attracting capital to these technologies will hopefully spur innovation here. Some of this segment is obviously also encouraged by governmental subsidies.
Ultimately, the pressure to invest in sustainability will come from the citizenry in the democratic world. To some extent, investing in sustainability in the developing world is a moral imperative as well as a commercially viable venture. It is good to see awareness and dialog around who pays the price for environmental calamities or the negative externalities that a company imposes. For now, these costs are socialized via higher health care costs due to pollution, or by individual families in their living expenses, or by the state via deficit financing to repair infrastructure hurt by extreme weather events. It is a matter of time before taxes go up to pay for these deficits or firms are required to compensate the citizenry for the negative externalities that private and state enterprises generate.
You ask about investing timespans. The horizon or payback periods are much more rapid for investments in green tech. Adaptation strategies will require more patient capital. For instance, the replacement cycle of a car is, say, 15 years. Even if we hypothetically decide to replace all of our gas guzzlers with electric vehicles, that move will not happen for the next 15 years or longer. As an aside, consider the net zero promises committed by Western oil majors by 2050. That date is at least 3-4 CEOs and 3-4 generations of boards away. Who will hold these firms to those promises? Do we need something like a Federal Reserve or a similar relatively apolitical multi-generational institution to oversee climate promises and spending?
Will ESG shares outperform in the long run? What catalysts do we need to make that happen? Perhaps tougher governmental regulation to make firms internalize negative externalities or a massive outflow of capital from the asset management industry in favor of pro ESG companies or a big shift in consumer preferences in favor of sustainable products. The investing skill, as you know, lies in forecasting both trends and more important the timing of those trends. The directional trends in favor of ESG shares and products, to me, are quite clear. I am less sure about the timing, meaning when will these forces begin to have real bite. Is it 3 years, 5 years or is it a generation?
How is investing in resources different?
TP: How does sustainability investing differ from investing in resources? There is a view that, say, investing in beverage industry with access to water is valuable (even if the practices of such firms are unsustainable). What do you think are the risks of such investments as compared to ESG investing?
SR: If you mean, should an investor buy up water supplies and so on, if it can, as a price of…