Broadening the path to low-carbon investing: a diversified approach to climate- focused equities

Company fundamentals such as profitability and capital discipline are equally vital inputs in active climate-focused strategies. Strong fundamentals help quality businesses surmount macro hurdles beyond climate risks, such as inflation and higher interest rates. Attractive share valuations support return potential and help investors avoid risks in expensive parts of the market. We believe that integrating these three elements in stock selection—quality, climate and price—can better align a portfolio’s climate characteristics with investors’ long-term financial objectives (Display 1).

Quality, climate and price: vital inputs to address risks, find opportunities

For illustrative purposes only - Source: AllianceBernstein (AB).

How will companies fit into the transition?

In the transition to low-carbon economies there will be corporate leaders and laggards. Understanding how climate change impacts companies’ business models will be crucial for identifying the winners and losers. As a result, we believe an active approach that strikes a strategic balance between quality, climate and price can help a portfolio capture stronger return potential at significantly lower carbon exposure than the benchmark’s.

Quality: a solid foundation for sustainable growth

Companies with high-quality features enjoy flexibility to navigate short-term market stresses and longer-term challenges. We believe strong profitability, measured by return on assets (ROA) and return on invested capital, is a robust predictor of future earnings power. And capital discipline can help support margins, particularly in a world of higher interest rates.

Quality business models also tend to be more predictable and potentially less volatile. It’s an especially important consideration for climate-focused investors, given how economic conditions, geopolitics and market volatility can place unique strains on low-carbon industries, especially alternative energy.

Climate: a panoramic view of risks and opportunities

Evaluating climate credentials requires a panoramic view of both risks and opportunities. Carbon emissions are a prominent risk, and companies that don’t control the associated costs may face lower expected returns and additional volatility. In contrast, companies with clear carbon targets and strategic plans to curb CO2 emissions should enjoy advantages versus peers with higher carbon intensity.

Meanwhile, green opportunities are already surfacing in a range of industries—including those that aren’t typically targeted by climate- focused investors.

Asking the right questions is crucial to discern how companies are transitioning to the low carbon economy (Display 2).

Incorporating climate research can improve investment outcomes

For illustrative purposes only
*Transition risk: policy, technology and consumer preferences
†Physical: extreme weather events and changes in climate
Source: AB

Price: valuation underpins future return potential

Valuation is highly important: investors shouldn’t buy climate-focused stocks at any price. Both quality and climate factors can become overvalued, and so investors need to stick to a valuation discipline to improve their chances of strong returns.

Quality in action: the “greenabler” chain effect

Quality, climate-focused companies, at attractive valuations can be found among the greenablers. These firms are enabling other companies across the value chain to improve their climate credentials. Their products and services help a wide swath of industries to decarbonise, bolstering their climate focus—and growth potential.

Autodeskisonesuchgreenabler. Thefirmprovides computer-aided design software for clients in various industries, including infrastructure, water and transportation—all with a sustainability bent. Autodesk helps businesses such as SchneiderElectric, which designs fuel-efficient machinery, and Eaton Construction, which builds energy- saving LEED*-certified structures.

Greenablers can also be overlooked in industries often assumed to be “less green”, like manufacturing. Consider Prysmian Group, the world’s largest cable producer, supplying the power, energy, infrastructure, construction, industrial and telecom markets. Global decarbonisation hinges on energy transition and electrification, so Prysmian is well positioned to enable customers to connect renewable generation capabilities directly to power grids.

Green expenditures: investing in resilience

Green capex is a pivotal indicator both of a company’s commitment to sustainability and its preparedness for the transition to a low-carbon economy. So far, corporates are focusing green capex on solar power, battery storage, energy efficiency and electric vehicles. But over time, we expect green investment to broaden across a wider range of areas, including the full range of renewable and/or low-carbon power generation.

Quantitative research helps estimate expected returns

We believe that the combination of fundamental and quantitative research may provide a climate-focused portfolio with an advantage over portfolios that only deploy one type of research. In the illustrative examples below, based on real companies in distinct sectors, we show how quality, climate and price can be used to shape return forecasts (Display3). For climate, we incorporate a carbon price of $50 per tonne, applied to the industry context. This helps us compare between companies within and across industries at a time when more firms are applying their own shadow prices on carbon, which complicates comparisons. While the mining company offers high quality and an attractive valuation, the cost of carbon drags down its return potential. In contrast, the pharmaceutical manufacturer enjoys stronger return potential because of lower carbon- emission costs.

Balancing quality, climate and price to shape return forecasts
Expected Return (12-Months Forward), Incorporating the Cost of Carbon Emissions, Scopes 1+2+F*

For illustrative purposes only - This example is provided for the sole purpose of illustrating how a research process can be used to help identify investable ideas in a climate-focused portfolio management process. We believe the Scope 1,2 and F framework best estimates a stock’s carbon emissions. This data is included in our propriatery quantitative tool. Scope 1,2 and F emissions are measured in metric tonnes of CO2 equivalent greenhouse gas emissions per annum. To derive the impact of carbon on a return forecast, we multiply the company’s most recently disclosed total annual amissions (scopes1+2+F) by the cost of carbon per tonne and offset unsing the company’s market cap. This gives us an estimate of the coast to the company to offset all its emissions, which we then use to reduce the expected return from our proprietary model.
*Scope F is fossil fuels produced but not consumed As of December 31, 2023
Source: AB

A diversified climate approach for a changing world

By following a roadmap to quality stocks with attractive valuations, we believe investors can create a climate-aware portfolio that taps into a wider array of sectors, industries, business models and return sources. With a diversified equity strategy and risk-management tools, this type of portfolio can be designed to deliver through macroeconomic cycles, while capturing the extraordinary capital growth being unleashed by growing efforts to decarbonise the world.

*Leadership in Energy and Environmental Design.

Erin Bigley, Chief Responsibility Officer; CFA, AllianceBernstein
Kent Hargis, Chief Investment Officer Strategic Core Equities; Portfolio Manager Global Low Carbon, AllianceBernstein