Demand for low-carbon portfolios has historically led many sustainable funds to seek out companies which already have strong sustainability credentials. Today, however, some funds are starting to consider companies that would not be considered sustainable now but show clear potential for improvement based on shifts in their corporate practices, business models or governance to target better sustainability, according to the Morgan Stanley Institute for Sustainable Investing’s new report, “An Emerging Trend for Investors to Consider Sustainable Improvers: Driving Financial Performance Alongside Long-Term Environmental or Social Change.”
These funds’ portfolios might include a clothing company reducing waste and improving social responsibility in its supply chain, or a manufacturer adopting processes that will reduce its carbon footprint. Defining the potential for improvement varies based on institutional investors’ strategies, as well as their views on the usefulness and credibility of carbon-reducing technologies.
Identifying investments that are not sustainable today but may become so in the future could create an investment opportunity if those sustainability efforts are reflected in stronger financial or valuation metrics. What’s more, if institutions embrace this approach, it may encourage companies to boost investment in green initiatives and innovation. Investors may also take the view that their engagement can help to drive positive environmental or social change, as part of stewardship efforts.
“We increasingly hear from asset managers, as well as asset owners, that they see value in the transition from brown to green activities as well as the opportunity to drive positive change,” says Matthew Slovik, Head of Global Sustainable Finance at Morgan Stanley.
Evolving Attitudes Toward Traditional Energy Companies
Between 2018 and 2023, sustainability funds reduced their holdings in traditional energy companies to 1.8% of holdings from 3.7%—less than half that of traditional funds. More than $7 trillion, or 13% of global assets under management (AUM), is in funds that screen out exposure to thermal coal, and more than $5 trillion, or 10% of global AUM, is in funds that screen out other fossil fuels, such as oil and gas.
Both individual and institutional investors may be open to a more nuanced approach in the future. More than half (51%) say they would invest in fossil fuel-based energy companies if they have robust transition plans in place, while less than a quarter would exclude them altogether on environmental grounds, according to the 2024 Sustainable Signals survey of individual investors and of institutional investors from the Institute for Sustainable Investing.
Defining what constitutes a robust plan is not always clear, but investors often consider the usefulness and credibility of technologies such as carbon capture and storage, the need for energy companies to diversify their business models or phase out high-emitting assets. Institute analysis found that among the small but growing number of dedicated improver funds, most have one traditional energy company in their top 10 holdings.
New Updates to Old Buildings
Sustainable equity funds are less likely than traditional funds to have real estate holdings, with the average weighting of real estate at about 3.0%, compared with 4.5% for traditional funds. Yet the sector could be an important driver of decarbonization:
Claus Vinge Skrumsager, Head of North Haven Secured Private Credit at Morgan Stanley Investment Management, highlights that “Building operations and construction account for around 40% of global energy related CO2 emissions and 75% of the EU building stock is energy inefficient, so retrofitting buildings is a major environmental necessity. We see this creating an attractive yield opportunity for targeted private credit contractually tied to sustainability performance improvements.”
Building improvements can mitigate a property’s environmental impact, reducing operating costs and boosting asset values. This not only enhances a property’s sustainability, but can also create financial benefits for tenants, owners and lenders. As a result, more sustainable property funds are adding investments in refurbishments to their overall strategies.
Establishing Credibility and Investor Confidence
Traditional investors have well-understood frameworks in place to support them in assessing companies’ future potential, with detailed financial statements giving a strong picture of current positioning complemented by earnings forecasts, valuation methodologies, industry and macroeconomic analysis. Establishing forward-looking frameworks for sustainability topics to support investor confidence in future sustainability trajectories is key to an improvers approach. Increased corporate sustainability disclosures have come a long way in establishing a clearer view of current sustainability performance, and investors have a growing number of tools they can call on to evaluate future sustainability potential.
Frameworks to assess company transition plans and targets are becoming more sophisticated. For example, the Science Based Targets initiative (SBTi) is a standardized set of benchmarks that allows businesses to show how they are complying with their climate goals, while the UK’s Transition Plan Taskforce (TPT) released its disclosure framework in October 2023 and is collecting input for its guidance for selected industries, including oil and gas and mining and metals.
More disclosure on capital expenditures (CapEx) and research and development (R&D) allocation may help investors track sustainability steps companies are taking before they become evident in revenues. European companies are increasingly required to disclose the proportions of both capex and some operating expenses, primarily R&D, that align with EU regulations, which may provide more tangible data for investors.
“There will always be an element of uncertainty about a company’s future strategy—even the most robust plans may need to be adapted if external circumstances change,” says Jamie Martin, Head of Morgan Stanley’s EMEA Sustainability Office. “But regulation does not just mean a longer list of backward-looking metrics—changes such as greater visibility on sustainability-related CapEx and R&D are are creating a step change in the confidence that investors can have in a company’s sustainability performance and future direction.”
