Fund Strategist, May 7, 2007

AGAINST THE GRAIN

[Rachel's introduction: When writers attack the precautionary principle, they follow a consistent pattern: they distort the principle, then they attack their own distortion. This writer is no different. He says, the precautionary principle "requires that a scientific advance can only occur if there is certainty that there will be no negative consequences." Precaution does not require "certainty" about anything in the future because nothing that lies in the future can be known with certainty.]

By Daniel Ben-Ami

Heard the one about well-meaning environmental measures in America and "tortilla protests" involving tens of thousands of angry people in Mexico City? The price of maize, from which the Mexican staple food is made, has surged as a result of huge American government subsidies to biofuel production. America's aim was to encourage biofuels as a way of lessening the country's dependence on more conventional forms of energy. Yet poor Mexicans have inadvertently suffered as a result of the initiative.

And it is not only maize prices that are soaring. Beer prices too have surged as a result of the drive to produce ethanol to use for biofuel. Maize is being planted instead of the malting barley. As a result barley prices have risen and beer drinkers are having to pay more to enjoy their drink.

Many conclusions can be drawn from these experiences. The most compelling is that measures designed to do good can have unintended consequences. No doubt the last thing American officials had on their mind when they designed such subsidies was any intention of harming the livelihood of poor Mexicans. American government policy is designed to help reduce carbon emissions and also lessen the country's dependence on imported energy. Yet the impact on Mexico was as severe as if it had been a deliberate measure.

What is true of biofuels and tortillas has wider implications. Economic life is being reorganised around the environment and the idea of "sustainability" more generally. Most of commentary assumes that this can only be a healthy development. Few consider the problems involved or whether the consequences of this shift could be harmful. Fund management groups, in particular, are generally loath to discuss any potential problems with the shift to green capitalism.

This article will provide a framework to help assess this transition. It will start by examining what is meant by "sustainability". Although the concept seems straightforward it is more complex than it first appears. It will then consider whether the move to sustainability can be profitable. Some people will make money from it but this is not the whole story. Finally, it will consider whether the shift to green capitalism could have damaging consequences for society as a whole.

It is a particularly opportune time to consider the meaning of sustainability because it is the twentieth anniversary of the idea becoming mainstream. Back in 1987 the World Commission on Environment and Development, a body established by the United Nations, published its landmark report called "Our Common Future". It is often known as the Brundtland report after its chairman, Gro Harlem Brundtland, a former Norwegian prime minister. Its highly influential definition of sustainable development is worth quoting at length:

"Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. It contains two key concepts:" -- the concept of 'needs', in particular the essential needs of the world's poor, to which the overriding priority should be given; and;" -- the idea of limitations imposed by the state of technology and social organization on the environment's ability to meet present and future needs."

(Our Common Future, Oxford University Press, p43).

It is important to examine this definition in more detail to explore exactly what it means. The concept of "sustainability" is too often taken as self-evident. The low horizons embodied in this concept of sustainable development are rarely questioned.

First, the focus in on basic needs. Rather than a more ambitious goal of economic transformation and modernisation it settles for a minimalist conception of what economic growth should be about.

Second, it accepts the idea that the environment places limits on human activity. For the advocates of sustainability any attempt to overcome such constraints puts the survival of future generations in jeopardy. The emphasis is on survival rather than transforming society for the better through economic growth.

It would be a big mistake to believe this conception of limits cannot be challenged. On the contrary, there is a strong tradition of thought starting with Sir Francis Bacon (1561-1626), a scientist and Lord Chancellor, which sees overcoming environmental limits as a central element of progress. As humanity advances, according to this view, it develops the capacity to transform the environment to better meet human needs.

From such a perspective the development of science and technology -- from modern medicine to the aeroplane and beyond -- is desirable because it enables humanity to transcend environmental limits. In contrast, the acceptance of such limits means reconciliation with poverty and disease. This viewpoint, which could be called the Enlightenment perspective, was broadly in the ascendant until the 1970s when environmentalism came to the fore.

However, it would be wrong to conclude that things have stayed the same since the 1970s or even since sustainability became a mainstream concept in the 1980s. More recently the meaning of the term "sustainability" has broadened considerably. It is taken to be not just a statement about humanity's relationship to the natural world but also about how people should relate to one another. What could be called social sustainability has joined environmental sustainability as a key concept. It is hard to think of any area of activity in relation to society or the natural world that cannot be covered by the ever expanding concept of sustainability.

This definition is apparent in the five principles on sustainable development promoted by the government-appointed Sustainable Development Commission. These include:

- Living within environmental limits. The original key idea of sustainability.

- Ensuring a strong, healthy and just society. Including promoting personal well-being and social cohesion.

- Achieving a sustainable economy. This includes the acceptance of the "polluter pays" principle in which social and environmental costs fall on those who impose them (see the comment in last week's Fund Strategy on this topic).

- Using sound science responsibly. This includes acceptance of the "precautionary principle" as well as public attitudes towards science.

- Promoting good governance. Encouraging systems of governance on all levels of society.

Many people find some of these principles attractive. But it is possible to raise objections to all of them. For example, the precautionary principle arguably embodies an over-cautious attitude towards science and innovation. It requires that a scientific advance can only occur if there is certainty that there will be no negative consequences. But it is impossible to foretell the future with such a high degree of certainty. By its nature any scientific advance or innovation involves a degree of uncertainty.

It is also possible to object to the idea of encouraging governance "at all levels of society". To some this could sound like regulating even the most intimate aspects of individual's personal lives. For example, the government seems excessively keen on regulating how individuals eat, drink and smoke. Much of the sustainability agenda does seem to be aimed at encouraging "responsible" behaviour. Much of the teaching of environmentalism in schools focuses on values and behaviour.

Going into further detail on these principles is beyond the scope of this article. However, even if they are problematic it does not necessarily follow that money cannot be made from their implementation. Sustainableinvestment could still be lucrative even if it involves a transformation that some see as undesirable.

The problem is working out how to measure the extent of the transition to green capitalism. There is a lot of talk about the need for sustainability and the dangers of climate change (see the Fund Strategy cover story on climate change in the December 11, 2006 issue). However, making a transition to a system in which consumption and production are organised around the principles of sustainability is a different matter.

The shift to green capitalism can be judged at several different levels. On the level of words it is clear that a fundamental shift has taken place: there is widespread acceptance that sustainability is desirable. In relation to consumption there are significant, although often symbolic, changes. But in relation to production the transformation is, at least so far, of a much smaller magnitude.

There is widespread acceptance of the need for sustainability. Children are taught environmental principles in schools, the media is broadly favourable to the sustainability agenda and even the Financial Times recently published a magazine asking "Can England's middle classes save the planet?"

In relation to personal consumption it is easy to point to examples of people following the sustainability agenda. Walk around any supermarket and it is hard to avoid labels on products claiming to be environmentally friendly, organic, locally produced, fair trade or even dolphin friendly. Each of these are in some way meant to signal the consumer's adherence to the environmental agenda. As consumers increasingly absorb such ideas it is likely that more companies will be in a position to profit from sustainability.

However, a closer examination shows that consumers tend to be more contradictory in their behaviour. They may eschew, for example, Kenyan flowers but at the same time fly Ryanair on holiday to Spain. Or they may buy organic salmon in Waitrose and then enjoy a burger at McDonald's. Consumers are far from consistent in their attitude towards products. Typically they will want to signal that they are responsible, perhaps by buying organic chocolate, while still enjoying the benefits of modern mass production. To the chagrin of environmentalists consumers do not tend to consistently follow principles of sustainability.

One area where support for sustainability is clear is government and into corporate regulatory frameworks. The British government is trying to embody sustainability in all its key areas of work. Within the Department for Environment, Food and Rural Affairs (Defra) the mission of the Sustainable Development Unit is "to embed, monitor and report on sustainable development across Whitehall and the UK" (www.sustainable-development.gov.uk). David Miliband, the environment minister, is promoting "one planet living", a concept taken from the World Wildlife Fund. Then there is the Sustainable Development Commission, an independent watchdog on sustainable development appointed by the government (www.sd-commission.org.uk).

Companies have endorsed a corporate social responsibility framework which, in broad terms, commits them to the sustainability agenda. Environmentalist organisations have often condemned such activity as mere "greenwash" -- putting on a green face while continuing with business as normal. But talking to business leaders it is hard to escape the conclusion that they take the sustainability agenda seriously. A recent article in Management Today showed how Tony Juniper, the head of Friends of the Earth, "is suddenly the hottest corporate date in town". In any case it is becoming a legal obligation for businesses to consider the environmental consequences of their actions. The Companies Act 2006 even gives the directors of companies a legal duty to consider the impact of their business on the environment.

However, the transformation in terms of deeds rather than intentions is considerably less. Companies are finding it harder to shift to a sustainable model than the rhetoric often suggests.

James Woudhuysen, professor of innovation and forecasting at De Montfort University in Leicester, portrays the sustainable sector as rapidly growing but still niche. For example, the European market for hybrid electric vehicles, such as the Toyota Prius, almost doubled in 2006. But at30,000 vehicle sales it still accounts for only 0.5% of the market. Similarly there is much talk about renewable energy in America, along with considerable government backing, but it still accounts for a small proportion of energy use (see bar chart below).

He argues that the restructuring of the market around sustainability is likely to be a long drawn-out process. Some areas, such as reducing carbon emissions in the supply chain, could be done with little effort. Such initiatives as road pricing and adding Radio Frequency Identification tags to goods have already started. But transforming the entire energy sector into something that can be recognised as "green" is a long way off. The amount of investment in the energy infrastructure is huge. "The installed base [of energy] is not wished away in a hurry", he says.

A high profile example of the problem of inertia is the hydrogen highway initiative announced by Arnold Schwarzenegger, the governor of California, in 2004 (www.hydrogenhighway.ca.gov). Woudhuysen points out it is not simply a matter of building a commercially viable hydrogen powered car -- although that in itself is a challenge. It will also be necessary to encourage an extensive network of petrol stations to supply hydrogen to car users. In addition, safety concerns about hydrogen cars will need to be allayed.

In Woudhuysen's view the wholesale shift to sustainable production, as opposed to consumption or regulation, is likely to require a generational change. "I think we're at the start of a 10-20 year process," he says. When today's generation of twentysomethings are on the boards of large companies the change could come close to completion.

None of these factors mean it is impossible to make money out of sustainability initiatives. There will always be niche areas that provide lucrative returns. Over time the rise of ethical consumerism should also bolster demand for green products. But in many cases the profitability of green technology or initiatives will depend on state subsidies or regulation.

This latter point is acknowledged in a recent paper by Patrick Schotanus of Aegon on climate change ("Global climate change, investments and the role of financial markets"). It argues that:

"We believe there will be continued and probably increased financial incentives to reduce the use of currently expensive fossil fuels -- either to reduce the carbon output of the world, to defend economies against high commodity prices or to increase domestic security. In some cases the alternatives industries may be profitable under free market conditions but in most, regulatory pricing and incentive structures are being created to redistribute capital and encourage investment. We do not need an industry to be efficient and fully developed in order to invest. However, we are looking for regulatory certainty -- clear regulation for a sufficient time horizon in order to get a sufficient return on a capital investment."

The example of biofuel in America which started this article certainly involves heavy state subsidies. According to an October 2006 study by the Global Subsidies Initiative the subsidies in this area date back to the Energy Tax Act of 1978 ("Biofuels -- At What Cost? Government support for ethanol and biodiesel in the United States". Available at www.globalsubsidies.org). It estimates that current biofuel subsidies are between $5.5bn-$7.3bn (£2.7bn-£3.6bn) a year.

So it is certainly possible for sustainable initiatives to be lucrative but in many cases they will depend on state intervention. Green capitalism is not, for better or worse, synonymous with the free market. The form of government intervention is likely to play a key role in determining which initiatives are profitable or not. The more astute fund managers in this area are likely to monitor the state of regulation closely in addition to considering corporate fundamentals.

This brings us to the final question of whether or not the shift to sustainability is desirable. It is hard to imagine anyone objecting in principle to, for example, a shift to cleaner energy or a less polluted environment. But it is also important to consider the costs embodied in such a shift. If renewable energy remains significantly more expensive than fossil fuels then changing energy sources could hit economic activity. In some cases there can be a trade-off between promoting prosperity and giving a high priority to the environment.

Ultimately sustainability means putting limits on the drive to achieve greater affluence. As in the original Brundtland definition, it means emphasising basic needs at the expense of more ambitious development. For those who take a bleak view of human potential it makes sense to stick with what we have already got or perhaps even turn the clock back. In contrast, for those who believe there is a lot that could be gained from further prosperity the sustainability agenda threatens to put a brake on further development.

It comes down to a political choice. Not in the sense of the old left- right distinction but between those who favour the advancement of prosperity and those who believe affluence creates serious problems. The debate within the financial community plays down this aspect of the discussion. But hard choices will need to be made about whether or not the shift to green capitalism is a desirable one.

Sustainable funds

There is a large number of funds investing in sustainable themes. A few, such as products from CIS and Norwich Union, have "sustainable" in their name but many more follow the principles of sustainability. About £4.7bn is invested in ethical or ecological unit trusts or Oeics according to Morningstar. However, this has to be set against a total universe of this type of fund of about £422bn. In other words, ethical funds make up just slightly over 1% of the total unit trust / Oeic universe.

In continental Europe too there is significant interest in sustainability. There is even a German-based website (www.sustainable- investment.org). It provides investors with information on sustainable funds, stocks and indices. The platform is run by the Sustainable Business Institute at the European Business School and the platform development was funded by Germany's Federal Ministry of Education and Research. But although the platform lists about 140 funds this is also a small proportion of the European fund universe.

On a more global scale, New Energy Finance, a London-based analyst, estimates there was $8.6bn (£4.3bn) of venture capital or private equity investment in clean energy worldwide in 2006. But although this amount might sound like a lot in isolation it should be set against the total size of the global fund industry. From this perspective such specialist funds are still relatively small players in what, potentially, could become a huge market.

However, over the longer term the trend is likely to be for more mainstream funds to be influenced by the environmental agenda. This seems to be the case in Britain with the National Association of Pension Funds (NAPF) inviting Al Gore, the American vice president turned environmental campaigner, to address its annual conference in March. The NAPF was also an "official partner" for Red Nose Day 2007.

Internationally many big institutional investors have committed themselves to the sustainability agenda. The Carbon Disclosure Project, based in London, "provides a secretariat for the world's largest institutional investor collaboration on the business implications of climate change" (www.cdproject.net/).

Fund Strategy is a division of Centaur Media plc 2007