Green Investment: New Trend, New Direction

Abstract

This chapter focuses on asset and investment management within the framework of carbon neutrality and sustainable development. Our conclusions are as follows: At first glance, it appears investment based on the principle of carbon neutrality and sustainable development (sustainable investing) may reduce expected returns. In our view, however, this is not necessarily the case. Though achieving carbon neutrality is a process of internalizing the externalities from traditional energy use, increasing costs in the near term and requiring technological breakthroughs and the further development of rules in the medium term, we believe sustainable investing would not necessarily lead to a decline in returns. In addition, as the world strives to achieve carbon neutrality, opportunities and risks vary among markets with different resource endowments and relative positions on the value chain. We think making active decisions and doing rigorous research are the key to realizing investment returns and guarding against risks.

Second, we believe combating climate change and abiding by sustainability principles will have profound medium- and long-term effects on industries, industrial structure and regional economies. In our view, implementing the principles of carbon neutrality will generate far-reaching implications for production, energy, financials, technologies, consumption, and relative geographical advantages and landscape. We suggest paying attention to a number of issues and trends: (1) the growing utilization of clean and renewable energy; (2) the mounting financial risks to industries with large carbon footprints; (3) recycling of resource amid transformation towards a circular economy; (4) the positive role of advanced technologies in “green energy” use and energy conservation; (5) the reshaping of regional economies; and (6) low-carbon consumption.

Third, we identify potential winners and losers in a wide range of industries amid the goal toward carbon neutrality and sustainable development based on the views of CICC sector analysts. We also compile the CICC China Carbon Neutrality Investment Index (CCCNII). The market cap-weighted CCCNII and the equal-weighted CCCNII have registered annualized returns of 17.2% and 25.1% since 2009, outperforming major benchmark indices. They have delivered notable excess returns in the past 3 years, partly driven by gains from the solar-power and electric-vehicle value chains.

From an economic perspective, achieving carbon neutrality is essentially a process of changing the way people internalize negative externalities from traditional human activity and production. We think this process will also generate a fundamental shift in how people invest.

This chapter focuses on a number of topics relating to sustainable investment and asset management. In particular, we aim to answer the following three questions:

• (1) How will sustainable investment affect potential investment returns? Will it necessarily reduce expected investment gains?

• (2) How will following carbon neutrality principles affect the structure of the industries? What trends will it bring to industries?

• (3) Which sectors will benefit from carbon neutrality and sustainable development? Which sectors will be negatively impacted? How can investors capitalize on opportunities from carbon neutrality and hedge against risks?

Overall, we draw the following conclusions:

Sustainable investing will not necessarily reduce investment returns. Under the investment framework based on carbon neutrality and sustainable development, environmental externalities from human activities that were not fully reflected in previous investment decisions are now taken into consideration. While sustainable investing seemingly imposes extra restrictions on investments and may reduce expected returns, it may also help balance short-term costs with medium/long-term returns. Additionally, sustainable investment based on carbon neutrality and sustainable development provides investors with additional information on corporate fundamentals. We also think carbon neutrality may trigger a technological revolution. As such, we do not believe sustainable investing will necessarily reduce investment returns, though whether it would provide a substantial boost to returns remains to be seen. Making active decisions and doing rigorous research are of great importance.

Combating climate change and following the principles of carbon neutrality and sustainable development represent a new industrial revolution, which will impact industries, the industrial structure and regional economies significantly in the medium and long term. We believe they will bring about far-reaching implications for production, living environments, energy, financials, technologies, consumption, and relative geographical advantages and landscape.

We suggest paying attention to a number of issues and trends: (1) rising utilization of clean and renewable energy, (2) the complexity of financial analysis, and mounting financial risks to industries with large carbon footprints, (3) resource recycling amid transformation towards a circular economy, (4) the positive role of advanced technologies in “green energy” use and energy conservation, (5) reshaping of regional economies, and (6) low-carbon consumption.

Potential winners and losers: We identify potential winners and losers under carbon neutrality within a wide range of industries based on the views of CICC sector analysts. We also compile the CICC China Carbon Neutrality Investment Index (CCCNII). The market cap-weighted CCCNII and equal-weighted CCCNII have registered annualized returns of 17.2% and 25.1% since 2009, outperforming major benchmark indices. They have delivered notable excess returns in the past 3 years, partly as a result of gains from the solar-power and electric-vehicle value chains.

12.1 How Will Following the Principles of Carbon Neutrality and Sustainable Development Affect Potential Investment Returns?

This is a general question, but investment institutions and researchers have yet to reach a consensus. We try to answer this question by exploring the following two parts.

12.1.1 Existing Framework for Building Sustainable Investment Portfolios and Its Potential Challenges

12.1.1.1 Why Should Investors Focus on Carbon Neutrality?

In previous chapters, we elaborated on why humans should place emphasis on carbon neutrality and sustainable development. In this chapter, we will focus on why investors should attach importance to these two issues.

Overall, the reason why investors should pay attention to carbon neutrality and sustainable development can be divided into financial (affecting investment returns) and non-financial (complying with laws and industry requirements) factors.

First, sustainable investment has attracted wide attention from the global financial and investment industries. In order to fulfill the Paris Agreement, an international treaty on climate change, more than 275 large asset-management institutions in 16 countries created the Institutional Investors Group on Climate Change (IIGCC), and launched the Net Zero Investment Framework that is consistent with the Paris Agreement and can be constantly revised (Fig. 12.1). Institutions that participate in the IIGCC have a combined assets under management (AUM) of US$35trn.¹ We believe the positive response from financial and investment institutions around the world to the call for addressing climate change may push their Chinese counterparts to follow suit. We think China’s financial and investment institutions that take the lead in combating climate change will gain first-mover advantage.

Fig. 12.1

IIGCC’s net zero investment framework for consultation. Source IIGCC (Net Zero Investment Framework), CICC ResearchFootnote

IIGCC, https://www.iigcc.org/resource/net-zero-investment-framework-for-consultation/.

Second, China’s commitment to carbon neutrality will also push a wide range of domestic industries (including financials and investment) to formulate codes of conduct on carbon neutrality and sustainable development. China’s goal of achieving carbon neutrality by 2060 has drawn wide attention across the country. All domestic industries, including financials and investment, are discussing how the country should achieve this goal. We think the 14th Five-Year Plan and longer-term policy framework will update China’s targets and measures on green development based on the commitment to carbon neutrality. In our view, all industries including financials may formulate codes of conduct to help China achieve carbon neutrality and sustainable development. We think this will affect future investment behavior.

Chinese investors just begin to give consideration to compliance with climate treaties. However, as China officially announced the target of reaching peak carbon emissions by 2030 and achieving carbon neutrality by 2060, we think Chinese regulators and domestic financial and investment institutions may introduce disciplined frameworks. In addition, as global asset managers play a greater role in the Chinese market amid further opening-up of the market, their behavior will also affect the performance of the Chinese market and domestic investors will need to focus more on the principle of low carbon and zero emissions in their investment management.

Lastly, as the world steps up efforts to embrace the principles of carbon neutrality and sustainable development, we believe this will also change risks and return conditions that investors will face. The commitment to carbon neutrality by major economies and strict implementation of the widespread “carbon neutrality and sustainable development” principles in China could be similar to a new round of longer-lasting and farther-reaching worldwide supply-side reform. Moreover, requirements from carbon neutrality and sustainable development are something like a new “energy revolution”. We believe this will produce notable and sustained impacts on almost all industries and companies at various positions of different industries, thereby affecting the investment value of many sectors and companies.

Overall, investors need to attach importance to carbon neutrality and sustainable development in all of the three scenarios: (1) fulfilling obligations, (2) capturing opportunities from green development, and (3) guarding against the risk that certain areas face due to carbon neutrality. When exploring international markets and attracting foreign money, Chinese asset managers also need to place emphasis on the principle of carbon neutrality and sustainable development as following this principle has become one of the prevalent options in foreign financial and investment industries.

12.1.1.2 How to Follow the Principle of Carbon Neutrality and Sustainable Development in Formulating Investment Portfolios?

How can investors help achieve the goal of carbon neutrality? Superficially, achieving carbon neutrality and promoting sustainable development seem like a job for industrial companies, and financial institutions are not directly responsible for emissions reduction as they are not large carbon emitters. However, in practice, global financial and investment industries are both following the rules that the Paris Agreement stipulated in their investment process. As investors face new financial and investment principles, the cost of obtaining financial resources will change for different types of companies, thereby affecting corporate and individual behavior.

How do investors follow the principles of carbon neutrality and sustainable development? Currently, in the Chinese market, carbon emission-related regulatory rules are still under development, and the disclosure of emissions data remains incomplete. Therefore, there are only a few quantitative investment portfolios that are built based on the carbon neutrality framework in China. In foreign markets, however, a number of investment portfolios are built based on corporate emissions data in an attempt to curb investment behavior and affect industrial companies. IIGCC released the Paris Aligned Investment Initiative (PAII) in May 2019, and issued the Net Zero Investment Framework for Consultation in 2020, providing asset owners with a preliminary framework on how to build investment portfolios that comply with the Paris Agreement. IIGCC stressed that this framework also applies to asset managers, although it is designed for asset owners.

EU and other relevant institutions have taken the lead in developing investment frameworks that are systematically built based on the goal of carbon neutrality. The investment framework developed by IIGCC whose members are mostly from Europe is relatively more mature than the others. As such, our analysis is mainly based on IIGCC’s investment framework, although this framework is not perfect and it continues to be updated frequently.

Investment portfolio-based emissions reduction via two aspects: According to the Net Zero Investment Framework for Consultation, delivering a “net zero investment strategy” should focus on achieving two alignment objectives: (1) decarbonizing investment portfolios in a way that is consistent with achieving global net zero greenhouse gas (GHG) emissions by 2050, and (2) increasing investment in “climate solutions” that are needed to meet climate goals such as renewable energy, low carbon buildings, and energy efficient technologies.³

IIGCC’s investment framework covers four major asset classes: sovereign bonds, listed equities, corporate fixed income, and real estate. Further work will be undertaken in Phase II of the PAII to broaden the investment framework to include additional asset classes (infrastructure and private equity), consider the adaptation goals of the Paris Agreement, and address technical issues identified in Phase I.⁴ In addition, a large number of asset management institutions are also exploring how to promote low or zero carbon emissions via their investment portfolios.

Potential creation of investment portfolios based on informative corporate emissions data: If data on any individual company’s carbon emissions is available, the strategy of building investment portfolios that are aligned with carbon neutrality and emissions reduction will be relatively intuitive. Investment institutions can estimate an investment portfolio’s carbon emissions volume or emissions density per unit of investment value based on emissions volume, investment size and proportion of each asset in the portfolio, so as to formulate emissions reduction targets consistent with climate treaties.

12.1.1.3 Potential Problems

We believe the IIGCC’s investment framework still needs to be improved further. Under the current conditions, it may face the following issues when it is used to build and manage investment portfolios based on the principle of tackling climate change, reaching carbon neutrality and promoting sustainable development.

Collection of complete, sustained and public carbon emissions data is of great importance to building sustainable investment portfolios. However, such data collection still faces hurdles even in Europe, which has made significant progress in carbon emissions control. In our view, continuous and complete disclosure of carbon emissions data as well as worldwide standard unification might need coordination between policymakers around the world.

Potential double counting issues in calculating a portfolio’s carbon emissions volume: As mentioned earlier, when calculating a portfolio’s emissions volume, three types of carbon emissions merit close attention: (1) a company’s carbon emissions generated in the course of its operations (scope 1), (2) carbon emissions from generation of electricity and heating that the company purchases from third parties (scope 2), and (3) carbon emissions from the value chain (scope 3), such as the emissions from upstream firms that produce components or the emissions from downstream consumers when using this company’s products. In the process of asset allocation, incorrect separation of these three scopes may lead to double counting. For example, if an asset manager invests in both a power plant and the plant’s downstream customers, it would be difficult to accurately calculate a portfolio’s carbon emission density.

The impact of investor behavior on corporate actions tends to be indirect. While long-only investors who avoid investing in companies with a large carbon footprint, this practice also reduces their impact on these companies. Constraining corporate carbon emissions via investor behavior only has an indirect impact. If long-only investors in the stock market tentatively avoid investing in large carbon emitters, it will in turn weaken their impact on corporate behavior.

The role of short selling in emissions reduction via investment portfolios: Investors cannot affect a company’s behavior if they do not hold this company’s assets. However, we believe things will change if short selling is allowed. Investors can rely on short selling to hedge against the risk of climate change. They can also leverage short selling to affect the behavior of companies with high emissions. In addition, shorting companies with large carbon footprints can be used to offset the impact of longing firms with limited emissions volume. We believe the short selling system will play different roles in regional carbon emission reduction, as its maturity varies between countries.

Target setting of investment portfolios under IIGCC’s investment framework for carbon neutrality and climate change is displayed in Fig. 12.2. The strategic asset allocation (SAA) under IIGCC’s carbon neutrality-based investment framework is presented in Fig. 12.3.

Fig. 12.2

Setting targets for investment portfolios under IIGCC’s Net Zero Investment Framework. Source IIGCC (Net Zero Investment Framework), CICC ResearchFootnote

IIGCC, https://www.iigcc.org/resource/net-zero-investment-framework-for-consultation/.

Fig. 12.3

Steps for alignment through Strategic Asset Allocation (SAA) under IIGCC’s Net Zero Investment Framework. Source IIGCC (Net Zero Investment Framework), CICC ResearchFootnote

IIGCC, https://www.iigcc.org/resource/net-zero-investment-framework-for-consultation/.

12.1.2 How Will the Real Investment Returns Be Affected by Following the Principles of Carbon Neutrality and Sustainable Development?

As the notion of carbon neutrality and sustainable development is becoming increasingly popular in recent years, investment research institutions and other organizations have paid more attention to the impact of these principles on potential investment returns. In particular, sectors related to solar power and electric vehicles (EVs) have significantly outperformed the overall market. Driven by policy support around the world and the plunging cost of EVs, the era of grid parity for solar power plants is coming and the replacement of traditional fuel vehicles by EVs is also accelerating globally. This trend has also sparked discussions about the relationship between following principles of sustainability and reaping investment returns.

For example, in a research paper released in April 2020, MSCI stated that⁷ from December 2009 to December 2019, the environmental, social and governance factor cumulatively contributed 1.88 percentage point to the top 20 ESG funds’ returns, with more than 80% of those returns occurring in the last 4 years of the study period. Other studies such as research by G Badía (2018) and JC Mollet (2014)⁸ show that there are no statistically significant differences between the performance of high- and low-rated portfolios built based on social responsibilities and carbon neutrality.

Our views and analysis are as follows:

If investing based on the principles of carbon neutrality and sustainable development can have a clear and positive impact on investment returns, we believe this would contribute to achieving carbon neutrality without government support or legal restrictions and mandates. As the Nash Equilibrium shows, if a strategy can benefit all players in a game, this strategy is very likely to be naturally chosen in an entire country without additional government support or legal constraints. However, it remains unclear whether a country can achieve carbon neutrality without government support or legal restrictions due to the following reasons:

Abandoning fossil fuel technologies and pursuing carbon neutrality represent a revolutionary initiative to be undertaken by humanity voluntarily. It is a process of internalizing externalities from the use of traditional energy. It will increase a country’s short-term cost, which is clearly a near-term challenge, especially for companies and individuals that rely heavily on traditional energy.

The goal of achieving carbon neutrality is a process of self-disciplined technological innovation and revolution. We believe this process needs the support of capex in the short and medium term, which can create both winners and losers. In the long term, direct or indirect benefits of this revolution will remain uncertain and unpredictable, although potential gains might outweigh the cost, especially for an entire country or the whole world. For example, in order to cut carbon emissions, automakers need to invest heavily in advance. However, the rising penetration of EVs amid emissions reduction is also a revolution in the auto industry, given that the interconnection of intelligent vehicles may effectively improve travel experience and efficiency.

Whether costs and benefits from carbon neutrality can be reasonably allocated between different groups or production to some extent depends on the design of systems which also affects the potential investment returns. The specific mid- and long-term impact of carbon neutrality on a country’s capital market indices also depends on the country’s stage of development and position in the global value chain.

If a country is determined to reach carbon neutrality, we believe taking systematic actions earlier may help the country face lower costs. Our view is echoed by a number of theoretical studies on climate change such as the research paper “The Environment and Directed Technical Change”⁹ published in American Economic Review in 2012. If a country will eventually return to the correct path, assuming other conditions remain constant, early “stop loss” can ensure lower costs.

Lastly, it remains uncertain whether following the principle of sustainability can boost investment returns. However, carbon neutrality and sustainable development are external shocks that humans have brought on themselves. Active research and preparations can help enhance returns and lessen risks when facing uncertainties from both carbon neutrality and all other issues. For example, investors who invested in alternative energy and EV reaped solid returns in recent years. They would not have registered such returns if they had not done forward-looking studies on the solar power and EV industries.

Overall, our conclusion is consistent with the view in the article “Responsible Investing: the ES-efficient Frontier” published in Journal of Financial Economics. Carbon neutrality is an entirely new topic that investors around the globe are facing. In our view, it will not only affect investment procedures and portfolio building, but will also have an impact on potential investment returns. We think investors can seize opportunities earlier and effectively against risks by making active decisions and doing rigorous research.

12.2 How Will Addressing Climate Change and Following the Principles of Carbon Neutrality Affect Industrial Structures?

Combating climate change and following the principles of sustainability have the potential of fueling a new technological revolution that can revamp the ways energy is used. Like the Industrial Revolution in the past, we believe this technological revolution will affect all aspects of production and how people live, which will generate far-reaching implications for existing industries and the overall industrial landscape.

We think the following impacts on industries and industrial structure merit attention based on the views of CICC sector analysts and existing studies, as well as our research.

12.2.1 Increasing Use of Clean and Renewable Energy

Mass adoption of fossil fuels such as coal and petroleum started several centuries ago. Efforts to address climate change and follow the principles of carbon neutrality and sustainable development help cut emissions, save energy and reduce the use of traditional energy that causes heavy pollutions. In addition, we believe these efforts will also stimulate consumption of clean and renewable energy such as solar, wind and hydro power. We think this will push human society to rely more on clean and renewable energy for production and daily life.

Renewable energy industries such as wind power and solar power are coming into a new era around the globe over the past decade, which is one of the signs of the fourth industrial revolution. The world’s energy structure is increasingly diversified and will be dominated by clean and low-carbon energy sources. According to BP’s Statistical Review of World Energy 2020, the share of non-fossil fuel energy sources in energy consumption rose from 9% in 1980 to 16% in 2019. Annual average growth in the consumption of renewable energy reached 13.7% in the past decade, making renewable energy the only energy source with double-digit consumption growth in the same period. In addition the International Renewable Energy Agency (IRENA) expects renewable energy to contribute almost 36% of global energy supply in 2030.

China played a major role in the transformation of the global energy structure. According to the National Bureau of Statistics (NBS), coal accounted for 57.7% of China’s energy consumption in 2019, 1.5 ppt lower than the share in 2018, and the proportion of clean energy expanded 1.3 ppt to 23.4%.

Fig. 12.4

Coal output as a percentage of China’s energy production has contracted, while the share of renewable energy has increased considerably. Source Wind Info, CICC Research

Over a longer period, the proportion of raw coal production within the China’s total energy production trended downward from 74.2% in 1990 to 68.6% at end-2019 (Fig. 12.4), whereas the share of renewable energy expanded from 4.8% to 18.8% in the same period. In addition, raw coal and crude oil combined made up 92.8% of China’s energy consumption in 1990, and the aggregate share of hydro, nuclear, and wind power rose from only 5.1% in 1990 to 15.3% at end-2019. China’s world-leading adoption of non-fossil fuel energy facilitated the country’s transformation towards clean energy sources. As of 2019, China’s cumulative installation volumes of hydro, wind and solar power were among the highest around the world.

12.2.2 Mounting Financial Risks to Industries with Large Carbon Footprints

In Chap. 4, we discussed the status quo, existing problems and policy recommendations for “green finance”. We believe efforts to address climate change and follow the principles of sustainability will lead to at least two changes in the financial industry:

Under a financial analytical framework, a new factor—sustainable development—is added, making financial investment, pricing, risk measurement and regulation complicated. Putting aside carbon neutrality, a financial analytical framework needs to include factors that are mostly limited to economic and financial returns. However, when considering carbon neutrality and efforts to address climate change, externalities arising from resource and energy utilization could be internalized. The process of financial decision making, regulation and system design will become more complicated. In the previous section, we stated that following the principles of carbon neutrality and sustainable development will make the process of building investment portfolios more complex. We believe this is probably only one of the impacts on the financial industry from carbon neutrality.

Under the principles of carbon neutrality and sustainable development, a number of industries that are closely related to traditional energy sources or emit high levels of carbon (e.g. petroleum, coal and raw material processing) may lose their luster. We believe this will create large uncertainties in the value of financial assets related to traditional industries (e.g. loans and equities), thus heightening the risk of bad debts and defaults.

We believe this problem is particularly striking in China. The outstanding mid- and long-term loans that Chinese financial institutions issued to heavy industries with large carbon footprints totaled Rmb9.54trn (as of December 3, 2020, see Fig. 12.5), accounting for 86% of the total balance of mid- and long-term loans to the entire secondary sector. The heavy chemical industry now faces strong pressure to transform, which we believe is technologically challenging and will last for some time. In our view, additional requirements from carbon neutrality may reduce market demand for products from heavy industries, heightening the risk to banks with exposure to these industries.

Fig. 12.5

Growth rate of mid- and long-term loans in heavy industry keeps increasing. Source Wind Info, CICC Research

12.2.3 Resource Recycling Amid Transformation Towards a Circular Economy

Production of basic materials such as steel, nonferrous metals and cement accounts for a very large share of China’s total carbon emissions. Implementing the idea of “circular economy” in these industries could be one of the most important options for China to reduce carbon emissions and reach carbon neutrality. In “The Circularity Gap Report 2021”, the Circle Economy organization stated¹⁰ that only 8.6% of the world’s economic resources are currently participating in the practices promoted by the “circular economy”. Simple practices such as reducing usage of raw materials can reduce the global emissions and total material footprint by 39% and 28%.

It is particularly important for the steel, cement, fertilizer and plastics industries to transform and accept the concepts promoted by the notion of circular economy and considerably raise the recycling rate of key materials. We believe China’s demand for crude steel and cement is likely to shrink as its population begins to contract and the urbanization rate decelerates. Energy Transitions Commission estimates steel output based on recycling of steel scrap as a percentage of total steel production will rise from less than 10% at present to 60% in 2050.¹¹ In the cement industry, recycling potential is limited, but modification of building design and material quality may almost halve cement demand compared to current practices. According to the Energy Transitions Commission, 52% of China’s plastics demand could be met by recycled plastics thanks to advancement of physical and chemical recycling technologies. Thus, reducing the use of and recycling of raw materials are of vital importance to carbon emissions reduction.

Looking at the steel industry as example, as steel production relies heavily on fossil fuel energy such as coal, the steel industry accounted for 18% of total carbon emissions among all energy-consuming sectors in China in 2017, according to CEADs. In other words, emissions reduction in the steel industry is crucial for China to achieve carbon neutrality. Chinese Academy of Engineering estimates recycling 1tonne of steel scrap can save 4.3tonnes of iron ore, 1tonne of raw coal, and 1.7tonnes of water, i.e. reducing 1.6tonnes of carbon dioxide emissions. Energy Transitions Commission expects steel scrap supply to grow 10% every year and its price to plunge as a growing number of vehicles, buildings and other equipment reach their designed lifespans. The World Steel Association estimates China’s annual steel scrap supply will be around 300–400mn tonnes in total in 2050, which can be used to replace natural resources to save raw materials and reduce carbon dioxide emissions.

12.2.4 The Positive Role of Advanced Technologies in “Green Energy” Use and Conservation

The process of reaching carbon neutrality itself is a technological revolution. The positive role of technologies in carbon emissions reduction cannot be overestimated. Their positive role includes at least two aspects:

Technological advances hold the key to full-scale utilization of renewable and clean energy. For example, incremental photovoltaic (PV) installed capacity rose from 16 GW in 2010 to 105 GW in 2019.¹² We believe technological advances served as a fundamental driver for the strong growth. Innovations in silicon wafers, cells and other modules not only enhanced the power of PV panels, but also reduced the manufacturing cost.

The price of polysilicon modules has dropped from US$2/W to around US$0.2/W. The lower manufacturing cost of PV modules has also pushed down the average cost of solar power generation. According to IRENA, the average cost of global PV power stations dropped from US$0.378/kWh in 2010 to US$0.068/kWh in 2019,¹³ close to or even below the cost of traditional energy-based power stations, making solar power generation more attractive around the world.

However, electricity generated by solar and wind power plants cannot be fully connected to power grids at times, and curtailment occurs due to a number of problems such as intermittent production and ineffective peak shaving.

The combination of energy storage technologies and renewable power generation helps store the electricity that cannot be transmitted to power grids immediately and reduce the volatility of electricity transmission. The mass adoption of electrochemical energy storage systems is less costly than before thanks to technological advancements in lithium-ion batteries and further cost contraction.

Apart from supply-side electricity storage, ultra high-voltage (UHV) power transmission has effectively resolved the problem of long-distance power transmission that renewable power plants face. It paves the way for mass development of quality renewable energy in northwestern China.

Technological advances create important ways to conserve energy. According to a report on China’s energy consumption in the construction industry, buildings accounted for 21.7% of China’s total energy consumption and made up 21.9% of the country’s carbon emissions in 2018.¹⁴ Reducing carbon emissions related to buildings is of vital importance for China to achieve carbon neutrality. In particular, technological advances hold the key to reaching this goal.

For example, technological improvements to buildings’ outer protective structure can reduce the use of heating and cooling systems. Energy use technologies such as solar power systems and heating based on ground-source heat can effectively convert solar and geothermal energy into heat and electricity to meet the needs of production and daily life. In addition, installing reclaimed water and rainwater recycling systems in buildings can considerably enhance resource recycling efficiency and reduce the negative impact of buildings on the environment.

12.2.5 Low-Carbon Consumption

Low-carbon consumption is key to carbon emissions reduction in the end market. Consumption is the sole end and purpose of all production activities, and personal consumption is the final source of carbon emissions. Chinese consumption is maintaining strong growth momentum. Consumer spending has contributed more to economic growth than investment, and now serves as a driver of economic growth. The transition period for consumption upgrading also presents opportunities for consumers to develop the habits of green consumption and green lifestyle. If these opportunities are missed, the economy would face higher transitional costs due to the vicious circle of mass production, ever-higher levels of consumption and a growing number of disused materials. We believe it is of vital importance that China places increasing strategic emphasis on a low-carbon lifestyle.

Green consumption has penetrated almost all aspects of human life such as clothing, food, shelter and travel. Environmentally friendly and resource-saving consumption has become mainstream as disposable income per capita rises further, consumers adopt “green” lifestyles, and consumption upgrading is increasingly apparent.

The UN Environment Programme (UNEP) released a report¹⁵ in 2017 showing that half of Chinese consumers are willing to pay a premium of up to 10% for sustainable products.¹⁶ Meanwhile, China released a report in 2019 on a survey of domestic green consumption. According to this report, the concept of green consumption is increasingly popular among Chinese consumers, with 83% of the respondents saying they were in favor of green consumption behavior (47% showing strong support for such behavior). In addition, according to another report on household low-carbon living and consumption, 54% of the respondents said they would consider energy conservation, low utilization cost, and environmental friendliness when buying home appliances. Overall, the concept of energy conservation and low-carbon consumption is increasingly popular among Chinese consumers, and a growing number of Chinese people live a green lifestyle.

12.2.6 Reshaping of Regional Economies

A country is unlikely to gain first-mover advantage in the process of the carbon neutrality revolution unless it formulates strategies based on local economic conditions, strengths and weakness. How effective a country or a region is in responding to the revolution could be affected by a number of factors such as the extent of its reliance on traditional energy sources, expertise of domestic manufacturers, its position in the global value chain, and its technological innovation capabilities.

The cost of carbon neutrality transformation would be lower if a country starts the transformation earlier. Developed economies have natural advantages in this aspect. Theoretical studies¹⁷ show that the sooner the transformation starts, the lower the cost would be. In developed economies, their technologies are more advanced, and sectors with lower carbon emissions account for a large proportion. As such, they are more likely than other economies to achieve carbon neutrality. In other words, they have gained first-mover advantage.

We think economies that rely heavily on traditional energy sources will face strong challenges in the medium and long term. These economies can be divided into two groups: resource-rich economies (such as the Middle East countries, Russia and Australia), and resource-depleted economies like China and Japan.

We think economies with stronger manufacturing industries and advanced technologies are more likely to gain advantages in the transformation towards carbon neutrality. China’s alternative energy value chains, especially the solar power value chain, have obtained a global competitive edge following years of efforts. If China can retain the competitive edge, we believe this advantage will also contribute to its transformation towards carbon neutrality.

12.2.7 Impact of Carbon Neutrality on Each Industry, Based on Views of CICC Sector Analysts

We identify the sectors that may benefit from carbon neutrality and sustainable development and the sectors that could be impaired, based on CICC sector analysts’ forecasts of opportunities and challenges (Table 12.1). Our analysis focuses on four factors: (1) current carbon emission, (2) the magnitude of policy support and regulatory pressure, (3) “green premium” (additional cost from widespread adoption of the most advanced clean technologies), and (4) social awareness of social and environmental governance (measured by whether companies issue social responsibility reports and disclose full data).

Table 12.1 Potential winners and losers amid carbon neutrality

12.3 How to Capture Investment Opportunities from Carbon Neutrality and Guard Against Risks?

In this section, our analysis focuses on two parts:

We discuss how to capture opportunities and avoid risks, based on CICC macro and sector teams’ views on carbon neutrality.

We analyze existing indices on carbon neutrality and sustainable development, and compile the CICC China Carbon Neutrality Investment Index (CCCNII).

12.3.1 Investment Opportunities and Risks from the Carbon Neutrality Investment Theme

We suggest paying attention to the following issues when analyzing investment opportunities from carbon neutrality:

Achieving carbon neutrality is a long process, and relies heavily on technological advances. Our views on both investment opportunities and risks are based on current forecasts for economic growth and technological advances. However, economic growth and technological advances may face major uncertainties in the long term.

Carbon neutrality requires changes in energy use, which affects all aspects of production and everyday living. As such, it is difficult to identify investment opportunities and risks from the perspective of all areas.

Nevertheless, given the extent of the impact of moving toward carbon neutrality, we find the following investment themes, based on CICC macro and sector teams’ views and our forecasts for technology development and economic growth in both China and around the world in the next 3–5 years.

Clean energy: Companies that produce clean energy or provide relevant services in a bid to increase clean energy supply, including energy-storage service providers and the firms that focus on wind, nuclear, solar, and hydro power, lithium-ion batteries, and hydrogen energy.

Energy conservation and emissions reduction: In addition to the firms that increase clean energy supply, we think beneficiaries of carbon neutrality may also include areas related to energy conservation and emissions reduction such as smart power grids, smart cities, intelligent transport, energy-saving buildings, circular economy, green agriculture, low-carbon consumption, environmentally friendly packaging, carbon capture and storage, as well as green finance.

Indirect changes arising from carbon neutrality: Rising penetration of smart vehicles driven by 5G applications in EVs; demand for relevant services from carbon taxes and trading; and demand for data and services from ESG investment. In addition, as mentioned earlier, regions with different industrial landscapes may have different features due to carbon neutrality, which could present investment opportunities, in our view.

The areas that investors should avoid amid the transition toward carbon neutrality include:

Traditional energy producers and relevant service providers that are slow in transforming, such as companies in the petroleum and coal value chains that are reluctant to take actions in response to carbon neutrality.

Companies that are in the areas with high carbon emissions; lack a strong desire to transform and face high additional cost from carbon neutrality such as producers of steel, nonferrous metals and cement in the manufacturing industry, as well as suppliers of traditional fuel vehicles and companies in the related value chain in the transport industry.

12.3.2 Summary of Existing Carbon Neutrality Indices

12.3.2.1 Existing Carbon-Neutrality Indices

The world’s major index companies such as MSCI, FTSE, S&P Global, STOXX, and China Securities Index Co., Ltd. have all released a series of indices on low-carbon economy and green development. These indices have different design plans (see Table 12.2), and can be divided into three categories based on compilation methodology.

Table 12.2 Details on compilation of MSCI, STOXX, S&P, FTSE’s low-carbon indices

Broad-based indices retain all constituents of benchmark indices. They reduce carbon footprint by overweighting stocks with limited carbon emissions and underweighting stocks with significant emissions volumes. Such indices shows performance similar to that of benchmark indices.

Indices focusing on leading stocks in the low-carbon economy exclude sectors or stocks with large carbon footprints and prefer representative companies with low carbon emissions. Such indices have fewer constituents, but are more representative. They also perform better than other indices during market rallies.

Thematic indices: select environmental stocks that benefit from the low-carbon economy. The China Mainland Low Carbon Economy Index and China Low Carbon Index are both thematic indices. Unlike the indices in the first two categories that focus on carbon emissions of listed firms, the thematic indices mainly include environmental stocks that stand to benefit from the low-carbon economy.

12.3.2.2 Carbon Neutrality-Related Funds

In a broad sense, carbon neutrality funds refer to funds whose investment portfolios follow the low carbon principle. Morningstar classifies worldwide low-carbon products based on two factors: carbon risk score and fossil-fuel involvement. According to Morningstar, for a fund to receive the Low Carbon designation, it must have a Morningstar Portfolio Carbon Risk Score below 10 for the trailing 12 months and exposure to companies with fossil-fuel involvement below 7% over the same trailing 12 months.¹⁸ The size and share of Low Carbon Designation™ funds have trended upward since 2012.

In a narrow sense, carbon neutrality funds refer to funds whose purpose is to reduce the global carbon footprint. For example, index funds that passively track low-carbon benchmark indices are typical narrow-sense carbon neutrality funds. The world now has 34 index ETFs and open-ended funds that are related to carbon neutrality, and their aggregate size stands at about US$19bn. Among them, the larger ones were issued mainly in Europe. As the concept of carbon neutrality did not emerge until recently, they were mostly launched in the past 3 years, and they mainly track MSCI and FTSE’s low-carbon indices.

12.3.2.3 CICC China Carbon Neutrality Investment Index

The CICC China Carbon Neutrality Investment Index’s (CCCNII) constituents include typical Chinese companies that strive to achieve carbon neutrality and are listed on the Chinese mainland or overseas. They can reflect the performance of Chinese industries related to carbon neutrality (see Fig. 12.6).

Fig. 12.6

Details on compilation of the CCCNII. Source CICC Research

Our compilation process is as follows:

Sample scope:

Our sample scope is limited to stocks that are publicly traded in China or overseas and have launched IPOs in a specified period. It covers A-shares, H-shares, B-shares, red chips, P chips, and ADRs.

Stock selection:

• Among stocks in the sample scope, the names with market cap and turnover are excluded.

• We select carbon neutrality-related sectors from the perspective of fundamentals. Our constituent candidates include listed firms in areas such as circular economy, environmentally friendly energy, transportation, manufacturing, consumption, agriculture, and city development. Our selection is based on three factors: energy supply, energy demand, and comprehensive changes.

• We choose leading firms in respective areas as final constituents based on the views of CICC sector analysts.

Methodology for constructing the CCCNII:

Fig. 12.7

A glance at CCCNII’s market cap-weighted performance. Source Factset, Wind Info, CICC Research

We review constituents biannually and add newly listed stocks. We adopt market cap-weighted and equal-weighted methods to calculate weight of individual stocks. The weighting of each constituent is up to 10%.

The market cap-weighted CCCNII and equal-weighted CCCNII have registered annualized returns of 17.2% and 25.1% since 2009, outperforming major benchmark indices. They have delivered notable excess returns in the past 3 years, partly driven by the gains of companies in the solar-power and electric-vehicle value chains.

Comparisons of CCCNII and other main indices are displayed in Fig. 12.7. Detailed constituents of CCCNII are shown in Fig. 12.8.

Fig. 12.8

CCCNII’s constituents. Source CICC Research