Environmental Finance speaks with Federated Hermes' Ingrid Kukuljan on the importance of investing in the companies that help mitigate biodiversity degradation at this crucial point in time.
Environmental Finance: What is a 'biodiversity champion', and how strict is Federated Hermes' criteria for inclusion in its investment strategy?
Ingrid Kukuljan: When we look at the impact of biodiversity loss it's clear we've reached a tipping point. Human activity has severely altered 75% of the planet's land surface and 66% of the marine environment. Average species population sizes fell by 68% between 1970 and 2016.
As responsible investors, we believe the best way to address this challenge is to identify biodiversity champions, that is, companies around the world that are best placed to mitigate biodiversity decline.
To be included as a biodiversity champion in our strategy, we look for two key performance indicators.
Firstly, the company needs to map to at least one of the UN Sustainable Development Goals (SDGs). The reason for this is that 80% of UN SDGs depend on biodiversity and if we don't address the issue of biodiversity loss we are unlikely to reach 2030 targets. Secondly, and crucially, the company must help restore, reverse loss of, or preserve biodiversity.
EF: Which topics within biodiversity do you prioritise, and why?
IK: There are five main drivers of regional and global biodiversity loss: change in land and sea use, direct exploitation of organisms, invasive alien species, climate change, and pollution.
We've extensively researched each of these drivers and have defined six investable themes for the strategy that address all of them. These themes are land pollution, marine pollution and exploitation, unsustainable living, climate change, unsustainable farming, and deforestation. Each of these themes has multiple sub-verticals that are aligned to specific SDGs.
Idea generation within the portfolio is driven by this thematic framework and our analysis of all industry sub-verticals. Within those, we seek companies that provide products and services which have the highest positive impact on preventing loss of or restoring biodiversity.
The climate-nature nexus
Protecting and restoring our ecosystems is considered to be the second most effective solution to climate change after switching from fossil fuels. Research further suggests over 50% of global GDP is highly or moderately dependent on nature1, and a failure to reverse biodiversity decline could result in collapsing food systems, loss of livelihoods and pose a systemic risk to the global economy.
While companies and investors have largely ignored this problem thus far, the financial industry can play a key role through capital allocation and stewardship as we face a global biodiversity funding gap of more than $800 million dollars2 per annum.
EF: How do you find a balance between investing in companies that benefit biodiversity across different habitats?
IK: The issue with drivers of biodiversity loss is that it very rarely occurs just as a single, self-contained instance. Often it takes place across multiple habitats, ecologies, and locations simultaneously. That's why focusing on a single habitat in isolation – say, biodiversity on land, for example, or exclusively at sea – will not solve the issue.
The flipside's also true about our biodiversity champions and, in many cases, we find that there are companies that have the potential or ability to prevent biodiversity loss across multiple habitats – whether on land or on water – in multiple geographies. One of our holding companies, for instance, is a manufacturer of home decking which is made out of 95% recycled and reclaimed polyethylene, displacing the use of timber and plastic and preventing land and ocean pollution as well as deforestation.
EF: How do you assess fair value as a biodiversity investor?
IK: We assess the value of biodiversity credentials in two ways. The first is by using our Qualitive Biodiversity Assessment, which maps one or more of the six biodiversity themes and provides a credible biodiversity thesis around which the portfolio is managed.
The second medium is our Quantitative Biodiversity Assessment: our Biodiversity Impact Database. This database calculates the biodiversity impact of each name within the strategy across key performance indicators for examining biodiversity impact (such as species loss avoided), as well as the broader sustainability impacts.
EF: How large is the investable universe for biodiversity?
IK: If you want to invest in transition, the investable universe for biodiversity encompasses literally every company in the global index as they all need to transition to a biodiversity-positive business model or at least to reduce negative impacts. In terms of what we define as biodiversity champions, our watchlist is just under 200 companies.
"The issue with drivers of biodiversity loss is that it very rarely occurs just as a single, self-contained instance. Often it takes place across multiple habitats, ecologies, and locations simultaneously"
We invest in companies capable of generating alpha via outsized secular growth opportunities versus the market, through the solutions they provide. These companies benefit from anticipated regulatory change through regulated competitive advantage or early adoption relative to peers.
The stocks within the strategy's portfolio are selected for the long term, with a holding period that is intended to be over five years and we use discounted cash flow and multiple analysis. For each stock we run a DCF (Discounted Cash Flow) analysis assessing base (most likely), best, and worst-case scenarios.
EF: What are the portfolio's risk and financial parameters?
IK: There are three key parameters we use. The first is liquidity – the daily liquidity of a stock needs to be equivalent to 1% of the strategy's net asset value. The second is stock correlation. Finally, we only target single thematic exposure to a maximum of 25%.
We are 'growth at a reasonable price' investors, so we look to identify companies that offer growth at reasonable valuation. We look for companies with attractive returns versus cost, cash flow yield, a track record of organic growth, and sustainable or improving profitability.
The strategy targets a concentrated portfolio of around 30- 50 stocks held with high conviction and built-in absolute terms, without reference to an index. We adjust weighting depending on risk, with smaller companies held at smaller weights (1-1.5%). For high conviction holdings the weighting is between 2% to 4% and the typical maximum position size will be 5% of the portfolio.
EF: How do you maintain the 'purity' of biodiversity investment in listed companies?
IK: There are many instances where biodiversity is only a part of a more complex narrative and that's why it's key to have full traceability and accountability on the activities of all our portfolio companies. Our Biodiversity Impacts database is an important tool here. It provides a look through into areas such as carbon emissions, waste generated, and water usage – both for individual holdings and across the portfolio as a whole versus our benchmark. It's also where we get look-through into things like clean energy usage, recycling levels, and how much land has been protected from change of use or encroachment of human activity. It's a really granular tool and is a differentiator when we look to understand how our portfolio companies are performing from a biodiversity point of view. It means we only invest in stocks where we can demonstrate that a company helps to restore, reverse loss of or preserve biodiversity.
Federated Hermes is a pioneer in the field of biodiversity with a strong track record in advocacy and stewardship. The company is a member of industry organisations including the Finance for Biodiversity Pledge, the PRI Sustainable Commodities Practitioners' Group, the SPOTT Supporter Network, the Partnership for Biodiversity Accounting Financials, and the PRI Plastics Working Group.
Ingrid Kukuljan is head of impact & sustainable investing and portfolio manager for Federated Hermes' Biodiversity Equity Strategy.
For more insights on the vital role investors play in limiting biodiversity loss, visit our biodiversity hub at https://www.hermes-investment.com/uk/en/institutions/biodiversity-hub/
1 IPBES Report (2019), EOS, Our Commitment to Nature (2021), WWF and ZSL, Living Planet Report (2020), Seven ESG Trends to Watch in 2021, S&P Global (spglobal.com).
2 Global Canopy, The Little Book of Investing in Nature (2021).