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The Taskforce on Nature-related Financial Disclosures (TNFD) is an international initiative that is developing a framework for companies and financial institutions to disclose their nature-related risks and opportunities. Climate and net-zero commitments are well understood, with corporations relying on the Taskforce for Climate-related Financial Disclosures that released a set of recommendations in 2017.

The idea of TNFD is not entirely new. It has built upon the foundational success of the Task Force on Climate-Related Financial Disclosures (TCFD), which focuses on the financial implications of climate change for companies. However, as the global dialogue evolved, it became clear that climate was only a part of the broader environmental narrative. Biodiversity loss, land degradation, and ecosystem collapse pose significant risks to economies and businesses around the globe. The TNFD first came into existence in June 2021 to address this gap and ensure a holistic environmental approach in corporate disclosures.

Biodiversity is the diversity of all living organisms and is the living component of nature capital. Net zero and nature are intrinsically linked, and both need to be addressed to build a better and more sustainable future. A simple example of this is that forests, which cover about 31% of the earth, absorbed 7.6 gigatonnes of CO2 p.a. over the period of 2001-2019 according to a 2021 study in the journal Nature Climate Change. Preserving - and perhaps increasing - forests are key to preserving biodiversity, helping to lower ambient temperatures of regions and sequester CO2.

Importance of a nature-positive economy

A 'nature-positive economy' is essential for a sustainable future and is a key concept that drives the TNFD framework. A nature-positive economy is an economy that has a net positive impact on nature, an economy that restores and regenerates nature rather than depleting it. Nature provides us with essential ecosystem services, such as clean air and water, food, and climate regulation. Without a healthy natural environment, our economy and society cannot thrive.

There are several things that can be done to create a nature-positive economy. One important step is to reduce our impact on nature. This can be done by reducing our consumption of natural resources, reducing pollution, and protecting and restoring ecosystems. Investing in nature-based solutions will be an important step forward. Nature-based solutions are ways to address climate change and other environmental challenges using nature. For example, forests can be used to absorb carbon dioxide from the atmosphere, and wetlands can be used to filter water and reduce flooding.

The transition to a nature-positive economy is essential for a sustainable future. However, it is a transition that will require a concerted effort from all stakeholders, including governments, businesses, and individuals.

The sectors that have the most impact on biodiversity are the logical companies that will be the early adopters of the TNFD recommendations. These sectors include materials, energy, agriculture and food & beverage. 

A framework for nature-based solutions

The TNFD's final framework was published in mid-September 2023. It includes 14 recommended disclosures covering nature-related issues, impacts, risks and opportunities that are structured around four pillars (refer Figure 1).

Figure 1: TNFD's recommended disclosures

Source: TNFD, Sept 2023.

It is hoped that the TNFD provides a clear, structured framework that help corporates understand the implications of biodiversity and natural capital for their activities. The framework is intended to assist corporates and financial institutions manage their nature-related risks and opportunities, and to support the transition to a nature-positive economy. While it is largely based on the TCFD framework, it also considers the specific risks and opportunities associated with nature.

The TNFD framework covers four specific areas:

• Nature-related dependencies: This includes the extent to which a company or financial institution relies on nature, such as for its raw materials, water, or pollination services.
• Nature-related impacts: This includes the positive and negative impacts that a company or financial institution has on nature, such as through its operations, supply chain, or investments.
• Nature-related risks: This includes the risks that a company or financial institution faces from nature, such as from climate change, biodiversity loss, or water scarcity.
• Nature-related opportunities: This includes the opportunities that a company or financial institution can seize from nature, such as by investing in sustainable agriculture or renewable energy.

The TNFD framework is expected to be a valuable tool for companies and financial institutions to manage nature-related risks and opportunities. It will also help to promote the transition to a nature-positive economy.

Some of the benefits of the TNFD framework include:

• Helping companies and financial institutions to identify and manage their nature-related risks and opportunities.
• Improving the transparency of nature-related risks and opportunities.
• Driving investment in nature-positive activities.
• Aligning financial markets with the targets of the Paris Agreement and the UN Sustainable Development Goals.

Global progress

Although the TNFD framework has only recently been settled; governments and intergovernmental organisations have increasingly called attention to the impact on nature. Pleasingly, a rising number of businesses have made pledges relating to biodiversity.
Companies globally are only in the early stages of setting a broad set of nature-related goals whereas most have set climate-related targets (refer Fig 2). The EU set a biodiversity strategy in 2020 that aims to complete 100 target actions by 2030. Some of these targets include restoring degraded and carbon rich ecosystems, converting at least 30% of its land and ocean area into legally protected areas and encouraging at least EUR20bn p.a. in bio-diversity-related financing. Despite this, S&P claims that only 29.5% of the largest companies in the S&P Europe 350 Index have set biodiversity targets

Figure 2: Corporate targets are less common for other dimensions of nature compares to climate change

Source: McKinsey

McKinsey has calculated that ~47% of Fortune Global 500 companies have set nature-related targets against one dimension of nature - generally this is against climate (refer Figure 2). Approximately 16% have set targets against three or more dimensions of nature and no companies have targets against all six dimensions that were looked at in this analysis. The Science-Based Targets for Nature (SBTN) initiative suggests that companies are more likely to focus on the key issues that directly impact their activities which could explain why no company has set targets against all six dimensions.  Cutting the data based on a sector level reveals that the sectors that have a higher exposure to biodiversity risk are leading the charge on target setting.

Figure 3: Fortune Global 500 Companies' nature-related targets by sector

Source: McKinsey

Implementation of TNFD

Implementing TNFD is not without its challenges. In particular, there's a need for:

• Data Collection: Many companies lack the data or the means to gather it to understand their complete environmental impact;
• Standardization: With no globally recognized metrics to measure nature-related risks, creating a standardized framework will be demanding;
• Economic Pressures: Short-term profit goals can overshadow long-term sustainability targets, making it challenging for some companies to prioritize nature-related disclosures; and
• Stakeholder Alignment: All stakeholders, from suppliers and employees to regulators and consumers, need to align for effective disclosure and action.

The framework is consistent with the recommended standards of the TCFD, ISSB (International Sustainability Standards Board) and GRI (Global Reporting Initiative). The recommendations have an intention to provide a practical solution for corporates to start their journey to increase the scope and disclosures over the coming years. The expectation is that, as with climate-related reporting, TNFD disclosures will improve over time.

The LEAP approach - Locate, Evaluate, Assess and Prepare - has been developed by the TNFD to help organisations to identify, assess and manage nature-related risks and opportunities. While the approach is not a requirement, it is designed to help with identification and assessment. Figure 4 provides an overview of LEAP and its elements, which covers:

• Locate: Identify the organization's interface with nature, including its direct operations, supply chains, and value chains.
• Evaluate: Evaluate the organization's dependencies and impacts on nature.
• Assess: Assess the nature-related risks and opportunities facing the organization.
• Prepare: Prepare to respond to (and report on) nature-related risks and opportunities.

Figure 4: The TNFD approach for identification and assessment of nature-related

Source: TNFD, Sept 2023

Conclusion

While the challenges are significant, the TNFD offers a critical pathway for integrating nature into financial decision-making and improving outcomes for our environment. The success of the TCFD suggests that with global cooperation and commitment, the TNFD can become an influential tool in driving sustainable business practices. Governments, financial institutions, environmental organizations, and businesses all have important roles to play.

By implementing frameworks such as the TNFD, the global community takes a step closer to ensuring that the economic activities of today do not compromise the planet's well-being tomorrow. The shift from merely profit-driven strategies to those that also account for nature-related impacts signifies an evolution in global business practices. It is an evolution that is not just commendable but essential for the longevity and prosperity of both businesses and the planet.

Tyndall will be increasingly engaging with corporates around biodiversity and promoting the implementation of the TNFD framework, as we have been with TCFD. According to work by Jarden, only 12 (24%) of ASX50 companies have nature-related targets. It was noted that BHP, Woolworths, South 32 and Origin Energy had undertaken TNFD pilots, and only Brambles and South 32 have linked nature to remuneration. 

Clearly, there is plenty of improvement required. We expect that those companies in sectors more exposed to nature-related risks such as agriculture, food and beverage, and mining, are likely to lead the charge. 

Author: Brad Potter, Head of Australian Equities

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Decarbonisation is one of the most important challenges of our time, but it is also often one of the most difficult to successfully invest in.

Renewable energy stocks have been among the most popular and talked about investments in recent years, thanks to low interest rates, government subsidies, and strong demand from consumers and investors who want to support a greener future.

However, valuations of these stocks became very expensive, reflecting their current leadership rather than their future potential.

In this article, we will explain why we have been cautious about investing in renewable energy stocks and where we see better opportunities in the energy sector.

What are the challenges?

One of the main challenges for renewable energy stocks is that they are very sensitive to changes in interest rates. Renewable energy projects have long-dated cashflows that depend on the future price of electricity and the cost of capital. When interest rates are low, these cashflows are more valuable and attractive to investors. However, when interest rates rise, as they have recently, these cashflows are discounted more heavily and lose some of their appeal. This is especially true for projects that rely on debt financing, which becomes more expensive as interest rates increase.

Another challenge for renewable energy stocks is inflation. Renewable energy projects often require large upfront investments in equipment and infrastructure, such as solar panels, wind turbines, and transmission lines. These costs are subject to inflationary pressures, which can erode the profitability of the projects over time. Recent downgrades of wind turbine manufacturers have demonstrated that costs have risen dramatically. This means that renewable energy projects need to generate higher revenues to cover their rising costs, which may not be possible in a competitive market.

A third challenge for renewable energy stocks is local regulation. Whilst there may be federal incentives, renewable energy projects often face opposition from local communities who do not want projects like a wind farm in their backyard. For example, wind farms can face resistance from residents who complain about noise, visual impact, wildlife disruption, and property value decline. Renewable energy projects may also face regulatory hurdles from environmental agencies, landowners, grid operators, and other stakeholders who have different interests and agendas. These factors can delay or derail renewable energy projects, reducing their expected returns.

However, the biggest long term challenge for renewable energy stocks in our view is that most renewable energy sources provide intermittent rather than baseload power. This means that they depend on weather conditions and cannot guarantee a constant supply of electricity. This creates a problem for grid stability and reliability, which requires a balance between supply and demand at all times.

Energy storage in batteries is often seen as a solution for this problem, but it still has a long way to go before becoming widespread and cost-effective. According to the International Energy Agency (IEA), battery storage capacity needs to increase by more than 40 times by 2040 to support the growth of renewables.

Opportunities: Where to invest?

Given these challenges, we have been looking for opportunities in both providers of existing baseload power from sources such as hydro and nuclear, as well as solutions for reducing energy demand.

One example of the latter held within the Firetrail S3 Global Opportunities fund is Schneider Electric, a French company that provides products and services for energy efficiency and management. This is a solution that can be implemented now, as an immediate solution.

Schneider Electric helps its customers reduce their electricity consumption and carbon footprint by offering solutions such as smart meters, sensors, software, automation, lighting, heating, cooling, and electric vehicle charging. Schneider Electric benefits from growing demand for energy efficiency solutions from various sectors such as buildings, industries, data centres, and infrastructure. Schneider Electric also has a diversified geographic exposure and a solid financial performance.

S3 Characteristics are important!

We believe that decarbonisation is important, but we also believe that we need to approach investing in the sector in a pragmatic way. We are not interested in chasing popular or overvalued stocks that may not deliver on their promises or expectations. We are interested in finding undervalued or overlooked stocks that offer sustainable earnings and cashflows, sustainable business models, as well as sustainable positive change.

As one company executive we met recently said: "One of the most important facets of sustainability is remaining a going concern". We think this is very true in the current environment.

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Funds operated by this manager:

Firetrail Absolute Return Fund, Firetrail Australian High Conviction Fund, Firetrail Australian Small Companies Fund, Firetrail S3 Global Opportunities Fund, Firetrail S3 Global Opportunities Fund (Hedged)

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After a challenging few months, stock markets have started November brightly. With inflation getting under control, many central banks cooling their jets, and bond yields easing, are equity markets in for a strong end to 2023?

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The implications of inflation

Inflation--the increase in the general price level of goods and services in an economy over a timeframe--has become one of the most closely watched economic gauges in recent years as consumer prices hit record highs.

Besides bearing significant influence on standards of living, economic growth and the direction of interest rates, inflation also has significant implications on the top-down development of countries as well as the bottom-up fundamentals of companies.

On a top-down basis, inflation signals the strengths and weaknesses in the overall economy and drives the policies and responses of governments and central banks, either being supportive or restrictive. From a bottom-up perspective, inflation signals whether certain industries have the pricing power to pass on the changes in costs and to generate sustainable returns from future investments.

In other words, inflation encapsulates changes in both the overall economy and the operating metrics of a company. Moreover, inflation can have political implications, particularly in the developing world, as it is often a key issue in elections and can impact the popularity of elected politicians. That is why investors in the emerging markets often pay close attention to the general development of consumer prices, plus the outlook of inflation. Indeed, how a government navigates inflation often affects future investment returns.

In this article, we compare and contrast two of emerging Asia's largest economies, China and India, through the lens of inflation. Today, China and India face opposite inflationary pressures, which could alter the outlook for these two large emerging economies. Inflation in China is close to zero, while that of India is above 6% (as of August 2023).

Year-to-date (YTD), as at end-September 2023, the renminbi has depreciated more than 5% against the US dollar (USD), whereas the India rupee is flat versus the greenback. Equity markets also seem to be rewarding one and punishing the other; Indian equities (as measured by the MSCI India Index) were up 8.0%, in USD terms, on a YTD basis (as at end-September 2023), while China stocks (as measured by the MSCI China Index) were down 7.3% YTD.

China faces deflationary pressures

Let us begin with a close look at China. Concerns that China could be facing a deflationary spiral arose when the country reported that consumer inflation dropped by 0.3% YoY in July, the first decrease since February 2021. Since then, consumer prices in the world's second largest economy have moved higher, rising by 0.1% YoY in August, allaying fears a persistent deflationary trend in the nation.

Headwinds from falling property prices and the decline in construction activity due to its ailing real estate sector are likely to cause more lingering deflationary pressures, in our view.

Very low inflation or deflation can directly impact consumer behaviour. First, it can lead to a decrease in consumer spending as consumers may delay purchases in anticipation of lower prices in the future. This can lead to decreased economic growth and job creation. Second, low inflation can compound the debt burden. As the real value of debt increases due to the lack of inflation, this could lead to increased financial stress for households and businesses. At the same time, low inflation can discourage investments as investors may seek higher returns in other countries with higher inflation rates. And if subdued inflation persists for an extended period, it can lead to a deflationary spiral where prices continue to fall, potentially leading to a long-term economic stagnation.

The big picture is that Chinese economic growth has been on a declining trajectory since the 2008 Global Financial Crisis (GFC). Having said that, if China were to achieve its government's targeted GDP growth of 5% for 2023, that would still be a decent result for a maturing economy (see Chart 1 for China's real GDP growth, inflation and real interest rates).

Chart 1: China's real GDP, inflation and real interest rates

Source: Bloomberg, August 2023

More broadly, China currently faces several structural issues. It has negative population growth, a heavy debt burden in certain areas (namely property), an oversupply of goods, weak export markets and tight monetary policy.

China's monetary policy has historically been on the tighter side, averaging 3% in real interest rates. Despite its recently flagging economy, China's current real interest rates still stand at 3%. There have been times when real rates in the country were lower, such as during the GFC and around the period of global economic weakness of 2015.

This time around, the People's Bank of China (PBOC) is using alternative measures, like cutting mortgage rates incrementally and reducing banks' reserve requirements to boost overall liquidity. In our view, the Chinese government and the PBOC need to do more to stimulate the economy. Monetary policy loosening at a drip-feed speed is not creating a positive environment for the Chinese markets. Indeed, consumer and investor confidence in China is fading. Portfolio flows are negative and foreign investors are net sellers of Chinese equities.

Nonetheless, it is not all bad for the world's second largest economy on the inflation front. One of the positives is that China is still seeing some inflation on the services side, which accounts for 40% of the inflation basket. Services-related inflation is rising at 1.3% on average, compared to overall consumer inflation at 0.1% YoY (as at August 2023). Historically, China's services-related inflation had hovered between 2-3%. During the COVID-19 lockdowns, it fell below zero. A rise in services consumer price index (CPI) is good for the overall inflation picture in China, which is growing more slowly in recent years and whose growth is largely due to government spending. All in all, China needs inflation to move higher.

Higher commodity and agriculture prices could lead spur Chinese inflation

Going a step deeper into the drivers of inflation in China will show that agriculture prices (namely those of soybean and pork) and commodity prices (including hydrocarbons, which are the main components of oil and natural gas) are closely related to the direction of inflation in the country (see Chart 2). As such, rising commodity prices and higher agricultural prices could pose an upside risk to inflation in China. A surge in China's inflation in 2019, for instance, was partially attributed to the outbreak of swine flu in 2018, which caused an increase in pork prices amid a drop in supply.

Chart 2: China's inflation and commodity prices move in tandem

Source: Bloomberg, August 2023

COVID-19 further distorted the time series of inflation in China. Since the country's re-opening earlier in 2023 (and the absence of disease or other disruptions to supply), agriculture consumer prices look to have bottomed. Agriculture inflation in China is trending around 2% and could lift overall Chinese CPI. The same is true of rising commodity prices.

Oil prices have recently risen above USD 90 per barrel. China imports around 59% of its oil needs, making it the largest oil importer globally, and higher oil prices will support inflation in the country. There is, however, a risk of stagflation if rising commodity-driven inflation is accompanied by low growth. Indeed, without productivity gains or other spending increases, inflation without growth for China may be problematic for the world's second largest economy.

Chinese inflation and its impact on equity markets

The Chinese equity market, as measured by the MSCI China Index, is trading close to the lowest price earnings (PE) multiples in 20 years, with very low growth priced in by the market. During the 2010-2015 period, equity valuations in China fell with declining inflation. Over that period, the market return in China averaged 1.5% on an annualised basis. Without dividends, it was negative. Today, China is once again experiencing a period of low and declining inflation, which coincides with the downturn of its equity market. However, if Chinese inflation starts to rise due to higher agriculture and commodity prices and looser monetary policy, we do expect a better showing for China stocks. This is because corporate sales and earnings per share (EPS) growth rates tend to have a positive correlation with inflation (see Chart 3).

Chart 3: China's corporate sales and EPS growth are positively correlated with inflation

Source: Bloomberg, August 2023

Earnings growth in China has been decelerating since 2005 and hit bottom in 2016, when China implemented a massive monetary stimulus that lifted global equity markets and Chinese earnings. The effects of that stimulus have worn off, and the Chinese equity markets are now back to the lows of 2016. Chinese earnings growth is in a difficult position; it needs a forthcoming and large stimulus, which, in turn, will help lift inflation in the country.

After China's last set of quarterly results, earnings revisions for 2023 and 2024 were negative; growth expectations, though positive, are also falling. We have looked at the annualised three-year sales growth of corporate China, working under the assumption that it takes time for inflationary pressures to work through a company's operations. Our expectations are for Chinese inflation to rise to 2% in 2024 and sales growth to follow suit. If that materialises, it would be a good result for Chinese earnings growth. All things considered, the Chinese equity market needs a source of higher profitability, and rising inflation, amongst other factors, could be key to invigorate profit levels.

India at a sweet spot

Viewed through the lens of Inflation, India is at the opposite end of where China is. India's Inflation, while above the Reserve Bank of India (RBI)'s target of 4%, isn't looking too elevated, as compared to its historical averages. Inflation in India has slightly eased to 6.83% YoY in August (from 7.44% in July) and is currently in line with the country's average annual inflation rate, which over the past few decades has been around 6-7%.

As we see it, the Indian central bank remains accommodative, keeping real rates close to zero. The country's political climate is pro-business. The government of Indian Prime Minister Narendra Modi is in its third year of running large budget deficits, and with the coming general elections in 2024, the administration is unlikely to tighten its budget strings in the foreseeable future.

At the same time, high oil prices have yet to hit the Indian economy, which is still relying on cheap Russian oil. India's annual GDP growth has hovered steadily in recent years, generally between 6% and 10%, while inflation has moved around the same levels as GDP growth (see Chart 4). India is in a sweet spot at the moment as inflation is trending lower, yet it is at a faster rate than GDP growth.

Chart 4: India's real GDP, inflation and real interest rates

Source: Bloomberg, August 2023

The RBI tends to keep a closer eye on real GDP growth than inflation. In times of rising real GDP growth, the central bank has tightened monetary policy and loosened policy during periods of declining GDP growth. Expectations are for the RBI to continue to be accommodative, given that there are elections in 2024.

Future agriculture prices key to India's inflation

India's inflation basket is heavily weighted towards food, which makes up almost 37% of the CPI basket, while fuel comprises 5-6% of the total. Agriculture prices, on a YoY basis, have flattened, giving respite to inflationary pressures in India (see Chart 5). If there are any shocks to the global food supply, from either an escalation of the Ukraine-Russia war or from weather-related events, that could be a potential risk to inflation in India. Overall commodities, though rising largely because of higher oil prices, do not have that much of an impact on inflation in India.

Chart 5: India's intertwined Inflation and commodity prices

Source: Bloomberg, August 2023

The Indian equity market and its link with inflation

In India, the earnings yield, which is the inverse of the PE multiple, tends to move in tandem with inflation. During the commodities super cycle at the turn of the century, the Indian stock market did very well as inflation trended higher and valuations rose. Today, the environment looks similar. Inflation is high, growth expectations are rising and the market is starting to perform well.

India's earnings growth, which is reaching historic highs, could mean persistently higher inflation. However, stand-alone valuations in the country are not excessive and rising rates haven't dampened investor sentiment. Relative to cash, equity valuations look fair, our view.

Likewise, sales and earnings growth in India, historically, have had a fairly good relationship with inflation. In the post pandemic period, we have seen a divergence, however. Inflation has flattened and is expected to decline over 2024, while both sales and earnings are expected to continue to rise. Still, we reckon that if the country's sales and earnings were to remain strong in 2024, that would be supportive of higher rather than lower inflation.

All in all, the Indian equity market looks well-placed with inflation under control, supportive monetary and fiscal policies. And with investors looking for alternatives to China, the uptrend in the India equity market could last for a while. Overall, the Indian equity market is pricing in a longer growth cycle; earnings growth expectations remain high, while strong macro tailwinds should continue to support the corporate sales and earnings rebound.

Key takeout

• In China, inflation is at near-zero levels, and the country faces deflationary pressures.

• We believe that earnings expectations need to be adjusted lower in China, while the debt-fuelled growth and debt-supported return on equity is a thing of the past.

• In our view, the Chinese government and the PBOC need to do more to stimulate the economy, and China needs inflation to move higher.

• If inflation in China starts to rise due to higher agriculture and commodity prices and looser monetary policy, we do expect a better showing for China stocks.

• In India, inflation, while above the RBI's target of 4%, is not looking too elevated, as compared to its historical averages.

• Strong macro tailwinds are expected to continue to support the sales and earnings rebound in India.

• Government policies, both fiscal and monetary, are accommodative, with the RBI keeping real rates close to zero.

• But higher commodity and agriculture inflation could pressure earnings growth by late 2024.

Author: Mohammed Zaidi, Investment Director

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Globally equity markets declined in October. In the US, the S&P 500 fell -2.2%, the Nasdaq declined -2.8%, whilst in the UK, the FTSE 100 fell -3.8%. The main drivers of the declines were ongoing high inflation, rising bond yields, and the conflict in the middle east.

In Australia, the All Ordinaries Accumulation Index fell -3.9% in October. Gold was the top performing sector, whilst technology and healthcare were the worst performers, both of which were impacted by higher bond yields. Small caps again underperformed as investor risk aversion increased, with the Small Ordinaries Acc. Index declining -5.5%, whilst the Small Industrials Acc. Index fell -7.0%. Bond yields rose in October, in the US the 10-year bond yield rose +30 basis points to close at 4.84%, whilst its Australian counterpart climbed +44bp to 4.92%.

Investor sentiment continues to be impacted by the issue of high inflation and rising interest rates. We believe equity markets (being very forward looking) will respond positively to signs that central banks (particularly the RBA in Australia) are being more aggressive in their commitment to reduce inflation to targeted levels. Currently we expect one to two more interest rate rises in Australia in this current cycle, but this will be dependent on the path of inflation in the next 6- 12 months. Despite the current negativity impacting the ASX and in particular small/mid caps stocks, we do believe the bulk of the interest rate rises have been implemented in this cycle and hence once there is more clarity on the number of rate hikes remaining, equity markets are well placed to perform strongly.