NN IP: Investing in the cloud – cutting emissions but not alpha

28 aug 2019

The data centres enabling our always-on lifestyle consume 3% of the global electricity supply and account for 2% of greenhouse gas emissions, putting cloud computing on par with the airline industry. But where airlines face rising fuel costs and falling margins, cloud computing is stepping up energy efficiency while providing sustainable growth exposure. At NN Investment Partners, we are committed to investing in the transition towards cloud computing, which offers a smaller carbon footprint without sacrificing returns.

Traditionally, cloud computing refers to outsourcing a company’s IT needs, from data and storage to software. All the servers and applications sit in the Internet “cloud,” but more literally in a data centre or centres. The economic model of cloud computing lies in spreading the data centre costs by co-locating users, which leads to more efficient utilization compared with private data centres.

A secure cloud infrastructure enables innovation and offers the benefits of connectivity while guaranteeing the privacy of client data. For consumers, secure cloud computing ensures cheap, easy and safe digital participation. For enterprises, cloud computing offers many advantages: easier software updates, cheap data storage, clear savings on energy and capital expenditure, scaled processing capacity, increased collaboration potential and the ability to work from anywhere. As a result of these advantages, cloud computing giants are enjoying stellar growth rates (see Figure 1).

Compound annual sales growth rate for selected cloud software vendors, 2018-2020 [1]

Source: NN Investment Partners estimates (based upon company analysis)

Our sustainable equity funds, such as the NN (L) Global Sustainable Equity fund [2], are well positioned to take advantage of the growth in cloud computing (for example, with holdings in companies such as Adobe, Intuit and Microsoft). These investments have had a positive impact on both our carbon footprint and alpha generation.[3] As the digital transformation continues and cloud computing becomes an ever more inescapable part of our daily lives, we project growing opportunities for investors seeking to reduce carbon emissions and still benefit from alpha generation.

Cloud computing leads to shrinking carbon footprints

Cloud computing can reduce total greenhouse gas emissions, as it is an inherently energy-efficient virtualization technique. Microsoft is a good example to illustrate the carbon benefits of cloud computing. The company is on the path to a 75% reduction in carbon emissions by 2030 relative to 2013. When taking into account renewable energy purchases, carbon emissions from Microsoft Azure (Microsoft’s cloud infrastructure business) are 92% lower than traditional enterprise data centre deployments. These large savings are attributable to four key features: IT operational efficiency, IT equipment efficiency, data centre infrastructure efficiency and renewable electricity usage.

A cloud-based infrastructure is more energy-efficient than a traditional on-premises set-up. Server capacity in the data centre can scale up and down to fit fluctuating cloud computing requirements. As a result, customers use only the energy they need and don’t leave oversized carbon footprints. Moreover, most major cloud operators are committed to using 100% green energy in their own data centres. So, when a company moves its IT operations into the cloud, it makes a contribution to the environmental health of the planet.

A hyperscale cloud infrastructure data centre achieves approximately 65% server utilization rates versus 15% for on-premises data centres. As a result, when companies move to the cloud, they need fewer than one quarter of the servers that they would require in an on-premises setting [4]. An average on-premises data centre is also 29% less power-efficient than a typical large-scale cloud provider that uses modern designs, cooling systems and workload-optimized equipment. Overall, customers only need 16% of the power compared to that required for on-premises infrastructure.

Research from Accenture [5] also found significant across-the-board decreases in CO₂ emissions per user for cloud-based versus on-premises delivery for three Microsoft software applications. The cloud advantage is particularly strong for small deployments, as a small business running its own servers typically operates at a very low utilization level and may be idle for much of the day. Transitioning to cloud-based infrastructure ensures that server capacity is not wasted, leading to improved energy efficiency.

Tech giants commit to operational greenness

Energy efficiency is not the only benefit of the digital transformation. Hyperscale cloud leaders such as Adobe, Microsoft Azure and Amazon Web Services (which provides the cloud infrastructure for Intuit) have committed to achieving 100% renewable energy usage and have already made significant strides towards that goal. At the end of 2018, half of the power used by Microsoft’s data centres came from renewable energy; this figure should grow to 60% by the end of 2019. With the 60% milestone in sight, the company is targeting over 70% renewable energy for its data centres by 2023.

Microsoft is also making further efforts to greenify its operations. The firm is aiming to cut its carbon emissions by 75% by 2030. As part of that effort, it has raised its internal carbon 'tax' to USD 15 per metric ton on all carbon emissions, nearly double the current rate for carbon emissions. Since 2012, Microsoft has enforced a carbon tax that places the financial burden on business divisions to cut their own carbon emissions.

Additionally, Microsoft’s in-depth sustainability report for 2018 showed that total Scope 1, 2 and 3 [6] greenhouse gas emissions fell 7.3% from 19,005,000 metric tons of CO₂ equivalent in 2017 to mtCO2e 17,614,000 in 2018. This amounts to an absolute decrease of mtCO2e 1,391,000 for all direct and indirect emissions. This is a strong achievement in light of Microsoft’s 11% revenue growth in 2018. For comparison, Microsoft Azure has enjoyed stellar growth rates over the past few years, underpinning the impressive growth of the overall cloud computing industry (see Figure 2). Microsoft is a significant holding in the NN (L) Global Sustainable Equity fund, and through this investment, the fund has reduced its carbon footprint.

Microsoft Azure year-on-year sales growth rates

Source: Microsoft company filings, NN Investment Partners

Note: Microsoft's fiscal year 2019 ran from 1 July 2018 to 30 June 2019.

Despite valuation and cybersecurity risks, it’s greener in the cloud

Even as cloud computing opens up a world of possibilities, the transition to cloud infrastructure is not risk-free. Cloud computing stocks are currently trading at elevated valuation levels and most listed cloud software companies trade at a significant premium to the market. The latter offer above-average revenue growth, predictability and resilience, as cloud software is primarily sold on a subscription and per-seat basis. However, a slowdown in growth could have a relatively large impact on valuations.

Cybersecurity risks are also prevalent. Consumers and companies are increasingly entrusting their data to cloud computing providers, placing their faith in strong security and encryption possibilities. But keeping cloud computing simultaneously accessible and secure is a continuous challenge. Cloud companies must work to prevent security breaches and ensure that cybersecurity risks don’t materialize.

We assess these factors throughout our screening processes to ensure the fullest possible analysis of our investment decisions. Even after taking these risks into account, we still believe it’s greener in the cloud. Cloud computing not only saves billions of dollars in energy costs but can also reduce carbon emissions by millions of metric tons. In our view, the digital transition offers significant opportunities for investors seeking to reduce carbon emissions and still benefit from alpha generation. Through our investments in cloud computing shares in our sustainable equity funds, we offer our clients sustainable growth exposure combined with a shrinking carbon footprint, without sacrificing returns.

We believe further opportunities lie ahead for investors seeking exposure to cloud computing. Firms such as Adobe, Intuit and Microsoft play a major role in the digital transformation of our economy. These firms are expected to gain the largest incremental percentage of IT budgets in the next three years, mainly because of the shift from on-premises workloads towards the cloud. The overall industry offers favourable growth, an attractive subscription-based business model and a positive environmental impact. And with boardrooms prioritizing cloud computing and the digital transformation, the sector as a whole looks set to grow apace for the foreseeable future.

[1] For illustration purposes only. Company name, explanation and arguments are given as an example and do not represent any recommendation to buy, hold or sell the stock.

[2] NN (L) Global Sustainable Equity is a sub-fund of NN (L), established in Luxembourg. NN (L) is duly authorised by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Both the fund and sub-fund are registered with the CSSF. The prospectus and the Key Investor Information Document (KIID) (if applicable) and other legally required documents relating to the fund are available on www.nnip.com.

[3] For illustration purposes only. Company name, explanation and arguments are given as an example and do not represent any recommendation to buy, hold or sell the stock. The security may be/have been removed from portfolio at any time without any pre-notice.

[4] 2014 Data Center Efficiency Assessment

[5] Cloud Computing and Sustainability: The Environmental Benefits of Moving to the Cloud

[6] Scope 1 emissions refer to the direct emissions from the company. Scope 2 emissions are indirect emissions stemming from the company’s energy purchases. Scope 3 emissions are emissions from elsewhere in the value chain, including upstream and downstream operations.