Five questions with Storebrand
, Pippa Rudling
How can investors manage the uncertain transition to net zero?
Victoria Maclean of WHEB Asset Management, Bruno Bamberger from AXA IM and David Nelson, Climate Transition Analytics at WTW, spoke to an audience of investment consultants which is summarised below. As some of the guests and speakers said, there are more questions than answers, but raising those questions and sharing ideas is the only way forward.
The Net zero policy gap is increasing investment risks
As our panellists explained, there is currently a gap between the objective of many governments to achieve net zero by 2050, and the policies needed to deliver on that target. As a result, there is huge uncertainty around the speed at which we can switch from fossil fuels to renewables. Without the right policies to give clear guidance to investors, markets are unlikely to allocate sufficient resources to meeting the challenge.
However, policy makers are also telling investors that they intend to make long term investment in fossil fuels more expensive and riskier, by encouraging the transition to renewables. That uncertainty is increasing risks associated with oil and gas assets, which could impact investment returns in these assets. This is making investors wary of taking long term positions in the sector and may even prompt investment to flood out at some point.
Macroeconomic uncertainty distorts investment decisions
As a result of the policy gap, we might not see the necessary ongoing investment in oil and gas production to maintain sufficient supplies to counter the possible shortfall in renewables. This could cause another major supply shock with increased price volatility and even more extreme price spikes than we have seen in recent years. That volatility in turn poses a huge macroeconomic risk as it could lead to higher inflation, job losses, company insolvencies and recessions – with knock-on effects for exposed equity and bond portfolios.
As David pointed out, the energy supply curve is getting increasingly steep beyond 2030. As a result, many projects requiring high capital investment, but with potentially low operating costs, have fallen sharply in the last couple of years. Policy makers need to get ahead of this now to prevent a disorganised exit from carbon intensive industries, by showing how investment in renewable energy will stay ahead of the demand shift.
Managing for risk and return
As Bruno noted, mature schemes increasingly allocate to Buy and Maintain Credit strategies, and tend to focus on avoiding default risk. While shorter-maturity debt has little material transition downside, investors are increasingly looking to limit exposure to longer-maturity bonds in sectors, such as oil and gas, which have a high transition risk. It also highlights the need for fundamental analysis to align long-dated purchases with the long-term impacts of climate change policies.
Victoria made the point that it’s important to differentiate between investment decisions driven by values, by ESG and by impact considerations. The first is often the starting point for clients and often drives exclusions. ESG on the other hand is driven less by values and more by risk analysis. ESG is predominantly about the way a business is run and how it manages its risks. Impact is the external element: whether the products and services being provided result in a net positive effect on society. A company can have strong ESG risk management but still have a negative impact. Equally, a company with very positive social impact can come with considerable ESG risks.
Victoria and Bruno agreed that climate and ESG risks need to be considered in the same way as any of the risks investors are more familiar with, rather than seeing them as a separate category. The objective is to understand the risk and return profile of an investment and the material factors influencing that. Importantly, ESG and impact can be positive drivers of excess returns not just risk considerations.
Carbon footprint v. climate risk
Victoria highlighted the tendency of some ESG funds to target low emissions sectors such as software because this creates a portfolio footprint that looks low relative to an index. However, that approach doesn’t contribute to the transition even if it has a low footprint. An impact-driven approach would look for companies that contribute to the transitioning by lowering emissions in use, known as “avoided emissions”. It would consider the environmental impact of operations - the carbon footprint for manufacturing businesses like air-conditioning companies is likely higher than a software company. However, taking into account downstream emissions savings gives a better idea of how a company is influencing the transition.
As she put it, if you can see a demand for products that reduce emissions, then you can identify those who will benefit from the transition. Having a positive impact is not just about reducing corporate emissions but also the much bigger task of cutting customer and end-use emissions. Such systems level thinking enables you to identify products or services that reduce energy demand, and thus accelerate the transition to net zero. The positive climate impact is also closely tied to the structural growth drivers, so that impact drives the underlying investment thesis and return expectation.
Have you got the right data?
Understanding the positive impact of corporate activity is more difficult than simply seeing which companies comply with regulations or avoid bad PR. As David pointed out, there is an opportunity to manage the upside if you have the right data, to see which companies will use the transition to outperform. Interestingly his research shows that a company’s carbon footprint has no correlation with its ability to outperform. Instead, you need to look at the total financial impact that the transition to net zero will have on corporate valuations.
Good ESG is “not just about getting bad assets off your books but off the planet’s books”.
The choice not to an invest in a business or sector should be driven by risk, return and, where relevant, impact considerations. Positive impact funds would naturally end up excluding some companies because of the net negative impact. An assessment of the risk of oil majors might conclude that the climate risks create large downside risk. Those are legitimate reasons not to invest. However, as Victoria explained, simply divesting a portfolio of dirty assets does little or nothing to remove those dirty assets from the market. Divestment may even leave those assets in the hands of less scrupulous investors. In the same way that divesting from tobacco does not actually stop people smoking, so you can’t simply wash your hands of the consequences of your investment decisions.
This is why the panel believe that engagement is an important tool in a successful transition. As David found when analysing the global impact of net zero policies, the transition will not only create widespread global economic value but also large, concentrated pockets of losses. Active engagement that seeks to manage these opportunities and risks can help meet the manager’s fiduciary duty to maximise risk adjusted returns. Bruno emphasised that it’s not just about engaging with companies though. It is important to engage with the financial services industry as a whole, from counterparty banks to ESG data providers, as well as policymakers, so that these different investment strategies taken together can contribute positively to the transition.
This requires the sort of multi-level systems thinking that Victoria mentioned, which identifies, understands and solves complex transition problems facing entire supply chains. That often means working with policy makers and industry groups to make supply chains more sustainable at a granular level. This can help make active engagement more effective by identifying specific risks, rather than simply excluding on points of principle.
As Bruno explained, rather than just excluding high emitters, it can make more sense, and create more value, to encourage companies to reduce emissions. At a portfolio level this is ultimately achieved by increasing the overall level of alignment to net zero. For fixed income managers there are a few tools to implement this, including the previously mentioned divestment versus engagement, but also using natural cashflows to cost-effectively re-shape a portfolio over time. While active turnover can play a small part in re-aligning a portfolio, it can be costly for schemes and therefore contradict the financial objectives. Managers have a role to play by providing honest and detailed explanations of what investors are looking for in transition assets, how portfolios are shifting and why that will make some investments unacceptable. It is reassuring to hear that many companies are starting to respond, not least by providing more data to the Carbon Disclosure Project.
AMX has steadily built up a range of ESG services and funds that will help investors support ambitions for net zero by 2050. For example:
Thank you to our speakers for their contribution to this debate:
Bruno Bamberger is Solution Strategist at AXA Investment Managers who is responsible for designing a framework strategy for reshaping fixed income portfolios in line with Net zero targets.
Victoria Maclean is Associate Fund Manager at WHEB Asset Management who takes a bottom-up fundamentals approach to impact investing. She is particularly interested in companies that are actively providing answers to the challenges of climate change and other ESG issues.
David Nelson is Senior Director at WTW and runs the Climate Transition Analytics team, which is developing new ways of understanding the financial risks to cash flows and assets associated with climate change. They use those models to create financial products to help investors manage transition risk.
Photo by Simon Berger on Unsplash
This material is for general informational purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended to be construed as solicitation, the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. AMX does not warrant the accuracy, adequacy or completeness of the information and data, some of which has been provided by third parties.
Five questions with Storebrand
Five questions with Maple-Brown Abbott