Sustainability
Value investing and the energy transition: Guiding giants to greener pastures
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"By investing in and engaging with investee companies in high-emitting or carbon-intensive sectors to set up credible, Paris-aligned decarbonisation targets and commit the required capital to achieve them, we believe investors can facilitate the transition, aligned with their fiduciary duty, and ultimately create real economic impact. "
Since the Industrial Revolution, we have grown used to cheap and dependable fossil energy, while oil-related derivatives have become a significant part of the goods and services we produce and use on a daily basis. This has contributed to a significant step up in prosperity across many geographies, which is welcome but uneven. However, there has been a hidden cost associated with that prosperity and our societies have taken too much time to realise there is no such thing as a free lunch. Indeed, the impact of human activity on the climate — long overshadowed by our economies' addiction to fossil fuels — is now so obvious it can no longer be ignored. Humanity now faces one of its greatest challenges in centuries: how to achieve fair living standards for all while simultaneously addressing the climate issue by decarbonising our economies? It is imperative we find the right balance between environmental objectives and social considerations, or to put it differently, balancing energy reliability, affordability, and sustainability. The ‘energy trilemma’ is the name of the game. The solution? The ongoing energy transition. We are aware of the path to a Net Zero (“NZ”) economy. Yet, with 80% of global energy still derived from fossil fuels (International Energy Agency – World Energy Outlook 2023), and emerging economies increasing their energy consumption per capita, the path to decarbonisation will be long and winding to say the least. It will require a “careful balancing of the shorter-term risks of poorly prepared or uncoordinated action with the longer-term risks of insufficient or delayed action” (McKinsey & Company, The Net Zero Transition, January 2022).
The good news is evidence suggests that GDP growth per capita, a key indicator of prosperity, can be separated from CO2 emissions (Our World in Data). Take the example of the United Kingdom: the chart below from ‘Our World In Data’ shows the evolution of UK GDP per capita, which increased by 43% between 1990 and 2021, versus the evolution of consumption-based CO2 emissions per capita (i.e. adjusted for emissions from goods that are imported or exported), which declined by 35% (Our World in Data) during the same period.
Change in per capita CO2 emissions and GDP, United Kingdom
Source: World Bank (2023): Global Carbon Budget (2023): Population based on various sources (2023)
This was achieved through energy efficiency, successfully decoupling energy use from economic growth, and by switching from fossil fuels to low-carbon energy. The key question is whether this decarbonisation trend is sufficient and can be easily replicated in other countries so that Paris-aligned Net Zero objectives are met on a global scale. The answer, unfortunately, is “no”, according to the NGO Climate Policy Initiative. In their 2023 report, the NGO reported that the annual climate finance reached USD 1.3 trillion in 2022, shared equally between public institutions and private organisations (including households), but this falls short of the USD 8-9 trillion needed annually to reach NZ. Although these figures seem daunting, McKinsey (McKinsey & Company, The Net Zero Transition, January 2022) notes that approximately USD 3.7 trillion of current spending on high-emission assets will need to be redirected to low-emission assets over time. In addition, we should remember that by 2050, the cost of inaction could be approximately five times higher, as shown in the chart below (Climate Policy Initiative, 2023 report) in the business-as-usual (“BAU”) scenario from Climate Policy Initiative.
Cumulative climate finance needs versus losses under 1.5C and BAU scenarios
Source: CPI analysis and NGFS (2022)
The International Energy Agency (“IEA”) comes to a similar conclusion (International Energy Agency, What does COP28 need to do to keep 1.5 °C within reach? These are the IEA's five criteria for success, November 2023). It emphasises that to keep the 1.5°C goal achievable by 2030, among other things, we need to: 1/ triple global renewable power capacity, 2/ double the rate of energy efficiency improvements, 3/ cut methane emissions from the fossil fuel industry by 75%, and 4/ begin an orderly decline in the use of fossil fuels, starting with coal-fired power plants. But limiting global warming depends on the actions of many stakeholders, including the positioning and conviction of policymakers. Luckily, the IEA’s message was heard at COP28, where additional commitments were made targeting, among others, these four key points.
We are currently in the acceleration phase of the energy transition, a time when corporates and financial institutions should assume their fair share of responsibilities in shaping new decarbonised economic models. Despite increased support from governments in the US, Europe, and Asia, a significant portion of the USD 4.5 trillion clean energy investment required annually by 2030 to triple renewable capacity and double energy efficiency improvements must come from the private sector (BNP Paribas Exane estimates, Net Zero Hero 2: Engaging Equities, November 2023). This is in comparison to USD 1.7 trillion in capital expenditure in 2021 from global listed companies in the five highest emitting sectors (energy, utilities, materials, industrials, and autos), and nearly USD 0.4 trillion for European listed companies alone. BNP Paribas Exane concludes that these figures will have to increase by ~50% if we want to get on the Net Zero pathway.
This is where responsible investing comes into play. By investing in and engaging with investee companies in high-emitting or carbon-intensive sectors to set up credible, Paris-aligned decarbonisation targets and commit the required capital to achieve them, we believe investors can facilitate the transition, aligned with their fiduciary duty, and ultimately create real economic impact.
We see two means for investors to support corporates on their decarbonisation journey, both requiring active ownership: proxy voting and engaged dialogue with management teams on specific climate-related issues. Concerning the latter, the focus of formal engagement and engaged dialogues with investee companies should move beyond commitments and target setting and instead aim at tangible and quantified metrics. These metrics should assess the credibility and viability of transition strategies and plans, including aligning executive remuneration with climate targets, Paris-aligned capital allocation, and integrated accounting disclosing key parameters and assumptions for both existing assets and new technologies and developments. Both proxy voting and engaged dialogue have evolved significantly over the past couple of years, allowing for credible alignment with investors’ climate commitments and ambitions, but not backing out of potential escalation steps. Importantly, we believe such a sustainable strategy should drive incremental shareholder returns. Indeed, from a purely financial perspective, while significant upfront capital expenditure may resonate negatively among investors fearing capex with limited returns, the companies that are ahead of the pack on the transition front may enjoy sustained competitive advantages in a low carbon-emission world, which warrants a valuation premium.
Let’s take the example of energy companies. According to the IEA (International Energy Agency, "What does COP28 need to do to keep 1.5 °C within reach? These are the IEA's five criteria for success", November 2023), energy companies have a leading role to play in reaching NZ — not only by addressing emissions from their own operations but also by investing in renewable energies and CCUS (carbon capture, utilisation and storage) to neutralise residual emissions. Additionally, oil and gas companies must demonstrate how new resource development aligns with the Paris Agreement and be transparent in their plans to avoid jeopardising this goal. These recommendations represent a valuable toolbox when demanding strategic change from investee companies in the oil and gas industry. While some may argue that one investor alone cannot influence a company’s strategic direction, corporates do respond to collective engagement from different asset managers holding a significant share of the capital. At a time when the equity market refuses to value the pipeline of some purely renewable players because of value destruction concerns (which will ultimately make these players scale back their investments to focus on value creation rather than green gigawatt growth), we should welcome and encourage global energy companies with deep pockets who are ready to diversify their business model towards more Paris-aligned activities. Such activities include renewable power, EV charging stations, and CCUS, all while ensuring a secure and affordable energy supply. This approach allows energy companies to credibly address the energy trilemma, rather than merely focusing on the energy dilemma as has often been the case.
However, let’s not be naïve. Active ownership and engaged dialogue are not a free pass to invest in any carbon-intensive company. A thorough ESG analysis, including an integrated transition plan assessment aligned with international best practices and targeted active ownership based on the outcome, is essential for credible transition investments. At DPAM, we have developed a robust sustainable investment framework combining various screening steps (Global Standards, controversial activities, best-in-class) with an in-depth issuer ESG and climate risk and opportunities analysis (integrating international standards), and linked to a strong and unique engagement active ownership approach with an escalation policy to intensify engagement efforts. Coupled with broader stakeholder engagement efforts at the DPAM level, including collaborative engagement initiatives and policy dialogues/consultations, this approach should result in credible investments in transitioning companies across all sectors, regardless of their initial greenhouse gas (GHG) profile. Ultimately, the goal is to select the frontrunners in each industry leading the move towards a low-carbon economy. In this way, it makes more sense from a transition standpoint to own and engage with high-emitting companies rather than avoiding such industries and missing the opportunity to drive change.
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