Stockholm (NordSIP) – For many, responsible investing is about avoiding certain companies, be it for ethical reasons, reputation management or risk mitigation. With the fast integration of ESG in the investment process and increasing investor engagement, there is a growing awareness that transitioning companies can and need to be a part of the solution. Moving from exclusion to transition can be tricky, however. Change needs to be appropriately identified, managed, and measured, from idea generation to divestment.

    To better understand what it takes to successfully invest in transitioning companies at every stage of the investment process, NordSIP organised a webinar on August 26th. The event brought together Kristofer Dreiman, Head of Responsible Investments at Länsförsäkringar (LF), Johan Florén, Head of Communications and ESG at AP7, Andrew Parry, Head of Sustainable Investment at Newton Investment Management, and Thomas Miedema, Investment Manager at Walter Scott. Newton and Walter Scott are part of BNY Mellon Investment Management.

    From exclusions to transitions – a question of principle

    Kicking off the discussion, Dreiman briefly describes how the integration of ESG at LF has evolved historically, shifting focus between exclusions, inclusions, and active ownership. “We, as many of our peers in the Nordics, started by excluding companies, primarily those involved with thermal coal and unconventional oil and gas extraction from our portfolios in 2015,” he explains. In 2019, LF’s board of directors adopted a ‘climate-smart vision’, vowing to align the company’s portfolios with the 1,5 degrees trajectory of the Paris agreement by 2030. It quickly led to the realisation that exclusions alone would not be enough to reach the ambitious goals. The same year, 2019, the first transition criteria were introduced, initially applied to utilities. This forward-looking approach means that if a company is deemed to be in transition and thus contributing to a more sustainable future, it can still be a part of LF’s investable universe.

    “I think you have to take a step back and ask yourself: if these are the means, what is the end,” says Florén in his introductory statement. “We want to contribute to real economy effects.” As a responsible institutional owner, AP7 has a duty to help investee companies develop and transition, he reasons. “The alternative, a blanket divestment, is more or less redefining your investment universe,” he said. He then explains that even AP7’s exclusionary black-listing strategy could be viewed as a form of engagement, incentivising the companies to change. “We are prepared to reinvest if they shape up,” assures Florén.

    For Miedema, the truly long-term horizon in Walter Scott’s long-only equity portfolios means he views each investment as a partnership with the investee company. “We are looking for quality growth companies which are generally aligned with areas of the economy that are growing and have a sustainable future,” he explains, adding that for such companies, a sustainable transition comes relatively easy. There are, however, investment opportunities to be found even with companies facing a more challenging transition path. Leading engagement efforts to assist such companies in their transition is precisely where he sees his role as portfolio manager and investor.

    “It is really fascinating to see how we are converging on what we want,” adds Parry, commenting on how asset owners and asset managers seem to come together on engaging with transitioning companies. “As an active manager, it is our job to help navigate our clients through a world in flux,” he continues. Although divestment might be an option for an asset owner, an active manager who selects 40 or 50 stocks to invest in, has de facto already excluded most of the investable universe, Parry points out. “Engagement is, therefore, core to our investment process, and we’ve been doing it since 1999,” he says.

    Looking for opportunities in transition

    Achieving true impact often means owning some of the most challenged businesses, like steel, cement, utilities, the automotive industry, Parry continues, moving on to identifying opportunities and selecting the right transitioning companies. Parry sees “three deltas” investors can benefit from, in this fascinating focus area: the delta of engagement, the reallocation of capital into more sustainable activities and the potential for a lower ESG risk premium.

    For AP7, with more than 3000 companies in the portfolio, actively selecting specific transitioning companies is not an option, comments Florén. Yet, the investment opportunity created by transition as a theme is there. AP7 segments companies is in three categories: leaders, laggards and those in-between, the so-called ‘slip-streamers’, he explains. “If you are looking for change, clearly the group in the middle is where you have the big potential to contribute,” he says and goes on to point out that focusing on that group might be much more rewarding than just selecting companies with high ESG scores.

    At this moment, Dreiman joins the discussion from the slightly different perspective of a manager selector. Naturally, adding one more layer between the asset owner and the investee companies further complicates the quest for targeting transition, yet it is not an excuse for inaction. “At LF, we evaluate both the firm-wide commitment to responsible investing of the asset managers we choose to cooperate with, but also ask them to showcase and prove what kind of change has actually been achieved linked to the various sustainability strategies they apply,” he says. Managers can end up on LF’s observation list or lose their mandate altogether if they cannot explain or mitigate an ESG misalignment within a reasonable timeframe. “Sometimes we would ask a manager to divest from a company that is on our restricted list, but sometimes we would also change our view, presented with sufficient evidence and arguments. It’s a quite pragmatic approach,” he explains.

    When patience is a virtue

    A pragmatic and long-term approach is what Miedema and his colleagues advocate, too. He provides the example of investing in China Light & Power Company to illustrate the long-term nature of a successful engagement process. Getting to know the company well over many years, collecting all the data, regularly talking with management, trying to understand and challenge them is the only way to accelerate their transition, according to Miedema.

    Speaking of utilities and trying to help them change, the regulatory framework and other issues need to be considered, Parry remarks. “We have to understand the limitations of engagement, too,” he adds. “We can’t make a bad company a good company. That’s the responsibility of the management.” He agrees with Miedema on the necessity of a long-term investment horizon. Patience is a virtue in sustainability, he insists. “There are no quick fixes or easy wins as an active owner,” agrees Florén, adding that perseverance is the key. That said, he also talks about the importance of setting up intermediate goals and following up those goals.

    Monitoring and measuring change

    When quantifying transition and assessing the effects of engaging with companies, Miedema reflects on the relative improvement that he has observed over time. “Initiatives like TCFD and CDP are helping,” he comments, but for him, the ongoing conversation with the companies is still vital.

    For Parry, it all boils down to setting a clear baseline and measuring the delta. He chooses to illustrate that with a company taking the conversation beyond climate change and net-zero, Philip Morris. More than 20% of their revenues come from a non-tobacco related business, he explains. Still not enough yet showing a clear transition trajectory worth following.

    According to Florén, there is still room for improvement in evaluating the effect of engagement. He also reiterates that setting clear intermediate goals makes it easier to follow up and assess the result.

    Divining the future

    In their concluding remarks, the panellists take a leap beyond the typical ‘energy transition’ to explore other potential change-related investment themes for the future. Miedema sees the importance of circular economy growing even more going further. For Parry, the space to watch is the ‘S’ in ESG. The social dimension will become much more internalised in investment decisions, according to him.

    As expected, Florén declines to reveal the next big theme for AP7. He does, however, express an opinion that the importance of and the interest in voting will be growing and taking on a new direction.

    Concluding the session, Dreiman agrees with Parry on the growing importance of the social dimension and chooses ‘just transition’ as a future theme to watch out for. He is also careful to point out that for investors, a clear priority going forward would be to do their homework and define both short-, medium- and long-term ‘smart’ objectives.

    Investing In Change

    Selecting & Managing Transitioning Companies