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    Transitioning from Brown to Green: Best Practice & Case Studies Discussions in Stockholm

    Filipe Albuquerque & Aline Reichenberg Gustafsson, CFA

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    With the increasing urgency to move capital to enable the economy to transition from ‘brown to green’, investors are sometimes overwhelmed by the complexity of the task. The emergence and fast evolution of new technologies as well as the need to comprehend the trade-offs within entire value chains make the analysis of investment targets and the monitoring increasingly multifaceted and technical. In addition, for many incumbent businesses, transitioning towards new technologies also means phasing out older ‘browner’ activities that may still carry attractive short-term financial profits due to the present lack of emissions taxes.

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    How do investors effectively engage with companies when weighing the short-term gains against crucial longer-term global risks? On the way from brown to green there do not seem to be any black and white answers. Subtleties and compromises are what make this topic so challenging but also so crucial to discuss.

    In an engaging, interactive and exclusive forum, NordSIP hosted a selected group of Stockholm-based investors to join two transition investing experts to discuss these issues; one with a focus on bottom-up and the other on  top-down analysis: David Byrns, CFA, is a portfolio manager and senior investment analyst at American Century Investments and Charlotte Månsson, Head of Sustainable & Transition Solutions, Nordics & Netherlands at BlackRock. The closed session was held under the Chatham House Rule, allowing for a full and free exchange of views. This article aims to provide an overview of the key points discussed during the workshop.

    Where to Focus?

    In a recent survey of BlackRock clients,  almost 50% of respondents globally argued that the transition to a low carbon economy was their most important investment priority in the next one to three years. 56% of these global respondents said they would pursue this goal by increasing their allocation to transition strategies.

    For investors seeking to assist companies making the transition from brown to green, the first question is where their focus ought to be. Although it may, at first, appear counter to the ethos of sustainable finance, focusing on the most polluting companies could be one of the most effective route for investors looking to help facilitating the transition from brown to green via greenhouse gas (GHS) emission mitigation.

    While it might be appropriate for a purely green investor, focusing on low carbon intensity alone does not drive the transition. To decarbonise society, it is necessary to decarbonise incumbent businesses. Moreover, helping high-emitting companies becoming greener could represent an investment opportunity from a re-rating perspective. The same steps that help a company along its transition journey are also likely to make it more resilient to regulatory and consumer demand and increase its long-term market value.

    Nuance and KPIs

    Not all companies that are viable for transition investments or engagement will be at the same point in their transition journeys. Some will only just recently have committed to these efforts, while others will already have started addressing these issues and reducing their footprint. Others still might be unrecognised leaders in their field, or even dedicated leaders whose products or services are indispensable to a sustainable economy.

    Establishing which counterparties are reliable and dedicated to transitioning from brown to green practices is a complex issue. Once these opportunities are identified, investors need to choose a set of key performance indicators (KPIs) to monitor the companies’ progression, to establish the criteria that will underlie any investment decision or engagement efforts.

    Nevertheless, not all information is readily and publicly available for tracking KPI progress. Monitoring can require combing through company reports to find the necessary data. Engaging directly with target companies to find information about specific metrics may also be required.

    Bottom-up versus Top-down

    Investors can choose between two approaches to investing in the transition. A bottom-up perspective starts at the company level by identifying durable businesses that can survive and thrive in transition. A top-down approach starts by identifying the relevant most impactful sectors for the transition, and then finding the most attractively valued and positioned businesses in that sector.

    Using a bottom-up approach, a case study discussed during the session illustrates the differences between energy companies that can earn a place in a transition portfolio and those that cannot. A range of KPIs such as emissions intensity, low carbon energy production and net investments, renewable electricity capacity, and the lifecycle carbon intensity of energy product sold can help investors sort the wheat from the chaff. In the cases presented, the contrast between the value of the indicators of the chosen examples was sharp, especially when tracked over several years. These examples demonstrated the power of monitoring specific metrics over time to identify transition investment opportunities. Another case study considered the progress of a prominent US-based fossil fuel company, which has for a long time been a value stock with a reactionary and confrontational attitude to sustainability shareholder proposals. However, activist investor-led initiatives have recently started to produce changes in the company’s oversight and leadership, its investments in low carbon businesses and solutions, and its emissions trajectory. While the oil major is still taking a litigious stance towards small-scale sustainability activists, hopeful signs of progress illustrate the impact that investors can have, even in the most challenging cases.

    A top-down approach, on the other hand, can focus exclusively on a strategically important sector for the green to brown transition. Another case study highlighted the importance of the Materials sector, which accounted for 17% of GHG emissions in the MSCI ACWI index1. The Materials sector is critical to facilitating the transition since it covers companies providing the parts used in the construction of the equipment required to reduce our reliance on fossil fuels, such as wind turbines, solar panels, or electric vehicles. Without decarbonising materials production, much of the lifecycle emissions from lower carbon technologies remain. The more energy consumption shifts away from fossil fuels the more the remaining GHG emissions will come from the materials used.

    Once the Materials sector has been identified as a viable target for inclusion in a transition strategy, the investment process should include a forward-looking evaluation of the participants in the industry as well as along the supply chain. Just like in the bottom-up strategy, it is crucial to identify which companies credibly seek to reduce their emission, providing them a potential to re-rate and become ESG improvers with a valuation upside.

    Whichever the approach, top-down or bottom-up, while some companies might not be suitable for a transition portfolio, investors may continue to engage and help improve the level of disclosure, or even nudge them along a transition path and wait until progress starts to show.

    Investors in the room, however, expressed a shared concern for the cost of engaging with unresponsive companies and the difficulty of justifying allocating resources without generating any improvement.  Admittedly, asset managers overseeing a range of investment strategies can use cross-strategy synergies. A transition portfolio may be prevented from owning certain stocks that another strategy could continue holding. In this case, the asset manager can use the door opened by this other strategy to highlight the opportunity of added investments flows should steps be taken to accelerate a transition journey.

    When to Invest and when to Engage?

    Timelines also matter. How long investors can wait before investing will depend on the sector, the product and where in its transition journey the company is. Improvers have a place in a transition portfolio, often more so than leaders. Whether a company’s commitments are ambitious and credible and its ability to show signs of progress are crucial factors for determining when to invest.

    At the other end, how long investors should engage with companies that do not respond will depend on investors’ outlooks and resources. Under some circumstances, investors could be looking at engagement timelines as long as 5 to 10 years. Not all asset owners, however, have the ability to make such a commitment. To avoid confusion and disappointments, both investors and investees must be clear on what their expectations are.

    Another problematic scenario is when progress starts lagging even after a seemingly encouraging start. In this case, a time-based approach can also serve investors well, particularly if they clearly articulate their expectations of the investee’s advance. If improvement stalls after a year, shareholders can escalate their engagement to the board level and ask for further disclosures. If the investee remains unresponsive, proxy voting offers an opportunity for affecting the board’s composition while creating a window of enhanced engagement before considering divestment.

    Companies with a genuine interest in transitioning from brown to green should be able to show signs of commitment within two to three years. Ultimately, if no progress is made on the most relevant metrics many investors may choose to divest to show their commitment to the transition.

    What Role for Litigation and Shareholder Activism?

    Engagement is most effective when conducted from a position of ownership and size might procure a definite advantage. However, non-owners or small minority owners may succeed in certain cases, especially in collaboration with others.

    Whilst litigious energy companies have recently been in the news, the discussion also highlights the ability of litigation by climate activist of raising the profile of some issue to put it on investor’s agenda, despite little hope of victory in court.

    The increased litigiousness in the USA has, in some instances, been framed as the result of recent regulatory decisions lowering the threshold for shareholder proposals. The new criteria may have led to overly-prescriptive or lower-quality proposals, as manifest in the low level of support many experienced at companies’ annual general meetings. Although every investor is free to use their vote as they see fit, investors should focus on proposals directly linked to long-term shareholder value creation.

    Transition CapEx, Risks and the Right Balance

    Could the transition be too costly, with capital expenditure needs eroding shareholder returns? The example of Swedish steelmaker SSAB, whose stock experienced a precipitous decrease in price after it announced a €4.5 billion green mill  investment at the start of April, could serve as a cautionary tale, a participant points out.

    However, not all were as concerned. The focus, they agreed, was on matching investment horizons and risk tolerance. The recent downturn experienced by SSAB might be a temporary market reaction which could eventually be overcome. After all, leading unprecedented innovation in such an energy-intensive industry as steel cannot be expected to unfold without challenges.

    Nevertheless, investors should be aware of the risks involved in transition investing. The materials sector, for example, may be experiencing higher volatility in the short term. However, for investors with a long investment horizon, which is typically the case for institutional investors, short-term risks may be outweighed by the meaningful benefits offered by the opportunity to participate in the energy transition.

    Net-Zero Emissions Expectations and Survival

    Whilst engagement has shown to increase disclosures and improve performance in several cases, concerns remain about the limits of engagement with some high-emitting sectors, oil giants in particular. Net-zero emissions goals may be more challenging to integrate in oil companies’ business models than in other sectors, especially when taking Scope 3 considerations into account, and, therefore, the debate remains open as to their space in a transition portfolio.

    It seems logical that the profits generated by the extraction of fossil fuel should be dedicated, at least in part, to financing the innovation and investments required to reverse the course of global warming it helped generate in the first place. Investors need to exercise their stewardship and choosing which sectors and companies have the best potential to contribute positively to this turnaround is part of the process. Change typically has the potential to generate upside for savvy investors and the energy transition is no exception. The quicker we find these opportunities, the more sustainable our future on this planet will be.

    1 Source: International Energy Agency, based on 2022 global emissions.

    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA is Editor-in-Chief for NordSIP and Managing Director for Big Green Tree Media. She has 18 years of experience in the asset management industry in Stockholm, London and Geneva, including as a long/short equity hedge fund portfolio manager, and buy-side analyst, but also as CFO and COO in several asset management firms. Aline holds an MBA from Harvard Business School and a License in Economic Sciences from the University of Geneva.
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