Adam Hetts: Today on Global Perspectives we catch up again with Hamish Chamberlayne, our Head of Global Sustainable Equities and Aaron Scully, a Portfolio Manager on the Global Sustainable Equity Team. I am your host, Adam Hetts, Global Head of Portfolio Construction and Strategy here at Janus Henderson, and it is great to check back in with Hamish and Aaron, because there is a lot happening and a lot changing in sustainable investing. So Aaron, let’s start with the biggest change. Here in the US, we are a few months into the Biden Administration. At these early stages, what are you guys seeing as the biggest effects on sustainable investing?
Aaron Scully: Yeah, great question. A lot is going on right now. I think it would be a struggle to overstate the significance the Biden Administration is going to have on ESG, on sustainable investing, about the green sector. And I think there are three obvious areas we can talk about that will likely have a direct or indirect impact. The first is fiscal, so it seems like every other week there is a big spending bill announced. This latest one is the potentially transformative infrastructure plan. I have seen estimates it could be up to $4 trillion if you layer in the human infrastructure part of it. And a good portion of that is likely to end up being allocated to green energy and preparing for climate change. The second area that I think will influence ESG investing is the Securities and Exchange Commission (SEC). You know, the SEC recently sent a very powerful signal on ESG issues when it did not block a shareholder proposal to vote on bringing transparency to oil companies that plan, with regards to their plan to reduce scope 3 emissions. I think this is the first time that I am aware of that the SEC has not blocked a proposal that demands oil companies bring greater transparency to reducing their scope 3 emissions.
In addition, as SEC recently created a panel focused on climate change issues in ESG, I think we should expect the SEC under Biden to be one focused on bringing about greater transparency of all kinds of corporate ESG issues. If you don’t measure, how can you improve on it?
And then finally, third, I think this is the biggest wild card is just the US Federal Reserve (Fed). The Federal Reserve started talking about stress testing their book of investments to the risk of climate change. And there is a possibility that they publish those results. And I think what could happen from those results is that other investors would see which companies don’t fare as well and could start allocating capital away from those companies. And ultimately that hurts the companies cost to capital. So that could have a pretty profound effect. But again, it is a bit of a wild card. We still don’t know what the Fed is going to do.
Then finally, I guess I would be remiss if I didn’t mention the US Environmental Protection Agency (EPA) and the potential impact they will have. The challenge with the EPA is in the US, states’ rights can really get in the way of meaningful change implemented by the EPA. So it is a bit more challenging. But all in all, I think all these factors are a rising tide that is going to lift all the ESG boats.
Hetts: Well, that is a bit of a heavier hitting answer than I expected as early on as we are into the Biden Administration. So the fiscal, the kind of SEC regulatory changes, the Fed, EPA, maybe we can take some of those roughly in order. On fiscal, you mentioned $4 trillion. I literally raised an eyebrow when you said that. I have been seeing more of the $2 trillion, which has somehow become a more normal number these days. But $4 trillion, green energy, kind of renewable energy and there is so much talk even before that about renewables and then maybe too much talk since last year where a lot of renewable funds were up more than double, you know, in 2020. So with all this broad expectation of more support through kind of the infrastructure spending in the fiscal boost, how are you guys finding this balance of being exposed to green energy and renewables, but also avoiding the froth that we might be seeing from a lot of sky-high returns in that space already?
Scully: Yeah, so 2020 was a monster year, wasn’t it? And then fast forward to this year. You know, we have had a bit of a bubble burst and some of the special purpose acquisition company
(SPAC) tech, some of the more speculative parts of the renewable space like hydrogen. But I don’t think this all should be viewed as a surprise. You combine irrational valuations in some cases with rising interest rates and it creates the right condition for a sell-off. But with that said, we still think there is a great opportunity to generate alpha in the renewable space. But you just have to be careful, right, to pick the right parts of the renewable space.
And we break out the renewable space into three main groups. And that first group is the actual manufacturers of the things that go into renewables, such as turbines and solar panels and other parts of the renewable product. And then the second group of the space is those buyers of stabilized renewable assets that believe they can create value by, it is kind of a spread game, right? They are buying assets at a higher cash yield than their cost to capital. Or this same group could be an oil company that is trying to improve their green conventionals, right? So by buying a bunch of renewable assets, they can point to a lower emissions’ profile.
And then finally, the last group are those public companies that have a development capability to identify pieces of land that have favorable characteristics for wind or solar. They work with local government officials or first nations to get the assets entitled and then they develop the renewables. These companies can then opt to sell the assets to group number two or retain the assets on their balance sheet. We have found this last group to be the most compelling of the three and where we have focused a lot of our investments. Developing renewables is much harder than just being a financial engineer and buying assets. And there is real scarcity to these publicly traded development platforms.
We are also seeking out that first group of the manufacturers. Historically, this has been a challenged group. There was a lot of irrational competition, we struggled with what the competitive advantage was as the technology continuously changed. But the industry appears to be getting more rational as we have seen consolidation and we are really starting to see a differentiation in some of the technology. So that is another area that we are going to focus on in potentially generating alpha.
But ultimately, President Biden should be supportive for all three groups and again, the overall renewable sector.
Hetts: Thanks, a couple of follow-ups on renewables. You just mentioned Biden, my question was sort of focused around the US. But as you look at your portfolio, so to speak, of renewable investments or the renewable opportunity set, what is the global footprint like? Like what is the geographic dispersion of the renewable opportunity set?
Scully: Yeah, in terms of public companies?
Hetts: Sure.
Scully: Yeah, I mean look, shockingly there has been a scarcity of compelling investments up until recently. We have seen a number of initial public offerings (IPOs) and SPACs and as more and more capital comes in this space, you are seeing more public companies. But there is still, you know, I think, and Hamish may have different thoughts, but there is still, I would argue, not enough great renewable investments out there. And again, hopefully this changes as more capital comes into this sector and more early stage private companies with compelling technology come public. But I think it has been a struggle for us over the last few years to find those companies that kind of pencil out as a good investment, good technology, good barriers to entry, management team and cultures we really like, and are large enough, are liquid enough. A lot of these can be just a couple hundred million market cap and are just not investable.
Again, the good news is, it is gradually improving, especially over the last year.
Hetts: Does that scarcity push you into more of a US bias on the renewables front? Or are there ex-US kind of global opportunities as well for regional diversification?
Scully: Yeah, so we actually last year, so two of our investments are in North America, another investment in the UK. And again the common denominator is, do they have a development capability? Do they have a platform where they can do offshore and onshore wind, can you do solar? Do you have the manpower, the management expertise? Do you have the ability to navigate different government agencies and local politicians? So, the three all have a proven track record of doing that and doing it in some tough geographies. So, it is not just North America, it is also Europe and, you know, if we found a great idea in Asia, we would be open to buying that as well, we just haven’t yet.
Hetts: Another follow-up on renewables was this rise of renewables means we need more battery innovation and production in order to store all of this new power. So what does this demand for batteries mean to you guys from an investment perspective?
Scully: Yeah, so look, there is a lot of reasons to, and I am going to put hydrogen in there when you are talking about batteries, so we are talking about fuel cells as well. There are a lot of reasons to be excited about public companies that are focused on improved battery technology, about hydrogen fuel cells. And the efficiency and economics do continue to improve for different types of technology. These are companies that are also helping to address great societal and environmental challenges. It is exactly the kind of companies we want to look for.
And then finally, these are companies that are going to get a lot of government support, right? We continue to see, especially in the US recently, how much money is flowing into this space. All of that is good news for these companies that are helping to address climate change. However, this is the big bite, as we have seen with any new emerging technology or technologies, you are always going to see a number of bankruptcies, right, over time. And so, you know, while a lot of this technology is exciting, the economics and efficiency on this technology is just not robust enough yet to really get excited. And so it is critical that you have active managers that are sifting through all the companies to identify those companies with the best technology, with the best business models, the best culture, and hopefully avoid some of those bankruptcies.
Hetts: And you mentioned another kind of key pillar here of the Biden Administration. You mentioned the SEC, but more broadly, regulation and maybe this administration possibly, more likely to support more regulation compared to some of the deregulation we had seen over prior years. So with that, let’s talk about decarbonization a bit. I mean along with potentially more regulation, the US has rejoined the Paris agreement, we have got plenty of technology advances in this space. So it seems like all the moons of Jupiter are aligning for progress on decarbonization. So what do you both think we will see here in the next few years?
Hamish Chamberlayne: I will take that one. I think it is a nice way to sort of expand the topic here, because the point that we always make is that low-carbon investing is so much more than investing in renewable energy companies and removing fossil fuels in your portfolio. You know, I think it has been about 250 years since the industrial revolution. For the last 250 years, we have had this sort of fossil fuel-driven economic growth engine. And after 250 years, there is an incredible amount of complexity to our global economic system. You know, the fossil economy is a highly complex and interdependent system. And I think it is always really interesting to look at those charts of where emissions are coming from … where do greenhouse gas emissions come from? And you know, it is across the whole spectrum, lots of different sectors, and at a very high level. There are lots of sort of subcategories, but at a very high level, there are five key areas where emissions come from. You know, transportation, electricity, power generation, industry, and buildings, both commercial and residential, and then agriculture. And even within those industries, there are lots of subsectors and different economic activities. So we look at the breakdown, it looks incredibly complex, which makes sense.
Now the point is is that, you know, I think as Aaron has really illustrated very well, it is like the numbers are huge here. I mean it is hard to overstate what a different world we are living in today compared to four months ago. You know, I think it is an understatement to say the last four years have been frankly a bit noncommittal and a bit of a wilderness in terms of climate action. But, you know, these things can turn on a six-pence. And if you look around the world today, there is complete global political alignment and the stars, as you say, the stars are aligning for what we believe is sort of a globally synchronized investment boom into clean technologies. And there are many, many different areas which one can invest in to play the sort of decarbonization theme.
So I think again, there is the political commitment there now, there is the money there now which is coming. The world needs to align with the Paris Agreement, needs to get to a 1.5 degrees climate limit. So what does that look like? Well, there are a few big things that need to happen. We need to increase electricity share of the primary energy mix from 20% to 50% over the next few decades. And we need to convert essentially the entire automotive fleet, the global automotive fleet, to electric vehicles. We think this is going to happen. Actually, in fact, we think we are standing at the beginning of a decade of transformational change and we are going to see multiple S-curves hit this decade, you know, S-curves being hit or inflecting in the production and adoption of electric vehicles associated with the improvement in battery technology. S-curves in terms of the pace of adoption of renewable energy, but the costs have come down, it is economic and the political, what is going to happen really, really quickly throughout this decade. And then S-curves in the way that we, you know, deploy technology.
And I think again, one of the things we get really excited about and it is, I think it is best sort of articulated by something called the digitalization, electrification and decarbonization nexus. And essentially we have arrived at a moment in sort of technological development where the cost of computing after five decades of Moore’s Law is now so low that you can make everything connected, everything becomes smart. And I always say to people, I challenge people, can you find me a single industrial company out there that doesn’t have smart features and connectivity at the heart of its business strategy. So basically, we are just connecting. And with that, you can get this, you can change the way that you manage your assets, you can improve efficiencies, you can change the ways you organize your economy. And we believe it is just sort of going to gather pace over the coming decades.
So coming back to that original point, I mean so clearly, we see lots of investment opportunities. If you look at our portfolio today, we have got roughly 5% of our portfolio invested in renewable energy companies. However, when you look at our portfolio in a climate perspective and look at the way our portfolio is aligned with a low carbon future, we are aligned with what is just above a 1.5-degree future. And there are many companies in our portfolio that are playing into that decarbonization theme, are going back to those sectors. Thinking about transportation, we have got multiple investments exposed to the electrification of automobiles. Thinking about industry, we have multiple investments playing into the decarbonization of industry and smart manufacturing and factory automation. We have multiple investments in the communication sector, multiple investments in the business productivity sector and the building sector, the commercial and residential real estate sector. And all of these investments are playing into the sort of efficiency, green, decarbonization theme. And so we see significant opportunity for all of them.
Hopefully that sort of gives you a flavor of how we are thinking about the sheer, I think it is a huge opportunity set, and it is really diverse as well.
Hetts: Yeah, Hamish, that is great. I think I might be gleaning a broader framework out of that, so let me know if I am following this correctly. So you mentioned a smaller amount could be invested in just pure renewables, but more broadly it is aligning with this one-and-a-half degree kind of future. And it feels like the next step there is in identifying this nexus of themes. Can you repeat those three? I think it was electrification, decarbonization and I am missing a third perhaps?
Chamberlayne: Digitalization. So digitalization, electrification and decarbonization. I like to call it the DED nexus.
Hetts: Even easier, I will remember that. So this alignment with the future, more broadly, you have this alignment with the DED nexus, and then there is the targeting of emissions and this innovation across a few different sectors. Like you mentioned transportation, electricity, buildings, communications and so on. So my question might be for kind of the average listener, these different sectors that you are targeting, what do you find the most fascinating? Like what do you think will have the biggest impact in the near future and where you will see the biggest moves? Is it electric vehicles? Is it buildings? What do you think is the most interesting space to watch?
Chamberlayne: I think it is fair to say we are very excited about electric vehicles. We think that is a very visible and unpredictable trend over the next decade. But it is in all of those sectors. I think, you know, when you look at where emissions are coming from and you look at sort of, again, going back to these government programs, the infrastructure plans, the fiscal stimulus, it is targeted across all sectors that are seen as problem areas in terms of emissions and fossil fuel dependency. And so the most important point, there is this broad opportunity set and we think it is really important when thinking about portfolio construction, risk management, that you look at companies through an end market perspective rather than say a narrow sector classification.
And perhaps the best example of that is if we go into the industry sector and you know, I will give you three companies that are ultimately exposed to industrial drivers and yet they are classified as technology companies. So, you know, those three companies would be Autodesk, a design software leader, who has made end markets, architecture, engineering, construction and manufacturing customers. You have IPG Photonics classified as a technology company; it is the world leading manufacturer of fiber lasers, which obviously is highly efficient running electricity. They are transforming heavy industry and manufacturing process, making a much more efficient, much lower carbon, and also needing to lower waste because they are more precise. And then Texas Instruments, which I have already mentioned, where two-thirds of Texas Instruments’ revenues are to industrial and automotive end markets. And yet all three companies are classified as tech companies. So we think it is really instructive to think about the underlying or the end economic exposure when thinking about investment opportunities and constructing a portfolio with an attractive sort of risk profile, overall risk profile.
In terms of, again, the opportunity set, again I like to think of the kind of Apple analogy. And this is one of the key sort of challenges perhaps of thematic investing or thinking about thematic investing. And humans are not good at dealing with time horizons and time. I think one of the greatest sort of issues or challenges we face as investors is because we are professional investors and we are spending every day looking at the markets, looking at investment. Our sense of time can get warped somewhat. We can get sort of caught up in short-term noise and I think it is a real challenge to sort of cancel out that short-term noise. Because when you are thinking five and 10-year leaps, and you can remain sort of focused on those five and 10-year leap opportunities, you know, there is an incredible potential there.
And I like to sort of talk about Apple as the analogy. You know, 2007 was when the iPhone was introduced. You know, that is more than 10 years ago, but it feels like yesterday. If you look at Apple’s stock price chart over the last 13 years, I mean it has just been an incredible value creation story. And yet there were several times over the course of that story where you could have got shaken out of Apple and you could have got shaken out of that smartphone trend where we now have probably several, probably more than 60 or 70% of the global population now have smartphones, billions of people. And I think that is the way we are thinking about the opportunity set with regards to digitalization electrification and decarbonization. We are standing at the beginning of this decade and there are many companies in different sectors that are playing into this, you know, what we see as a generational investment trend.
Hetts: Very well said, thank you. All of this is helping me kind of mentally map out and organize this space. So to your point, there is this long-term secular trend and this alignment with the future. And then the themes underlying that are essentially this DED nexus that you mentioned, the decarbonization, digitalization, electrification. And then you have these different sectors through which you can express your views on those themes. So I think that is a great framework, hopefully I am communicating that back correctly. And a lot of terminology bouncing around here and one of the terms that I guess we haven’t touched on yet is around impact. And I know your team aims to invest with a positive impact. Impact investing, like sustainable investing is a very broad term. Can you explain how your team’s approach fits within the broader fields of impact investing and sustainable investing and whatever other terms you want to use more accurately than me?
Chamberlayne: Yeah, absolutely. And I think this is a, obviously, a very topical issue and there is unfortunately a lot of complexity here, a lot of confusion, I think. And so at the moment we are seeing, we are seeing a regulatory response to improve consistency in terms of use of definitions and taxonomy. You know, why has this issue arisen? Well, first of all sustainability, it is a very broad field, let’s be clear about that. I mean first of all, look at the definition of sustainability. Sustainability is essentially creating wealth today without borrowing from the future. And look at the SDGs, the United Nation’s Sustainable Development Goals, which have tried to sort of create a framework of thinking about sustainability issues. Well, there are 17 goals and underneath those goals, 169 targets covering a huge spectrum of different environmental and social factors. So it is a broad field and there is room for both narrow approaches that focus on one or two specific factors, or you can have a broader systems-based approach. And obviously, there is a spectrum in between narrow and broad. And then you get into the idea of the asset class and how an asset class can be associated with impact. And again, there are nuances here depending on whether you are at the private end of the spectrum – private equity, direct investment – all the way through to public equity markets and the fixed income markets. So there are lots of different considerations.
Now there is one big area of commonality across all sustainability, sort of all strategies that talk about sustainability, all strategies that talk about impact. And I am going to use another acronym here, and it is ITC. It is intentionality, transparency and consistency. And really what is common across all strategies that are doing sustainable investing properly is that there is a very clear contract between you and the client. And you have got to be very intentional about the way you invest, you have got to be very transparent about how you are developing your framework, how you are incorporating sustainability issues into your investment decision making. And you have got to have that consistency, so intentionality, transparency and consistency in terms of how you define your objectives, and then how you deliver and report against your objective to show that you are doing what you say you do.
So with regards to us, we are obviously in public equity markets. We define our sustainability objective through 10 sustainable development investment themes and we have a quantitative revenue threshold in terms of qualification or qualifying investments. So we are looking for alignment with those 10 sustainable development investment themes and we are looking at the revenues thresholds to ensure that we have high standards. And then obviously, we have very detailed reporting that we produce on a quarterly and annual basis across a lot of different sustainability metrics, which demonstrates that we are delivering against what is our stated objective.
Hetts: And that actually maybe leads to another question I had, is there is so much steam gained in the sustainable space and you guys have already been here for a long time. So I was curious what advice you have for everyday investors that are looking to make their first allocation to this space. I mean, with all the options out there, how do they find managers that are best aligned with their goals? I would imagine for your strategies you have these themes that investors can analyze themselves and find alignment. But do you find it difficult across the industry or do you feel like it is relatively easy for investors to find investment options that fit their own style? How would you go about that process if you were a new investor?
Chamberlayne: I think it is challenging, because I think, you know, it does require a bit of homework and a bit of research. Because some of these terms are thrown around quite freely and people can be using the same word to talk about different things often. So I think it does require a bit of homework on the investor side. I mean from our perspective, what have we found that works for us? It is trying to simplify things. I mean we are very, I think we are very transparent and we generally try to demystify the area of sustainable investing. Our core message is that there is this alignment between thinking about big sustainability issues and identifying attractive investment opportunities. And as Aaron said at the beginning, we are looking for those companies, transformational companies, which have got goods or services that are aligned with the development of a sustainable global economy, that ultimately is making the world a better place. And we define [that] better through our 10 sustainable development investment themes. And we think it makes great investment sense, because these are the companies that we believe are going to have this superior characteristic of growth, of resilience, of the ability to compound wealth. And I think what we have done very well over the years is set out to be very consistent in how we use our definitions, how we go about finding investment opportunities and then delivering results to our investors and making that connection between sustainability and the investment results. I mean, Aaron, do you have anything that you would add to that?
Scully: Yeah, I think you covered it well. I guess the other question that, you know, and we are going to talk up our own book here. If you allow me to put on my most blatant self-promotional hat for the active asset management industry, sustainable investing demands active management, right? So there is a lot of money that is flowing into passive strategies, but I think a number of these passive strategies have been shown to end up investing in companies that not only have a negative impact on society, but may end up having major ESG controversies. So good sustainable investing, what does that demand? It demands that you engage with senior management and the employees to really better understand the culture, to really understand if they really care about all the constituents in their ecosystem. It is to better understand their business model, to really identify the business models that will succeed. And I think with passive, you end up with sometimes the portfolio companies that may never earn a profit, that may go away. Again, companies that might be on the wrong side of sustainability. And so, you know, again, I am a bit biased here, but I think active management is the right way to go about sustainable investing.
Hetts: Thank you both, this has been great. I mean, every time I speak with you, I learn a ton, whether it sounds like it or not. But is there anything else that I didn’t ask that we didn’t get into?
Chamberlayne: Yeah, I think it is great. We obviously didn’t talk about any of our social themes, but perhaps that is something for another occasion.
Hetts: Yeah, we can maybe leave that as a cliffhanger for our third episode together. Well, great. Hamish, Aaron, thanks again for your time as this sustainable investing trend continues to get bigger and bigger, it is great to have you here as a resource as folks that have been in this space for a long time already. And for our listeners, as always, the views of Janus Henderson’s other investment teams and thought leaders are freely available within the Insights’ section of our website. And we look forward to bringing you more conversations in the near future.
