In this article, the fund managers of Henderson European Focus Trust (HEFT) explore whether exclusion is the only way to achieve our ambitious sustainability goals.
As the potentially negative impacts of human-induced climate change become more widely accepted by society and the pace of investment into businesses that display rosy Environmental, Social and Governance (ESG) credentials has picked up pace, the fund managers of Henderson European Focus Trust (HEFT) ask if there are alternative routes to exclusion in achieving our portfolio sustainability goals.
Last November, the news cycle buzzed around COP26 as 196 countries signed the Glasgow Climate Pact and made further promises to tackle climate change. According to the United Nations, more than 70 countries – including the biggest polluters China, the US, and European Union – have so far agreed to net-zero emissions targets by 2050, covering 76% of global emissions.1 It is a formidable task, and as such, over 400 financial institutions have been mobilised to bring capital to the fight. As a result, the assets under management of asset managers and asset owners committed to net zero goals totals $130trn.2
All manner of investors, from pension funds to wealth managers to retail investors, have been piling into funds that invest in companies with strong ESG credentials. According to Bloomberg Intelligence, investments in these strategies have grown by $12 trillion in the last six years alone, to $35 trillion, and will continue onwards to $53 trillion by 2025.2
Meanwhile, energy security concerns triggered by the Russia/Ukraine war have further highlighted that Europe and the rest of the world need to accelerate the transition towards clean energy and rid themselves of volatile polluting fuels. And to deliver on these sustainability goals, many investors have simply been excluding the most polluting firms and starving them of capital. Yet, it begs the question: is this the best way to achieve our sustainability goals?
Exclusion to what effect?
Many firms have a long and complicated road ahead to decarbonise their operations. For some, offloading their most polluting assets – not shutting them down – has been the immediate fix. Strong demand and substantial profits in a world where these sorts of assets remain perfectly legal means someone will want them. The enthusiastic buyer of choice that has emerged is private equity (PE). Opaque in nature, PE firms have been snapping up polluting assets to the tune of $60 billion over the past two years alone.4 According to the Economist, these include giant oilfields, coal-fired power plants, gas grids, miners, and utilities. And it won’t let up - asset disposals are foreseen to accelerate over the next few years
Sending ownership of high-polluting assets into the world of alternative finance is problematic for several reasons. First, capital markets can hardly claim to be decarbonising the planet if, rather than helping wind down polluting activities, some underlying companies are simply allowed to shift them off their books to be someone else's problem. Second, as high-polluting assets pass to private capital, it becomes harder to tell if the owners plan to reduce or expand their output over time. Given the high commodity prices we are currently seeing, the latter is very possible.
A long-haul journey to zero carbon
According to McKinsey5, the worst three systems for greenhouse emissions are: the production of energy, such as heat and electricity; industrial processes, including sectors such as steel, cement, chemicals, and pulp & paper; and mobility, meaning road, rail, aviation, and other forms of transport. Across all of these, the use of carbon-based fuels i.e., fossil fuels, are responsible for 83% of carbon emissions. It’s why the emergence of cleaner renewable forms of energy is so vital. So, given that transport emits 17% of global carbon dioxide, how best do we reduce its carbon footprint - should portfolio managers exclude firms such as airlines from their portfolios?
As we move out of the pandemic, air traffic has resumed. Meanwhile, demand has soared from environmentally conscious consumers, and search websites including Skyscanner, Kayak, and the like, have begun stating carbon emission units per flight, to indicate variation between airlines. It seems obvious, therefore, that winning airlines will emerge if decarbonisation becomes paramount in their strategic thinking.
It’s no mean feat. To reduce emissions, airlines need to invest in a raft of new technologies in their aerospace supply chain. In the shorter term, this includes fleets with better aerodynamics and more efficient engines, such as Airbus’ A320neo (new engine option), delivering 20% fuel savings and carbon reduction. In the medium term, net-zero sustainable aviation fuels (SAFs) are emerging as an ingredient to blend into traditional fuel kerosene to reduce its carbon footprint. Over the longer term, the wonders of hydrogen and all-electric powered aircraft are in the making.
It begs the question: how could airlines – or other polluters - invest in these sorts of technologies if capital allocators take away their ability to do so?
Inclusion as an approach
At Henderson European Focus Trust, we prefer a different approach – inclusion. We don't want to cancel; we want to embrace, challenge, and hold companies to account. Evaluating ESG scores as part of our investment process enables us to identify risks and opportunities in areas such as the energy transition – increasingly a focus for governments. While this might lead to the inclusion of renewable energy providers, for example, it could also lead to the inclusion of polluting firms that are employing meaningful strategies to move the dial on sustainability issues.
We ask ourselves not where a company has come from but where it is going. That’s why company engagement is also an integral part of our ESG assessment. We meet with top management annually or, in some cases bi-annually and will vote on important issues to put pressure on boards to ensure that the company is heading in the right direction.
Portfolio holding Holcim embodies our thought process. Indeed, this single holding represents 75% of portfolio emissions given the carbon intensity of cement production. Yet, through active engagement with its management, we are assured that the company has a credible plan to decarbonise its cement business - leading in its peer group and increasingly recognised by independent agencies that rank its energy transition plans in the top 2% in the industry.
Portfolio holding Shell offers another example. Recently, we met with management to discuss several environmental concerns and the action plans put in place to deal with these. One such concern was methane emission, a powerful greenhouse gas. Shell is dealing with this through plans to eliminate routine flaring – where gas is burnt during oil extraction – and reduce methane emissions to below 0.2% by 2025.
Decarbonising the planet will be neither straightforward nor quick. As it stands, each of us emits on average 4.39 tonnes of CO2 per year.6 What is more, the energy transition needs to be conducted in a sustainable way that doesn’t leave economies overly vulnerable to energy shocks. Given our fiduciary duties, we are also acutely aware that by excluding these sorts of assets from the portfolio, we may lose an important inflation hedge. This underlines why inclusion and engagement with companies transitioning to a cleaner future is so important.
While inclusion may seem counter intuitive to those who wish to act quickly on sustainability issues, it offers investors a voice to hold polluting firms accountable for setting and achieving strategies to help us reach net zero. These companies are the ones that need the most significant change and with the help of active, engaged investors, they can become part of the solution.
1Source: Net Zero Coalition | United Nations