Jonathan White, Head of Investment Strategy and Research, AXA IM Rosenberg Equities
Growing demand for a more sustainable approach to investing in recent years has increasingly made environmental, social and governance - or ESG – issues a mainstream investment topic. There have been plenty of catalysts for the extraordinary momentum of ESG growth across regions and asset classes, but the COVID-19 pandemic has shone an even brighter light on the underlying issues.
We believe that the impact of COVID-19 on the real economy and financial markets has been a big wake-up call for policymakers, business owners and investors on the potentially enormous economic threats posed by non-financial risks. The current health crisis has laid bare how damaging it is to close whole sections of economies to protect lives, and a future climate crisis could see environmental risks have a similar macroeconomic impact.
This has brought into sharp focus what has often been the central question around ESG - how can we achieve economic growth alongside reaching for environmental goals and a thriving society? In 2020, forced - and dramatic - economic shutdowns drove a material decline in carbon emissions of around 7% globally. Of course, this was an extraordinary situation, but the crisis has clearly demonstrated that with the current economic infrastructure there is a very painful trade-off between growth and addressing the threat of climate change.
To achieve both goals of carbon reduction and economic growth, we seemingly have a long way to go in adapting our economy. However, what we are seeing is that despite all the challenges, governments are reacting to the crisis through ambitious ‘green’ spending plans. Almost every day we are hearing new announcements from policymakers around the world underlining their commitment to climate-friendly recovery initiatives in terms of how they will spend the additional stimulus being launched. For example, in December 2020 the European Union pledged that 37% of its €672bn recovery fund would be invested in projects that support climate objectives. In February 2021, the Biden administration announced a plan to spend $2trn over four years to significantly escalate the use of clean energy in the transportation, electricity and building sectors. In our view, growing political will that green spending should drive the post-COVID recovery should help to accelerate existing investor appetite for ESG solutions and creates compelling investment opportunities today.
The E, S and G
We believe it is certainly possible to align the twin goals of sustainable investment and positive financial outcomes in a complementary manner. We believe that ESG provides additive economic insights that we do not find in traditional sources of financial information like company accounts. However, it is important to unbundle the E, S and G as they bring different insights to the table particularly with regard to investment horizon.
The E and S elements have fairly long-term horizons. Environmental and social data tell us things about the long-term influences driving the structural changes that are very important in investing – how we adapt to climate change, the transition to cleaner sources of power and business behaviours. The G is closer to the more traditional indicators of a company’s business practices we look at when assessing a company. In our experience, governance information really does add to and improve our insights into earnings quality. For example, we have found companies with better diversity in the boardroom are better at maintaining their profitability advantage.
Active management to lead the change
In its purest format passive investment in our view obstructs that role that finance must play in addressing climate change because it takes no account for sustainability information and is entirely backward looking.
ESG data is now widely and available resulting in a proliferation of EGS and climate-focused rules-based indices. While the development of passive ESG indices should be welcomed, extracting investment insight from data, and driving innovation is by definition the role of active management.
Regarding climate change, acting with conviction is critical because the level of capital flows needed to drive the change is material. Unlike passive, active management can act with conviction via combination of investment, divestment and engagement to direct more capital to good actors and deprive capital from bad actors.
At AXA IM, we believe that to fully harness the power of active management, responsibility for ESG needs to go beyond being the job only of an ESG expert or team. For us, in-depth ESG analysis as part of investment decision-making needs to be embedded in culture. For any organisation, that takes time – we have been doing it since the mid-1990s and it has taken us until relatively recently to arrive at a place where a focus on ESG is fully embedded in our organisational DNA.
A forward-looking approach to climate
Regarding climate change there are essentially four categories of companies:
(i) Those that have demonstrated little or no interest in addressing climate change - the laggards
(ii) Companies that have significantly moved or already have business models that are aligned to address climate change - the leaders
(iii) Companies which perform a function that is crucial to our way of life (e.g. utilities, transport) and may have a high carbon footprint but are taking climate risk seriously and are actively reducing their carbon footprint - these are the transitioning companies
(iv) Companies with business models that explicitly support a low carbon economy, such as renewable energy or battery technology - the green leaders.
Our approach to embedding climate considerations into an equity portfolio aims to avoid laggards and invest in the leaders. However, we also aim to invest in transitioning companies and green leaders.
One surprisingly underdiscussed topic is that there is often a trade-off in some areas of the market with respect to current carbon reduction versus the broad market index and investing in transitioning companies and some green leaders.
For example, company A in the table below has significant green revenues because it is generating energy based on wind and solar power. It has both a good track record of carbon intensity reduction and a low carbon intensity level relative to its peer group (this is often referred to as avoided emissions) but it still has a high current carbon intensity. Most of the world’s carbon intensity comes from the top 5% of polluters such as company A, but company A is also contributing positively to the mitigation of climate change through its revenues – this illustrates the trade-off between a current absolute intensity objective and investing in the transition.
When working with clients who wish to address climate change through their investments, we have come across a common challenge that an ambitious carbon intensity target may limit exposure to transitioning companies and some green leaders.
By combining divestment and investment allocation decisions investors are potentially able to reduce portfolio carbon intensity whilst actively investing in companies that are committed to a path of improvement or contributing to the mitigation of climate change through their ‘green’ revenues. We think of this as a ‘carbon footpath’ rather than ‘carbon footprint’ approach. This sort of forward-looking approach is critical in any type of investing.
The COVID-19 crisis has sharpened the importance of active ownership, particularly around issues such as public health, human capital and shareholder rights and we have doubled down on engagement activities around these topics during this period. As active managers we understand that our job is to strive to deliver sustainable investment while also aiming to provide the outcomes needed to reach investment goals. We believe these elements are very much aligned and allows us to commit clear investment principles.
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