Recent months have seen a surge in ‘net-zero’ emissions target announcements by governments, corporations and investors. This reflects a growing acceptance that the world needs to rapidly decarbonise if it is to limit global warming to less than two degrees above pre-industrial levels. The International Energy Agency’s (IEA) 'Net Zero by 2050' report last month served as a reminder of the immensity of the challenges ahead, particularly for the few sectors where emissions are concentrated.
For investors looking to create net-zero portfolios, the temptation is to rotate out of high-emitting sectors and companies into lower-emitting alternatives. However, while reducing ‘portfolio emissions’ can be optically appealing, this often falls short in reducing real-world emissions. It also risks cutting off supply of capital to the areas that need it most. Forward-looking investors should instead pick the leading decarbonisers from these high-emitting sectors.
When looking at the emissions distribution of any broad index of either equities or corporate bonds, the same five sectors routinely dominate, namely: energy, materials, automobiles, utilities and capital goods. For the MSCI All Countries World Index, these account for more than three quarters of emissions but only a fifth of market capitalisation. The concentration of emissions becomes even starker when looking at the work of the global investor engagement group, Climate Action 100+. The 167 companies it targets account for more than 80% of corporate industrial greenhouse gas emissions (1). This shows how avoiding just a few companies can lead to instant, large reductions in portfolio emissions for investors, in both absolute terms and relative to benchmarks.
However, without capital, how are utilities going to switch from fossil fuels to renewable energy generation? How are auto manufacturers going to convert production from petrol to electric vehicles? How are industrial companies going to invest in electrification of previously fossil fuel-driven processes? Completely avoiding high-emitting sectors might keep portfolio emissions down, but it does not address these questions. Instead, investors seeking to contribute to real-world decarbonisation should pick companies within these sectors that have ambitious yet credible plans to cut emissions. This means a willingness to selectively accept high emissions on day one if a company’s emissions trajectory is clearly downwards.
Concrete plans
Take global building materials giant, LaFarge Holcim (Note: this company is selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance). Not only does cement manufacturing require considerable heat, which is usually generated by fossil fuels, but the chemical process itself (‘calcination’) also releases carbon dioxide gas. This helps explain why the company emitted over 148 million tonnes of CO2 (scope 1, 2 and 3) in 2019. Given median emissions of 0.24 million tonnes for companies in the MSCI All Countries World Index, this puts LaFarge Holcim in the 98th percentile of emitters in the index.
A simplistic low-carbon strategy would avoid LaFarge Holcim. However, it has some of the most aggressive decarbonisation plans in its sector. Already the lowest carbon intensity cement producer among its peers, it seeks to reduce scope 1 and scope 2 emissions per tonne of cement by 17.5% and 65% respectively by 2030, relative to 2018. The group’s actions back these targets up: it is due to open the first net-zero cement production facility and over half of research and development spending is allocated to greener alternatives. Carbon-conscious investors should be supportive of these plans, despite the high emissions today.
Energias de Portugal (EDP) is another useful example (Note: this company is selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance). Until recently, owing to legacy coal assets, it had one the highest carbon intensities in the European utilities space. However, it is successfully reinventing itself as a low-carbon power company. By closing coal generation plants and investing heavily in renewables, it plans to reduce emissions from its own operations by 90% from 2015 to 2030 (2). Furthermore, EDP’s targets keep getting more ambitious: in February, the company moved its coal phase-out deadline forward by five years to 2025. In addition, only 2% of its capital expenditure is now allocated to coal power generation, which is purely for maintenance purposes. For climate-orientated investors looking to support real-world emissions reductions, EDP’s impressive trajectory should trump consideration of its current carbon footprint.
While a 'Net Zero by 2050’ target is easy enough for companies to pledge to, this may not translate to any meaningful action for years.
Not all targets are equal
Unfortunately, investors cannot simply pick companies with the most ambitious targets. According to the IEA, around 40% of companies with net-zero pledges have yet to give details of how they plan to achieve them. While a 'Net Zero by 2050' target is easy enough for companies to pledge to, this may not translate to any meaningful action for years. The devil, as usual, is in the detail. Analysis by the Transition Pathway Initiative shows that in fact very few companies in high-emitting sectors have sufficiently ambitious decarbonisation targets. Accordingly, only by judging the credibility of targets will investors be able to identify those high-emitting companies that are genuinely on the right path.
Summary
To support real progress towards net-zero emissions, investors need to go beyond merely focusing on companies’ emissions today. The trajectory of emissions is what really counts. Stripping a portfolio of its highest emitters will lead to some quick wins, but this denies investors access to certain sectors and can often fail to achieve meaningful real-world emissions reductions. Analysing companies’ decarbonisation plans and assessing their credibility is essential for directing capital to the right places. At the same time, investors gain exposure to companies that are true leaders in supporting the transition to a net-zero world.
References:
(1) https://www.climateaction100.org/whos-involved/companies/