Approach to Responsible Investment

Transition risk represents the single largest climate-related risk for listed infrastructure companies, as the world moves away from fossil fuels and towards lower carbon sources of energy. This transition has implications for utilities with coal-heavy generation assets. Companies that fail to adapt in this environment are likely to face not only stranded asset risk but also regulatory risk. Mounting consumer concern about climate change could put their social licence to operate under pressure, potentially leading to stricter regulatory outcomes. It may also affect the energy midstream space, where oil and refined product pipelines could face stranded asset risk by 2040[1]. While natural gas is likely to represent a key transition fuel, a long-term decline in demand is likely to begin once battery storage technology has advanced sufficiently. We also believe North American freight railways coal haulage volumes will continue to decline over the next ten years.

However, energy transition also represents a substantial opportunity. Attempts to reduce carbon emissions are having significant implications for the way in which electricity is generated, transmitted and distributed. Renewable energy is currently experiencing a virtuous cycle of falling costs, improving productivity and growing market share. In contrast, non-renewable energy is in a vicious cycle of declining market share, reduced revenues and rising costs.

As a result, large cap, publicly-listed electric utilities are already investing significant amounts of capital into the build-out of renewables, typically via regulated frameworks that allow them to recover and earn a return on the money spent. The carbon intensity of the portfolio’s utility holdings fell by -45% during the period from 2005 to 2020, through coal retirements and renewables build-out. The replacement of older coal-fired power stations with cheaper, low carbon wind and solar power is likely to present substantial capex opportunities for many utilities over the next three decades. These companies are expected to play a crucial role in achieving net zero by 2050.

The other main climate-related risk facing listed infrastructure companies relates to the physical risk of climate change. At their heart, infrastructure assets consist of networks to move things around, be it people, goods, energy or data. Extreme weather events can affect the efficient operation of these networks, which will need to be more resilient than in the past. The need to spend additional capex to improve resilience or rebuild facilities may represent a financial risk to some companies. However, this theme may also represent an opportunity. For example, utilities are often able to add the required expenditure to their rate base, underpinning regulated earnings growth. Other infrastructure companies may be able to secure a competitive advantage by moving early to improve their assets’ resilience, reducing downtime and improving operational efficiency.

We believe the most effective way to identify these risks is through regular meetings with senior management and other stakeholders including suppliers, competitors, regulators and industry bodies. Given the investment experience across the team, companies and markets are understood intimately and we believe we are best positioned to form a view on the companies approach to climate change and the materiality of climate change-related risks and opportunities.

We encourage companies to report climate-related statistics in a way that is consistent with the framework provided by the Task Force on Climate-Related Financial Disclosures (TCFD). We also encourage them to work with the Science Based Targets initiative (a clearly-defined pathway for companies to reduce greenhouse gas emissions). We maintain a database that monitors ESG metrics. These metrics include a range of climate-related statistics, including Absolute Carbon Emissions, Carbon Footprint and Carbon Intensity (all measured at a stock, portfolio and strategy level). This database also tracks whether companies with power generation assets are reducing their carbon intensity over rolling five-year periods.

Our team has integrated ESG criteria into its investment process since the strategy was established in 2007, with climate-related risks representing a key element of this. Climate change-related criteria are incorporated into the financial models that we maintain, and into the Quality scores that are assigned to each company that we research and analyse. The financial models are used to assess the financial impact of climate risks on company performance, so that we can rank stocks in our focus list according to their relative mispricing. Key assumptions in these models include the likelihood of renewables taking market share from fossil fuels over time; and increased electrification of the transportation sector in the long term. Moving forward we may further develop the models into a more robust scenario analysis, incorporating the impact of these climate-related risks under different pathways.

As well as feeding into our stock selection and portfolio construction process, this analysis also helps us to identify topics to engage with companies about. First, we raise the issue in meetings with company management, in order to put our view across and to understand the situation from the company’s perspective. If we don’t see change, we will then contact the Board, for example by writing a formal letter, outlining our concerns. If we feel that our concerns are still not being addressed, we may vote against the company via proxy shareholder voting. In instances where management does not respond adequately to engagement, this may negatively affect our quality scores for that company, which could result in our divesting ownership. We view this approach as being an important element of our fiduciary responsibilities. Topics we regularly engage on with companies include transition risk; physical risk of climate change; alternative fuel sources; regulatory risk for transition laggards; improving disclosure; and net zero targets.

We have used the Institutional Investors Group on Climate Change (IIGCC) Net Zero Investment Framework to set objectives for individual company net zero alignment. During the 2022 calendar year we will engage on the topic of net zero with the 10 companies held by our portfolios that produce the most carbon emissions. We will encourage these firms to set a long-term goal of net zero by 2050, with a medium-term goal of achieving alignment with a net zero pathway. As companies agree to these goals, we will monitor progress on an ongoing basis and encourage them to implement specific near-term steps in pursuit of these longer-term goals, such as linking executive remuneration to progress in this area. We will also continue to engage, sharing examples of industry best practice and urging them to accelerate their progress where possible. If engagement is unsuccessful, we will escalate following the process outlined above.

Our second climate change-related objective relates to the carbon intensity of the portfolio’s holdings. Utility companies produce around 85% of total portfolio carbon emissions. We will therefore require a positive direction of travel from these stocks. As utilities replace fossil fuels with cheaper renewables, we expect the portfolio’s look-through exposure to renewable generation assets to grow steadily over coming years.