Stewart Investors - Fixing climate change measures

Many research providers and standard-setting bodies have been working on climate measures and disclosures for investors with mixed success. A key gap is that no current standard, when considered across a portfolio of listed-equity investments, covers the essential questions of how much of a contribution can different solutions make and whether collectively they are enough.

If asked to list climate change solutions, many of us would start with renewable energy. It is obviously a key one given the use of fossil fuels for energy is the largest contributor to greenhouse gas emissions globally¹. However, beyond that we may soon get stuck, particularly if asked to focus on how much specific technologies or social changes can potentially contribute to decarbonising the economy; harder still if trying to identify a group of solutions which will be enough to achieve the goals of the Paris Agreement.

Some approaches to these climate change solutions focus on splitting ‘green’ and 'unsustainable’ revenues, being revenues from sustainable activities like renewable energy as opposed to unsustainable ones like burning fossil fuels, mostly based on industry involvement. More ambitious efforts like the Paris Agreement Capital Transition Assessment (PACTA), a collaboration between the 2° Investing Initiative² and the Principles for Responsible Investment, goes further and looks at the capital investment plans for companies in some sectors and whether they are aligned with Paris targets.

‘For other investors who wish to tweak around the edges of benchmarks or who choose to stay invested and engage with highly polluting companies, carbon footprints and tools like PACTA will be very useful, it is just not for us'.³

The European Union’s sustainable finance taxonomy⁴ has undertaken the significant task of setting thresholds for different activities to draw a line between what can and cannot be called sustainable. While the TCFD (Financial Stability Board Task Force on Climate-related Financial Disclosures⁵), rather disappointingly, has suggested portfolio level carbon intensity should be the primary metric for investor disclosure and presumably management of climate risks.

Climate change is unquestionably a complex issue, more so when considered alongside the speed and scale of change required to prevent the worst impacts of this environmental crisis unfolding. It is understandable then, that attempts to measure the implications of this issue for an investment context will also carry a degree of complexity and that it would be impossible for any single metric to capture this complexity.

While the various approaches should be useful for some investor types in some contexts, as an active, global, sustainable development focused, listed-equity investor, we have found current approaches near meaningless and often misleading. While regulators around the world expect investors to communicate to clients in plain and understandable language, our industry has built an incomprehensible jumble of information and ratings to describe climate change risks and opportunities.

For us, issues broadly fall into four areas:

Measuring the wrong things

Because of our focus on sustainable development, many of the companies in carbon-intensive sectors or with highly polluting products and services, are never going to be investible and so footprints and capital expenditure plans are not helpful beyond confirming what clients would already expect. For other investors who wish to tweak around the edges of benchmarks or who choose to stay invested and engage with highly polluting companies, carbon footprints and tools like PACTA will be very useful, it is just not for us.³

Drawing too narrow a frame

Climate change is a systemic problem, yet too often the investment implications are looked at too narrowly.

A significant part of our investment philosophy revolves around the idea of sustainability positioning, which we often refer to as headwinds or tailwinds. The tailwinds we are looking for relate to the products or services provided by the company and so the climate impacts are often downstream from the company itself.

The difficulty in calculating the emissions these products and services help avoid, is part of the issue, but for us the issue runs deeper because the supply chains which support solutions are not taken into account. Take for example companies like robotics manufacturer FANUC, liquids dispensing company Nordson and semiconductor manufacturer Taiwan Semiconductor (TSMC). All these companies provide essential technologies for the development of electric vehicles, but none would be classified as a solutions company.

Looking upstream reveals similar challenges. For example the role that large buyers of wood products, such as pallet business Brambles or consumer goods company Unilever, can have on reducing deforestation and promoting forest protection is significant, but none of these important contributions would be recognised in traditional climate change assessments.

Backward looking

While PACTA considers capital expenditure plans, these look out only over five years and in a few sectors. All other approaches effectively look backwards at either emissions or revenue splits. We are long-term investors and try to take at least a ten-year view, which is why sustainability considerations are so important to the way we invest. Part of looking forward is understanding how big the opportunity is likely to be years into the future, which is too often undefined in the context of investing for climate solutions. 

False precision and hiding real insight through aggregation

Notwithstanding caveats in the fine print, all the approaches to measuring and describing climate change related investments, invariably offer a number at the portfolio level, often with multiple decimal places, as ‘the’ answer.

Our investment approach relies on qualitative and subjective analysis in the understanding of quality. While what gets measured might get managed, we believe that not everything that gets measured matters and that not everything that matters can be measured. This includes holistically understanding company relationships, competitive dynamics, stewardship and reputation to name a few. As bottom-up investors, aggregation of climate metrics hides the stories of the companies we invest in and obscures real world impacts with abstraction.

Taken together these issues have made reporting on climate change particularly challenging for us.

Fortunately there is another way

Project Drawdown was founded in 2014 by Paul Hawken and Amanda Ravenhill to uncover the most substantive solutions to stop climate change and communicate them to the world. Using rigorous analysis and review, the initiative published the bestselling book Drawdown in 2017 which catalogued 80 climate change solutions with the potential to meet the Paris Climate change goal of holding global warming to well below 2°C.

By estimating the emissions reductions possible from scaling each solution, the initiative not only catalogues practical solutions for emissions reductions, but how large each may become in the future. In 2020, Project Drawdown published a major review which updated the solutions to account for technological progress.

Using Project Drawdown’s solutions we have begun an exercise to map the products, services and practices of the companies held within the strategies managed by the Sustainable Funds Group. We hope this analysis will present a balanced picture of how companies are impacting the climate and look forward to sharing the findings with you soon.

For more information on our approach please visit https://stewartinvestors.com

Source for company information: Stewart Investors investment team. For illustrative purposes only.

Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of Stewart Investors at a certain point in time, and the holdings may change over time.

Footnotes

1. Source: United States Environmental Protection Agency greenhouse gas emissions data. https://www.epa.gov/ghgemissions
2. 2° Investing Initiative: a leading global think tank on sustainable finance, developing the regulatory frameworks, data, and tools to help align financial markets with climate goals.
3. Some other investors start with the benchmark and they make changes to that. Many low carbon strategies, particularly Exchange Traded Funds make tweaks to the benchmark to reduce carbon exposure.
4. European Union’s sustainable finance taxonomy is a tool to help investors, companies, issuers and project promoters navigate the transition to a low-carbon, resilient and resource-efficient economy.
5. TCFD is a market-driven initiative, set up to develop a set of recommendations for voluntary and consistent climate related financial risk disclosures in mainstream filings.

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