At the Morningstar 2020 Virtual Conference, Hortense Bioy,Morningstar Europe & Asia, moderated a lively discussion between Simon Webber, Schroeders, and Lucas White, GMO, on climate change and the impact on portfolio construction.
We've summarized highlights from the panel.
What are the similarities and differences in the way you account for climate change in the strategies that you manage?
We look for companies we believe will do well in the end - companies that are developing new products and services for a low carbon economy of the future. We avoid companies like fossil fuel companies completely – but in our traditional strategy, we may invest in those companies if they are investing in improvements and making the transition. For example, we may invest in a fossil fuel company that is developing alternatives.
We invest globally in what we believe are high-quality companies. While we don't call it a sustainability strategy - essentially it is. We look for good quality companies that will be around for years to come. Years ago we had oil companies but sold our positions as they aren’t going to have the same success moving forward. Companies like Google obviously have less risk and we can assume they will be around for years to come.
In our natural resources strategy, we exclude coal, sand, and shale companies that have the highest stranded asset risk. We do have about 30% fossil fuel exposure.
In our climate change strategy, we look for opportunities where we can make money and generate strong returns from companies that are going to get involved in combat and climate change. We're looking for companies that are either involved in climate change mitigation or are helping the world adapt to climate change.
How do climate change strategies fit into an investor's portfolio?
Our strategy isn’t heavily diversified, it’s more “nichey.” I don’t consider it a replacement to a core strategy because it doesn’t have exposure to all gig sectors, but we do hope it will outperform the broad equity market There are a growing number of clients on the institutional side who have an ESG bucket and our strategy is slotted in there.
Our strategy is quite diversified and one of the things that we focus on is called low carbon leaders. Those are companies within any industry where that company has culture and innovation and a set of products that really sets them apart. We end up with a diversified set of holdings across industries.
Many investors want to make a difference in the world. They want their money to have a positive impact on society and the planet. Would these climate change strategies be suitable for these types of investors?
Yes, we do think the strategies have a positive impact in a number of respects. It may be harder to gauge impact investing, but we are able to report on a range of ESG factors.
Yes, it can be difficult to assess the impact that you have as an equity investor. Regardless you are having an impact in that you’re providing capital to companies that wouldn’t be receiving it in other circumstances.
Could an advisor argue that because you're not investing in fossil fuel companies you are avoiding negative impacts?
There is an argument there, but the reality is the world needs fossil fuels in order to transition to clean energy. You can’t simply quit fossil fuels cold turkey – it has to be a transition that will likely take decades.
In 2019, we consumed the most coal, oil, and fossil fuel globally than we’ve ever consumed. We’ve been setting records every year for fossil fuel consumption. This year everything slowed down considerably – the silver lining of the coronavirus. But it’s not enough, we aren’t transitioning from fossil fuels as quickly as the environment needs.
Do you see the production and consumption of fossil fuels to increase or decrease?
It’s difficult to say because of the impact the coronavirus has had on the economy. Consumption of fossil fuels is down, and it’s possible there is room for electric vehicles to start to replace fossil fuel-based solutions. It IS possible we’ve hit peak fossil fuel consumption.
Based on the data leading up to this year, it’s possible we would have hit a new record in consumption in 2020 but coronavirus may have changed that.
I agree we’re off track and it’s easy to be pessimistic. At the moment our model suggests we will get to just under 4 degrees-considerably higher than the 2 degrees we are aiming for. We hope the transition will be faster. But our model, which tracks the trajectory we're on, suggests we'd likely to get to just under four degrees - not the two degrees we are aiming for. Technologies are evolving and electric vehicles are taking off.
The inflection point can be rapid and it can also be supported by policy. In some places, like Europe and California, there are mandates that set the rates for transitioning to 100% renewables and 100 electric vehicles - you won't be able to buy or drive a combustion engine vehicle into a European city in 10-15 years.
The politics of the issue is important. One of the single biggest differences of policy in the upcoming US presidential election. In the last year, Europe has transitioned to their recovery plan which is very focused on creating a low carbon economy. The world would look very different with an aligned US and European set of policies on these issues in the next five years.
How can fixed income be incorporated into a climate change portfolio?
The valuation of the needs to be done separately. Analysis should be critical when you're investigating the corporate credit market. We want our analysts to work together from both the equity and fixed income analyst. The fixed income would likely be more focused on the risk profile and the potential of losing money when the company is badly positioned.
What about when green bond is involved? As a way to finance green projects, is that something that investors should also consider?
Green bond framework and reporting around it can add transparency to a company with wider benefits just from having that green bond. Some of our fixed income portfolio managers believe that adding green bonds to a portfolio gives them more interesting opportunities. It might help tilt the portfolio toward more sustainability themes and priorities, or end up giving companies access to capital to accelerate some investments in environmental or social enterprises.
At GMO we have looked at it, but there has been a capacity issue. Historically there was a capacity issue with green bonds and there has been an increased amount of issuance in recent years. It is still a very, very small part of the overall bond issuance in the world.
How do you balance a company with good intent, like renewable energy, that may be getting materials that were sourced with poor social standards?
It’s a trade off. Unfortunately, there is no such thing as clean energy without copper, lithium, nickel, cobalt, vanadium. There are materials that are going to be required. There are social impacts to any company. You have to be pragmatic about these things and balance the good of what the company is doing against the negative impact of the other.
We look at the environmental climate change aspects of what a business is doing - how their relations with their workforces are, with suppliers, etc. When engaging with companies we encourage them to make efforts to improve areas we may see as risk. While it may not be immediately pressing it could hurt the reputation of the business or disrupt operations.
How do you think COVID-19 has affected how investors will view climate change?
The lockdowns globally have had some positive impact on climate change. On a higher level, it’s made policy makers look at the vulnerabilities of economies. There are similarities to note, of investing in pandemic management and prevention mechanisms. It is always costly investing in things that you’re not prepared for. The same can be said for climate change – there are many parallels. With climate change we need to invest now to ensure better outcomes later.
There has been a lot of learning that has come from the pandemic. Business travel emissions are way down and workers are realizing that meetings can successfully take place virtually rather than in person cutting down on unnecessary travel and emissions.
Awareness of climate change has grown dramatically in the past 5-10 years. Initially, I was concerned the pandemic would cause the world to “take their eye off the ball” of climate change. While scientists have been concerned for years, in recent years it has risen to the forefront of global consciousness.
For a time, there was more focus on coronavirus, but climate change hasn’t been forgotten. It seems like a lot of the stimulus in Europe, China, and other countries may flow into clean energy projects. So it seems some of the impact has been to spur clean energy efforts and hopefully that will continue as it is one of the few obvious growth opportunities in global markets.