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Episode 50

Climate Analytics Special

Published on: October 22, 2020 • Duration: 25 minutes

This week Roger Hirst talks to experts in the fields of Environmental, Social and Governance investing. This trend could quickly have ground to a halt during the early Covid crisis. But instead, the trend has accelerated. That will provide a vast number of investment opportunities. 

  • [00:00:09] 2020 feels like the year in which Environmental, Governance and Social investing started to move into the mainstream and build momentum. This trend could quickly have ground to a halt during the early Covid crisis. But instead, the trend has accelerated. That will provide a vast number of investment opportunities. But how do we find them? And more importantly, how do we evaluate them? I spoke to some experts in this field about these trends and how to analyze them. But firstly, I wanted to understand the scale of the opportunity.

    [00:00:39] On the UN's numbers around about two trillion dollars a year of capital will need to be focused on climate solutions annually for the next few decades. If you look at the sustainable development agenda as a whole, you're talking about more like five to seven trillion dollars a year of investment in order to deliver and achieve those goals. And alongside that level of capital investment will be huge opportunities for the private sector. Those companies, first of all, that have positioned their business today to be at the forefront of their industries will be relatively well-placed as that plays out. And those companies that have the technologies and the solutions to be part of that transition and to provide the solutions to some of those problems, again, should benefit as we see that tailwind of growth and momentum get stronger over time.

    [00:01:26] These numbers are clearly huge. So regardless of one's own view on the ESG and climate narrative, there will be some incredible opportunities given the size of these trends. Investors themselves are already lining up. In fact, they've been in the driving seat, both in terms of fund allocation and the data analytics that helps drive the investment process.

    [00:01:43] So if we look at the data, we can see that the assets under management now globally, which identify themselves as ESG focused or socially-responsible focused, now make up about a third of assets under management globally. That's absolutely enormous. I think that says something very important about the institutional adoption of the ESG narrative. I think we should also remember that ESG data exists. Company ESG data exists as a result of investor pressure, as a result of institutional investors deploying pressure towards companies to disclose what they consider to be material data to their investment decision making. There is no mandatory requirement. There is no regulation that exists today that forces companies to disclose. So the reason that it exists is essentially as a result of investors themselves. So I think sometimes we do investors a little bit of a disservice in this space. They're not as far behind as we think. They're the reason that actually this type of information is available in the market.

    [00:02:35] The amount of interest that we're seeing from our clients and investors in sustainable investing is only getting stronger. One of the things that we run every year is a global investor survey where we ask 23,000 or so people around the world their views on a whole range of different areas of investment. One of them is sustainable investing. The numbers this year come out that 47% of those people globally, frequently invest sustainably, and that's up 5% from two years ago.

    [00:03:04] Investors are clearly allocating more and more capital to these themes. These are structural changes that we're seeing within the asset and investment management space. And these capital flows are also having a profound impact on the corporate sector.

    [00:03:16] Over the last year, the amount of businesses that have signed up to net zero pledges or goals has doubled. So we have about 1,500 companies now that have pledged to net zero goals. And that represents revenue of around 11 trillion dollars. So that's good news. The next phase, though, is that they're going to have to set plans and targets and transition to net zero. That's when the hard work begins.

    [00:03:46] The corporate sector is certainly embracing the ESG message, the sustainability agenda. And that's something that we see in the data, we hear about it every day when we look in the media. And there are really a number of factors. But what is important to understand that this is not only happening in the corporate world. This acceleration and the momentum that's picking up behind the sustainability agenda is really happening across the board. Starting with companies, of course, led by investors, standard setting bodies, regulators and multinational organizations. So we really see that momentum across the full spectrum of the market.

    [00:04:33] You see the same thing in the corporate world where I think very clearly there's a lot of momentum, particularly in some parts of the world and among certain companies around really trying to ensure and make their businesses resilient to the implications of a low carbon transition. Today, for example, you've got about 15% of European large companies that have signed up to the science-based targets initiative, committing them to robust decarbonization plans for their business.

    [00:05:00] The public may have been at the forefront in voicing their concerns about environmental issues, but they're also now increasingly able to take part in influencing the investment process through the adoption of new technologies, which empowers the individual.

    [00:05:11] Citizens matter enormously. We recently worked with the U.N. on a report. It was the task force of digital financing of the Sustainable Development Goals. One of the key messages out of that is citizen-centric financing. We are in an amazing time with all this technology around us. But how do we harness that? How do we put citizens back at the center? Citizens are normal people, you, me, auntie down the street. We're not connected to the financial system. We need to be again. And that's what a lot of new technology enables us to do. So I think we have a unique opportunity on our hands for citizens to reunite with finance. What does that mean? Well, why can't we finance things that we care about? Why can't I finance, why can I put my money towards gender equality? No poverty? Climate action? We have an opportunity to reorientate the financial system. And this is where the citizens can actually step up and do their part.

    [00:06:08] Clearly, change is taking place, but investing requires analytics. How do we know if a company is meeting its targets? And how do we even set them and then accurately monitor those targets? Climate risk analytics, fueled by accurate and specialized data, is becoming increasingly important to help understand how the landscape is shifting and who will be the winners and losers.

    [00:06:27] Data does play a critical role in the process, in every step of the process. So that the different stakeholders, whether that's a company or an investor or government, firstly sees what is our starting point, where are we now? So that we know the direction of travel, we can set the right targets for the future and most importantly, monitor and measure progress over time and report on it. For all of that, data is essential and very much required.

    [00:06:56] The economic theories of past are not as relevant today. We have to integrate environmental and social factors into the financial system, into business today. ESG data, Environmental Social Governance data, will need to be integrated across all sectors to be able to see where we are in terms of our carbon emissions and our transition to a net zero economy.

    [00:07:23] This is really about starting from first principles. What is going to change in a two degree transition? How are we going to get there? What do those changes mean for the value of the investments that we manage? So for us, this has been very much focused on starting with the questions rather than trying to simply focus on the data in isolation and the questions, really, we break up into two halves. First of all, how likely and how quickly are we seeing that transition to a two degree world play out? And we built something called the Climate Progress Dashboard that really helps us track the rate of progress and the rate of, or the pace of action on climate change. And secondly, what's the impact of that transition when it does play out, where we looked really at four dimensions of: What's the impacts of higher carbon prices? What's the effect of the physical damage associated with more volatile weather patterns and the physical effects of climate change? What are the implications of being unable to develop fossil fuel assets that oil, gas and coal companies have in the ground? And then finally, what are the implications of faster growth and slower growth in different industries, as we see massive capital reallocation from dirty to cleaner areas of the economy and the growth impacts that has on different sectors. And it's really about saying first of all we need to put all of these things together. This isn't about one single thing in isolation. There are no simple off-the-shelf answers to this question. This is really about fundamentally asking a different set of questions of the investments that we make.

    [00:08:52] Investors are now looking to combine data sets and investment principles to evaluate the opportunities and create new data-based valuation models.

    [00:08:59] In addition to this sort of growth of values-based investing, this focus on being able to invest according to your personal values, there's also enormous focus on integrating this type of data into the valuation-based investment model. And I think that the climate analytics work that we've done with Constellation Research really cuts to the heart of that, that there is a fiscal, economic issue. There is a long term valuation issue here, in which you need ESG data or material non-financial information, in order to be able to be opined more effectively, quite frankly, about what the future value of these stocks will look like, and which companies are best positioned to manage a transition to a decarbonized economy? Do you want to be invested in the equivalent of Blockbuster Video in the future, or do you want to be invested in the equivalent of Netflix? And this is the type of data that you need to help you do that.

    [00:09:50] Constellation have partnered with Refinitiv to look at the attractiveness of particular sectors and of particular stocks within those sectors. Combining ESG scores with other qualitative data to understand how prepared different companies will be for this evolving future. The recent report, 'Truckification  and Electrification - Merger or Collision?' combined these principles to specifically look at trends in the automobile sector.

    [00:10:13] So how do you answer that question? Who is ready for the decade ahead? Who's ready for that transition to electrification from truckification? And really the answer to that question lies in looking at the data. But not just any ordinary data. What we did with Refinitiv in this case was we combined Refinitiv's ESG data on what these companies are disclosing, what are their policies around climate change, with the industrial and operational data from the companies themselves. And by combining those two data sets, what you are allowed to do then is to assess: are these car companies actually making cars and trucks that have a lower impact on the climate over time? So it's a product-level look at the companies themselves and the trends in those products rather than just an ESG-level look or a product-level look.

    [00:11:09] By combining data sets with valuation metrics, Constellation and Refinitiv broke down the companies within the auto space to see which ones may need to act decisively if more stringent regulations were enforced, or consumers started to rapidly evolve their habits towards electrification.

    [00:11:23] So the findings of our research really can be summarized in this table. This is called a maturity and momentum table. And what you see here at the top on the upper left hand column are leaders, are car companies that are producing electrified products. You see, not surprisingly, Tesla at the top, but maybe surprisingly for some BAIC and BYD just below Tesla; Chinese carmakers that are emerging with mass produced electrified cars. And then casting your eye down you see some of the more familiar customers; VW, Daimler, and perhaps at the very bottom, you wouldn't be too surprised to see Ford, the producer of the F150, the best selling car in North America for the last 30 years, and unfortunately a big greenhouse gas emitter. So this constellation of data really shows us that some carmakers are beginning to make the transition, some have actually already made it like Tesla, but many others are still on their journey. One of the interesting things about this table, if we just take a second more to look at it, is that across the rows on the top, you see these different stages. And below that, the steps in each stage. And if you take a look at these steps and stages, what you see is a way of measuring performance in each of those columns that really assesses: is this company, first of all, engaged in reporting out its impacts? And then later on, in stages three and four, is it producing cars and does it have targets for the future that actually align with the world under two degrees of warming? So it's a whole range of different ESG and operational or industrial type metrics that, when combined, allow us to have a full picture of who is winning in the sector, who's ready for transition and who's less ready.

    [00:13:15] Perhaps a more surprising finding of the report is the consumer demand for SUVs has been increasing, putting them on a diverging path from that of investors and corporates who are themselves embracing the ESG narratives.

    [00:13:27] So I guess the interesting thing about the automobile sector is because of climate change, people want stronger, more robust cars, which goes against the transition to a Tesla or a lighter vehicle. So as we go forward, as people recognize these existential threats, they're also preparing and looking at survival.

    [00:13:53] Does demand matter? Can the public actually influence the emissions curve, by simply on what they buy when they go to buy a car? And what we found was that, yeah, demand actually matters quite a lot. And unfortunately, it mattered in the wrong direction. Over the last decade sales of SUVs skyrocketed and not just in the United States. We saw the same thing happening in Europe and the same thing happening in China. And in fact, nearly all the global markets led by the U.S., Europe and China exploded in their interest in SUVs.

    [00:14:28] Although many corporates are aligning themselves with ESG initiatives, the demand and profitability of SUVs is at odds with some of these long term goals. Combining climate analytics with performance and valuation metrics highlights the risks for these companies, which are chasing the easy profits of the SUV today.

    [00:14:45] So what this explosion of interest in SUVs means for our global automakers is that they've built up a huge amount of momentum - all of them, with the exception of Tesla and a couple of other electric car makers, a huge amount of momentum in SUV technology. It's what they know how to mass produce. It's what's most profitable for them. And it's where they're continuing to produce, frankly, many, many, many cars. And so the question then becomes, given all of this built up momentum in companies like VW and Ford and General Motors, Renault, everybody really, can these companies make the transition from knowing how to build SUVs, to in turn  knowing how to build electric cars at a price point that will make them competitive? And this really is the key question. So how do we measure that? How do we measure transition readiness at the company level? And that's where we we want to move to a new metric that we've developed called Sustainable Value. The Sustainable Value ratio, as you can see on this chart, is really a measure of the opportunity in the numerator and the risk in the denominator for each company. And at the end of this analysis, what we're able to do is to assess relative to all of the other companies in the sector, is this particular company more poised for opportunity? Are they more able to make that transition from SUVs into electrification, or are they more likely to be held back by their momentum, their investments in high-emitting SUV vehicles?

    [00:16:27] Companies which are chasing profits today but without a clear plan for the future, may find that they are shunned by investors who are increasingly putting climate issues, which incorporate risk analytics, at the core of their capital allocation process.

    [00:16:39] One of the things that's become clearer about climate and the implications of climate on the risks and indeed the opportunities for institutional investors is this issue of you cannot divest away from or diversify away from this issue. So this issue of climate change, or preventing the worst outcomes of climate change by rapid decarbonization is not something which you can avoid in the investment process, especially in carbon intensive industries. And so the need to internalize and quantify these externalities of the changing climate or indeed the externalities of the macro economy, which is decarbonizing so rapidly, have to be internalized and quantified into the investment process. And that gives both rise to risk management implications of making sure you're not overly exposed to either transition risk, the transition to a low carbon economy, or that you're not overly exposed to physical risk, the changes of the physical environment, geolocation risk, as a result of climate change, but also gives rise to the opportunities that you can identify that both of those raise, whereby you can invest in companies that are likely not just to survive but also thrive in a decarbonized economy and which don't have the same physical risk exposures of others.

    [00:17:57] We are seeing the corporate sector and investors moving in the same direction. Consumer incentives are not necessarily aligned with these changes. It'll be the role of governments and their regulators to help corral all these groups in the same direction.

    [00:18:11] What is really pleasing to see is a lot of regulatory and government response. Systemic policy change has to occur and it's starting to. Many, many governments around the world are putting in green policy. So coming out of Covid, we should hopefully see something quite significant. This is an opportunity. It's a crisis, but if we do this right and we focus on a future that incorporates environmental and social factors, we can create the world we want.

    [00:18:42] I think the focus on climate analytics and indeed ESG more broadly, but particularly on climate, the momentum is very likely to continue in the next few years. There are so many forces at play which really drive for that outcome, one of which is, of course, the regulatory overhang, the incoming regulation that we know that we're going to see in this space. Starting with the EU taxonomy, but certainly not limited to that. There's just general awareness from consumers and investors as a whole and indeed employees at companies that this needs to be sold for and the risks associated with it need to be managed.

    [00:19:13] Taxonomies of economic activity are a bit of a game changer in the regulatory and policy front. They will enable businesses to see what is aligned to a green future or a brown. They will drive a huge amount of investment in the future and enable a lot more investment to be channeled towards economically sustainable activities.

    [00:19:39] Collaboration is key in the process, in this transformation, and collaboration, urgency and action at scale, is really required to transform the risks that we face into opportunities, to turn the costs into advantages. From a private sector perspective, what's really required right now is the private sector to focus on the three Rs: Respond, Risk and Report. With the right degree of urgency, respond to the climate crisis by setting targets, by assessing different scenarios and stress-testing capabilities of businesses, of portfolios, across climate change and other environmental issues.

    [00:20:32] Data will be key. The collection and comparison of climate analytics, which incorporate different data sets, in addition to other fundamental forms of analysis, will become a central pillar for future investments.

    [00:20:45] Core to Refinitiv's purpose, the whole history of Refinitiv in all its various guises, is to really drive transparency into markets in order to allow for the optimization of capital creation and capital allocation. And so ESG and carbon and climate related issues start to become more and more central to that process, that the optimization of capital fundamentally. And that's why Refinitiv treats ESG data as fundamental data, as investment-grade data, as data which is fully auditable, just like all our financial data is. You need to be able to audit through to the source, you need to be able to treat the data in an apples-to-apples way, and you need to be able to integrate it fundamentally into your portfolio and analyses and into your company valuations.

    [00:21:28] What we've been focusing on is things like spatial finance. How do you connect geospatial data to asset-level data, for more forward-looking insight? Biodiversity loss in nature based capital. It's not integrated into the financial system today. How do we progress that and ensure that we move toward a launch of a task force of nature related financial disclosures to be able to integrate that into the financial system?

    [00:21:54] I really think that the integration into the core investment practices of the asset management community, the broader financial community, will absolutely continue and it will only get stronger in the years to come.

    [00:22:06] Overall, this is about momentum. Momentum in the corporate sector, and momentum within the investment community, driven by more and more nation states, signing up to specific climate initiatives.

    [00:22:16] At the U.N. General Assembly meeting, China committed and announced its plans to become carbon neutral by 2060. And this is coming from China that we all know is the biggest financier and builder of coal-fired plants. And such a message, such an announcement would have seemed completely impossible last year. So I think this only illustrates how much the world has changed in 2020.

    [00:22:46] We've got a very volatile and uncertain future ahead of us. Companies that embrace the uncertainty, work through the upheaval and capture the opportunity, will be set for success in the future. Not all of them will make it. But if they can transition to a low carbon economy, there are many opportunities for them in the future.

    [00:23:07] I tihink you've got this sort of confluence of things, all of which are coming together, and all of which paint the same picture, really, which is this rapid growth and continued interest and focus on sustainable investment, and really the maturing of that field from being a storytelling narrative into being a quantification and objective measurement of the outcomes that those funds are delivering.

    [00:23:29] The challenges are not regional. They cannot be solved by any one nation in isolation or any one sector or any one industry. There needs to be a lot of cross-economy international collaboration; it's a prerequisite to the success in this transformation.

    [00:23:46] From this accumulating body of evidence I think we'll be able to provide policymakers and consumers and investors an increasingly powerful view as to who is ready to make the transition in these sectors that are just most critical for the welfare of planet.

    [00:24:10] The advantages are going to accrue to those who are ready to make the transition, and the opportunities are huge. The flows behind these trends are in the trillions of dollars, and assets are voting with their feet. Investors, regulators and consumers are all aligning to accelerate the sustainability premium. Now monitoring these trends and analyzing the opportunities will combine traditional datasets with new climate analytics, to help investors pick the winners and losers. And these trends are already beginning to shape the investment landscape, in a process which has been accelerated during the Covid pandemic and will play an increasingly integral role to future corporate and investment decision making.

    [00:24:47] For a deeper dive into climate risk analytics, click the link to access the new report from Refinitiv and Constellation Research. In it, you'll get an overview of how the auto industry has transformed over the last decade, why it matters, and if automakers are ready once again to transform their products in working towards a decarbonized economy.