Thomas Hohne-Sparborth on how investors can navigate the carbon transition
Focus is a publication that aims to bring you face-to-face with a selection of key investment managers, advisers and providers from across the institutional pensions market.
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The world’s economic model is currently unsustainable. We are seeing unprecedented rates of resource extraction, pollution, emissions and waste – and every part of our economy is being impacted by the consequences.
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The transition to a more sustainable economy is not only an environmental necessity, but an economic one. Over half of our world’s GDP is dependent on nature, and the negative environmental impact – ranging from climate change to biodiversity loss – leads to real losses. At the same time, the investment opportunity is vast, with $5trn per year needed by 2030 in the energy system alone.
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In this guide, Professional Pensions and Lombard Odier explore the strategies and metrics that the firm is using to navigate the carbon transition.
In order to benefit, investors need to adopt a more forward-looking perspective, and understand how companies are realigning their business model. That means looking beyond the footprints of today and at the ambition and credibility of companies’ transition strategies, to see which will remain fit for the future.
Focus is a publication that brings you face to face with a selection of the most influential asset managers in the UK and across Europe.
Amid the turbulence of the pandemic and the emerging recovery period, it has helped to adopt an investment perspective that is both long term and broad in terms of asset type, global market, and investment structure.
Paul Craig on active management for a challenging world
Paul Craig, portfolio manager
THE INTERVIEW
Exploring the Quilter Investors Cirilium Portfolios
SNAPSHOT
Paul Craig talks us through three key aspects of Cirilium’s strategy
Cirilium Q&A
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“An unavoidable challenge,
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f we look at the amount of resource extraction and the adverse impact of that on the environment, I think that today some of these economic models are essentially hollowing themselves out from within,” says Hohne-Sparborth.
I
an unmistakable opportunity”
We believe it's essential for investors to realign their portfolios to the transition in order to safeguard future returns
Thomas Hohne-Sparborth head of sustainability research
Thomas Hohne-Sparborth, head of sustainability research at Lombard Odier, has no doubt: the current economic model is no longer fit for purpose and has outgrown its usefulness
It’s an economy that is wasteful, idle, lopsided and dirty. We call it the WILD economy
“It’s an economy that is wasteful, idle, lopsided and dirty. We call it the WILD economy.”
It’s a blunt assessment, but that firm belief in the need for fundamental change is informing Lombard Odier’s work. The firm’s focus is on more than simply divesting from those sectors perceived as harmful to the planet – in fact, its approach involves identifying opportunities for radical transition in sectors and companies that some investors have chosen simply to avoid.
“Our view is that we need to understand the specific challenges that companies will face in each individual sector or industry and what their transition pathway looks like,” Hohne-Sparborth says.
“We understand that sectors like steel, cement and chemicals will have a higher carbon footprint as of today. However, they also will remain essential even in a net-zero economy of the future and need financing to decarbonise.”
Hidden opportunities
Lombard Odier is working on understanding which companies within these high-emitting sectors are emerging as the climate leaders.
“To do that, we try to understand both how quickly a given industry can and needs to decarbonise, and which companies are already decarbonising in line with what can be achieved in that sector,” explains Hohne-Sparborth. “We take into account the targets and commitments that companies may be setting, as well as our own assessment of how credible and ambitious those targets are.”
Best laid plans
Hohne-Sparborth accepts that decarbonisation is first and foremost a risk mitigation tool, but he also believes that Lombard Odier can safeguard the risk/return profiles for investors by making sure that investee companies have identified their exposure to financial risks as it relates to climate transition and have a credible plan in place to address them.
“We're seeing major risks emerging on the horizon in many of these scenarios, whether it's physical or liability risks more linked to the fiscal consequence of climate change, or transitional risks in the form of carbon prices and new regulation,” he says.
Shift towards open- vs closed-ended funds
portfolio manager
Paul is manager of the Cirilium portfolio range and has more than 25 years’ experience in the asset management industry. Today he is one of the UK’s most influential fund selectors, having been named a 2021 FE Alpha fund manager, and has provided seed capital to numerous new fund launches.
Paul Craig
Hinesh is a portfolio manager for Quilter Investors on the Cirilium portfolio range. He joined the business in 2008 working in fixed income and macro as a strategist, an assistant portfolio manager and then a portfolio manager before joining the multi-asset desk in 2016. Hinesh has played an important role in developing the team’s investment capabilities and macroeconomics analysis. Before joining the business Hinesh was a senior analyst at Lehman Brothers.
Hinesh Patel
“
In practice, that means the team at Lombard Odier are shifting their analysis beyond carbon footprints and towards understanding which companies are able to demonstrate both a commitment to transitioning and a viable plan to do so. The focus falls more on spotting genuine innovation and less on divestment.
“We're actually quite happy to invest in any sector where we can find some of these climate leaders,” says Hohne-Sparborth. “It’s about taking that more forward-looking perspective that allows you to maintain diversification and start to understand what needs to be achieved within each sector and who is actually delivering on that.”
“We believe it's essential for investors to realign their portfolios to the transition in order to safeguard future returns.”
It may sound unlikely that companies so steeped in the fossil fuel economy can become beacons to follow in the decarbonisation transition, but Hohne-Sparborth points to several that demonstrate precisely that.
Take renewable power firm Orsted as an example. “It used to be big on coal, but now it has become a leader in wind energy. Then we have companies in industrial sectors like Cummins, which manufactures industrial machinery and is rapidly transitioning towards hydrogen to become a leader in that space.”
“These all have high carbon footprints, or have had in the past, and are rapidly generating new business models in their respective industries.
“Ultimately, it is these companies that we think will be an essential part of the transition – and may be among the winners of it.”
Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
Ultimately, it is these companies that we think will be an essential part of the transition – and may be among the winners of it
With Cirilium, the focus has always been on investing for the long term
Paul Craig, portfolio manager, Cirilium portfolio range
Constant evolution and our degree of diversification is what sets Cirilium apart
Seeding success
To understand key changes to Cirilium’s strategy over time, says Craig, it helps to pay attention to the investment structure. “For example, over the years we’ve broadened our focus from closed- towards open-ended funds for three reasons: closed-ended discounts narrowed, open-ended funds became cheaper, and our own Cirilium portfolios grew in size.”
Long lens
Some things have remained the same. “With Cirilium, the focus has always really been on investing for the long term – finding managers where there’s trust and transparency and working with those managers through economic cycles, through good times and bad,” says Craig. “We will buy into managers who are looking for growth for years to come, not just the next six months.”
A key part of Cirilium’s own culture is to keep an open mind. “In terms of where new manager ideas come from, we behave like a sponge and absorb information from everywhere,” says Craig, “including in-house Quilter research team recommendations and asking the fund managers we’ve invested in about who they see as their primary competitor.”
1: That is, the antithesis of the traditional portfolio mix of 60% equity and 40% lower risk bonds, implemented using modern passive strategies.
1
Dialogue also helps when deciding whether to adjust a core holding. “A lot of our work is understanding what the manager hopes to achieve,” says Craig, “for example, if they go through a period of underperformance is it for stylistic reasons that we are comfortable with? Do they tend to sell or hold if a stock hits a price target, and what does that do to their exposures?”
“We invest with people we know and trust and we want an open dialogue,” he says. “If they’ve identified an issue, we want them to come to us – we’re always trying to eliminate the negative surprise.”
Over the years, Cirilium has also broadened the type of asset in its toolkit, for example by paying more attention to alternative exposures, including long-short equity. “That part of the market has historically been largely reserved for sophisticated pools of capital such as sovereign wealth funds,” says Craig, “but again we can go in as cornerstone investors using Cirilium’s scale and expertise.”
fast-changing markets, says Paul Craig, who manages the range. The portfolios have grown from around £25m AUM in March 2009 to £8.6bn in March 2021, a period bookended by the global financial crisis and the pandemic, and characterised by the rise of passive, alternative and responsible investing.
irilium’s success over the last 13 years has been driven by combining a long-term view with an ability to adapt to
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Taking the long view
amid constant change
Being focused on meeting investor needs, means we never stop learning, says Paul Craig
“Cirilium was one of the first risk-targeted, fixed-cost multi-manager ranges,” he explains, “with the idea that an investor can pick Cirilium and we do all the heavy lifting.” But over time what was something of an outlier strategy has become much more of a norm.
Thomas Hohne-Sparborth, head of sustainability research
The TargetNetZero range
Profiling climate impact, Thomas Hohne-Sparborthtegy
in-depth Q&A
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Profiling climate impact, Thomas Hohne-Sparborth
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• Global and European approaches
• Low ex-ante tracking error of 0.5-1%
• High-conviction, low-turnover
• IG focus with opportunistic HY
Disciplined decarbonisation
carbon-footprint reduction from inception via scope 1, 2 and 3 analysis
CO reduction by 2030
30%
50%
100%
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Low turnover, concentrated fixed income strategy aligned with the Paris Agreement Target a high return objective of 100bps-150bps p.a. above benchmark (1) Low initial carbon footprint and targeting rapid decarbonisation; BBB average rating (IG with opportunistic HY exposure) Combined strengths of 20 sustainability experts and three highly experienced credit portfolio managers
• • • •
Independently reviewed, market-leading framework that assesses both direct and indirect emissions and implied temperature rises Science-based climate analysis alongside fundamental credit analysis and issuer engagement Sophisticated investor reporting capabilities including projected emissions trajectory
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Long-term opportunities in the ongoing and accelerating decarbonisation transition Capture climate transition candidates missed by low-carbon strategies
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‘Passive-plus’ core equities solution that tilts the MSCI World or Europe indices towards companies in climate-relevant sectors that are evolving towards 2050 net-zero targets Similarly, it penalises companies in these same sectors which fail to reduce carbon footprint or align with transition goals Combined strengths of 20 sustainability experts and well-established investment team of 5 with 13 years average experience
A long-term core equities building block aligned to Paris Agreement goals Low-tracking-error approach with a forward looking climate solution focused on temperature trajectories, not just simplistic carbon footprint analysis Peer-reviewed framework by OxfordUniversity, SystemIQ and PAT
Mitigate climate-transition risk while keeping similar financial risk profile to the index Capture long-term opportunities in decarbonisation
Launched: 26 April 2021 (2)
Fund size: USD 169 million
Benchmark: Barclays Global Aggregate Corporate
Total CO emissions / million USD invested
2
Expected change in CO emissions by 2050
Temperature alignment
516
759
TargetNetZero Strategy
Benchmark
Current projection
Target
54%
1%
90%
n/a
(-59% CO )
(-100% CO )
<2.0 C
2.8 C
0
<1.5 C
Launched: 26 April 2021 (3)
643
57%
2.6 C
28%
921
Fund size: USD 92 million
(-62% CO )
Benchmark: Barclays Euro Aggregate Corporate
Launched: 26 April 2021 (5)
509
40%
2%
727
Fund size: USD 40 million
(-44% CO )
Benchmark: MSCI Europe
LO Funds - TargetNetZero Global Equity
LO Funds - TargetNetZero European Equities
Launched: 26 April 2021 (4)
329
3.1 C
16%
470
Fund size: USD 28 million
Benchmark: MSCI World
Source: LOIM, 31 May 2021. For illustrative purpose only. Holdings and/or allocations are subject to change. Target risk/returns represent a portfolio construction goal and cannot be guaranteed. (4) Change of strategy effective. Previously LO Fund –Global Responsible Equity (launched: 21 March 2017). (5) Change of strategy effective. Previously LO Fund– Europe Responsible Equity Enhanced (launched: 25 June 2015). There can be no assurance that the investment objective will be achieved or that there will be a return on capital or that the substantial loss will not be incurred.
Note: 2050 CO2 reduction targets and projections have been converted from CO2e equivalent basis. As per IPCC guidance, achieving the goals of maintaining global warming below 1.5C requires net zero CO2 emissions by 2050, but overall greenhouse gas emissions (including methane and nitrous oxide) would reach net zero one or two decades later. Our net zero strategies conform to these guidelines and target net zero CO2 emissions by 2050. Overall GHG emissions would be expected to fall by approximately 90% to 2050.
Source: LOIM, 31 May 2021. For illustrative purpose only. Holdings and/or allocations are subject to change. Target risk/returns represent a portfolio construction goal and cannot be guaranteed. (1) Bloomberg Barclays Global Aggregate Corporates. (2) Change of strategy effective. Previously LO Funds – Global Responsible Corporate Fundamental (launched: 6 December 2012). (3) Change of strategy effective. Previously LO Funds – Euro Responsible Corporate Fundamental (launched: 8 February 1999). There can be no assurance that the investment objective will be achieved or that there will be a return on capital or that the substantial loss will not be incurred.
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Profiling climate impact
Thomas Hohne-Sparborth explains the key concepts and metrics that LOIM is using to navigate the decarbonisation challenge
When it comes to physical risk, we want to understand the financial impact of exposure to environmental changes
“The CLIC economy means circular, lean, inclusive and clean. We talk a lot about climate change, and it's a key challenge, but it's by no means the only challenge that we face. We need to move towards a more inclusive economy, and when it comes to environmental dimensions, simply cleaning up our emissions footprint is not enough.
“We need to reduce our extraction from the environment and reduce our waste flows into it, all of which creates greater circularity and a more resource-efficient economy.
What is the CLIC economy and why is it important?
“We're seeing huge investment opportunities linked to this transition to the CLIC economy, both in the transitioning industries and those companies that are actually enabling that transition.”
“We believe diversification becomes a problem if you pursue a low carbon strategy that merely aims to get out of all the sectors in the economy that have a high carbon footprint today and puts money only in healthcare and education instead.
What is it about your investment process that differentiates yourselves?
“Instead, we believe that if you can find players who have a credible transition trajectory towards net zero steel, or net zero or carbon-neutral cement, for instance, then that represents a tremendous commercial opportunity. They're very much the kind of companies we want to invest in.”
“One of the metrics we've developed is the implied temperature rise (ITR) metric. This assesses a company’s decarbonisation efforts against industry-specific benchmarks, which we can translate into the level of global warming that would result if every company in the economy were to manage its emissions with a similar level of ambition.
How do you quantify what companies are likely to be positively or negatively exposed to the effects of climate transition?
“Decarbonisation, on the one hand, will require upfront investment, but at the same time may reduce exposure to carbon prices. Crucially, we also want to know the upsides it may unlock as a result, in the form of increased market share or the ability to charge a green premium on some of its products.
“Take the automotive industry. If you just look at the Scope 1 and 2 emissions of a car manufacturer, you’re simply measuring the emissions that its manufacturing plant produces and the energy it consumes directly from suppliers; you're not looking at whether the vehicles it produces are diesel, petrol, hybrids or electric vehicles. That means you won’t capture the difference between a Tesla and a Ferrari, for instance.
TM
“Firstly, you're moving capital out of those sectors where financing of decarbonisation opportunities is needed the most. Secondly, it's blind to the opportunities that exist in some of these high-emitting sectors where we can find climate leaders.
“So a company decarbonising in line with what needs to be achieved might be classified as a 1.5 degree Celsius company; a company failing to take actions or with emissions still rapidly increasing is more likely to be aligned to global warming of three, four or five degrees.”
“Climate value impact builds on the previous concepts by quantifying whether companies are likely to be positively or negatively exposed to the effects of the climate transition. Ultimately, as investors we don't just want to understand the trajectory of a company’s emissions, but also the financial implications of that direction of travel.
What does a company’s climate value impact (CVI) profile tell us about how it will be affected by the climate transition?
“When it comes to physical risk, we want to understand the financial impact of exposure to environmental changes. Liability risk comes into a similar category – we want to understand the financial bottom line of potential climate litigation against companies.”
“Today, many investors are unfortunately still looking at what are called scope 1 and 2 emissions: direct emissions that come out of the factory's own plant and operations and the power it sources from its suppliers. But that only tells us part of the picture.
Why is it important to include Scope 3 emissions in your assessments?
“So that is why you need to look at scope 3 emissions, which cover downstream activities such as the emissions of goods and services after they are sold, as well as upstream activities which are generated indirectly by the producer company, such as business travel and commuting, transportation and investments.
“While most people acknowledge that scope 3 emissions are useful to look at that, you often get questions about data availability and issues around double counting. But we believe that in many cases that's a bit of an excuse for investors to not look at it. In fact, data quality has improved significantly, and once you understand how these emissions are calculated, there are quite credible ways of assessing them yourselves.”
Challenges, opportunities
of plastics produced have ended up in landfills
The estimated time a car sits idle
of US consumers would substitute meat for plant-based alternatives
tons. The potential amount of CO2 our natural capital could capture each year
The estimated amount of hydrogen-fulled vans and lorries by 2050
79%
91%
16
bn
Climate value impact to analyse the financial impact of the transition
Abatement Cost, availability and impact of technological solutions
Demand destruction Carbon-intensive products and services
Growth opportunities Alternatives compatible with a net-zero world
Transition pathways What actions are companies taking?
Financial impact What are the impacts on financial risk and return?
Investment integration Target transition risks and opportunities
3
TRANSITION RISK
EVOLUTION
Overview of GHG protocol scopes and emissions across the value chain
Upstream activities
Downstream activities
Reporting company
Scope 2 Indirect
Scope 1 Direct
Scope 3 Indirect
ADAPTATION RISK
Carbon-damaged world Adapting to unavoidable climate change
transportation and distribution
end-of-life treatment of sold goods
investments
franchises
leased assets
Physical risk: floods, drought, changing weather patterns
Liability risk: failure to decarbonise or adapt to climate change
purchased goods and services
capital goods
fuel and energy related activities
waste generated in operations
business travel
employee commuting
company facilities
company vehicles
processing of sold products
use of sold products
CO
CH
N 0
HFCs
PFCs
SF
4
purchased electricity, steam, heating & cooling for own use
Source: WRI/WBCSD Corporate Value Chain (Scope 3) Accounting and Reporting Standard (pdf).
Source: LOIM analysis. For illustrative purposes only
The coronavirus market challenge has helped to push the concept of ‘quality growth’ companies into the spotlight, but it’s been one of the foundation stones of the Cirilium proposition ever since it was first launched in 2008.
Can you name a key theme that has shaped your investing over the years?
It means we’ve always focused on finding managers with the freedom to look outside the confines of the main market indices which are, by nature, dominated by the largest beasts in the jungle. In all likelihood, the next generation of mega-caps are still on the ‘nursery slopes’ of mid-cap indices.
This is certainly the case with the next generation of leaders in nascent industry sectors such as bio-tech, electric and self-driving cars, alternative energy, ‘big data’, 5G and the burgeoning number of new industries it stands to nurture such as the ‘internet of things’.
Each has their own investment process, but they all tend to use rigorous proprietary research and modelling to identify highly cash generative companies; they also look further out than the average investment manager, for example in terms of checking whether a company has a pipeline of new ideas; and they are unwilling to pay too much for their growth opportunities. Their motto might be ‘growth, but not at any price’.
Do the best quality growth managers have anything in common?
It has often been crucial to be able to go in as the cornerstone investor. Also, alternatives can be many different things but a common denominator tends to be the performance fees. We can negotiate on that and examine the basis on which the performance fee is charged to try to avoid paying for beta.
For example, we have a tendency to go for market neutral managers, who net out the long and short and so may have very little actual market exposure. If we want to make beta calls or make a call on market direction, we’ll do that long-only. We don’t need to pay an alternatives manager for that.
Does Cirilium have special strengths when investing in alternative strategies?
The next generation of mega-caps are still on the ‘nursery slopes’ of mid-cap indices
talks us through three key aspects of Cirilium’s strategy – quality growth, alternatives and the ongoing integration of responsible investing
Cirilium’s five key changes over the last 13 years
Inside the Cirilium Portfolios
