Thomas Hohne-Sparborth on how investors can navigate the carbon transition
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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.
THE INTERVIEW
“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
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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
The TargetNetZero range
Our solutions to decarbonise, diversify, drive the transition – and perform
• Passive-plus, core equity strategies
Equities
Credit
• Global and European approaches
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• 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%
Strategy profile
Why we like this strategy
Why invest now?
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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
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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.
CO reduction by 2050
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
1
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
