It is time to shake the CO2-placebo

Sondre Myge of Skagen Funds addresses how ESG investing should focus on results and how to measure environmental performance to deliver long-term real economy outcomes and investment returns.

Increasing criticism of ESG claims is as warranted as it is timely, but it is important not to paint with too broad a brush. ESG’s biggest problem is the folly of investors’ belief that they can follow the ‘carrot and stick’ approach of government taxes and subsidies to influence the cost of company capital and CO2 emissions. The belief that punishing (selling) “brown” stocks will raise their cost of capital and incentivise a reduction in emissions, while “green” companies will use lower financing costs to increase the share of renewable and sustainable solutions in the real economy is misplaced.

New research entitled Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms’ confirms that cost of capital is a poor way to motivate change, and risks being counter-productive. The study finds that divestment only makes brown companies “browner” without making green companies “greener”. It also notes that access to capital is a stronger motivation for brown assets to attempt decarbonisation – less stick, more carrot.

Single KPI contributes little

Many funds, particularly those with an ESG focus, rely on a single KPI to demonstrate their commitment to decarbonisation: the portfolio’s weight-adjusted carbon footprint. This measure is calculated by dividing Scope 1 (direct emissions from owned or controlled sources) and Scope 2 (indirect emissions from the generation of purchased energy) carbon emissions by revenue in millions of dollars.

While this metric is intuitive, simple and perhaps reassuring for end clients – the number is always in favour of the fund in question compared to its benchmark – it contributes little to the global effort to decarbonise the real economy. Any year-on-year change can largely be explained by changes in the revenue numerator of the equation rather than improvements in its emissions denominator. We prefer to look at carbon intensity by production rather than revenue, which provides tangible insight into emissions performance and is more actionable for forward-looking investors focused on company fundamentals.

For Skagen Focus, our global small and mid-cap fund, using this methodology has helped to identify contrarian and misunderstood opportunities in the market. One such example is Cementir, a vertically integrated cement producer, which has committed to significant investments in technology and carbon capture facilities that should see it climb from the bottom to the top of its peer group in terms of emissions reductions. Improved profitability and a real change in underlying production could provide a re-rating catalyst as the market reassesses the company’s potential; the portfolio managers estimate Cementir’s potential upside at over 60% based on their current share price target.

Focus on outcomes

Scaling efforts on operational carbon intensity and transition pathways will provide a clearer view of environmental performance. How many tons of CO2 are required to produce one ton of aluminium, and how does this performance intensity compare with historic figures, industry averages and forward-looking trends? Maybe management should set a credible target to reduce operational emission reductions from a high to a low(er) level. Who will be the winners and losers as increasingly systemic carbon pricing starts to bite?

To improve their long-term decision-making, investors should relate CO2 emissions to operational metrics and management targets for decarbonisation pathways. This approach provides a more tangible view of potential risks and opportunities, including the improvement potential of brown assets. Simply using ESG as a measure to improve another factor, referred to as “input-ESG”, will bring us closer to real-world changes and the realities of the green transition. It avoids the problem of simply rewarding green and punishing brown. For example, a 2% cut in emissions by a large brown company will have a much greater absolute impact than a 20% reduction by a small green asset.

A story from the planned economy of East Germany is that of a TV factory receiving its annual production target – to make “x” tons of TVs. As the months passed, management noted progress was lagging and so decided to add scrap metal from the local steel factory – making heavier TVs and achieving their target ‘output’. Capital markets risk a similar set of dysfunctional KPIs unless we link ESG deliveries to long-term real economy outcomes and financially material risks and opportunities.

The problem with ESG is not what it represents but how it has been used by market participants – waking up from our CO2 placebo is an important starting point to fix this.

*Sondre Myge is head of ESG at Skagen Funds.

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