LTGG: progress on our climate commitments

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Taking stock of portfolio progress on climate commitments

The image below has 10,000 dots on it. Imagine they collectively represent a breath of air.

The vast majority of the light grey dots relate to oxygen, nitrogen, argon and a handful of other elements.

Now, focus on the black dots. They’re carbon. For your grandparents, their grandparents and indeed most of human history, a breath would have contained three of them.

A breath taken by you today contains four. And there’s a decent chance that a breath taken by your grandchildren will contain five.

That matters because the climate is unfathomably sensitive to carbon concentration. If those four dots move to five, human civilisation is likely to be entirely transformed.

Until a couple of decades ago, this was an abstract concept. But a rapidly increasing proportion of humanity is now witnessing the effects of climate change first-hand.

Attitudes are changing in response. At the beginning of last year, the United Nations Development Programme conducted the largest ever survey of public opinion on climate change.

It took a novel and unconventional approach to polling and canvassed representative attitudes from 50 countries covering more than half of the world's population. The survey indicated that 64 per cent of people believe we’re facing a climate emergency. In high-income countries, the figure was 72 per cent. In the least developed countries, 58 per cent.

It seems reasonably safe to assume that the numbers will have since ticked up further. Over the last 18 months, our first-hand experiences of the early onset effects of climate change have included record-breaking heatwaves and droughts, uncontrollable wildfires and deadly floods.

This headline 64 per cent figure is notable in the context of Everett Rogers’ diffusion theory, first published in the 1960s. It explains the pace and manner in which new ideas and technologies spread.

When we consider social attitudes regarding the five groupings below, we’re well into the ‘late majority’ phase. From an investment perspective, that matters because it’s the point at which both societal attitudes and the policy backdrop evolve most quickly.

The five categories of people adopting an innovation

It’s easy to overlook the pace of change here, given all the noise around inflation, geopolitics and short-term energy security stopgaps. But since last year’s LTGG environmental update, we have seen significant developments across four key areas that we need to factor into our long-term thinking:

1. Bigger sticks
At present, roughly a quarter of global carbon emissions are priced at a paltry average of $3/tonne. We previously said we expected both the proportion of priced emissions and the average price of those emissions to rise markedly over our investment horizon. Recent developments substantiate that view.

China’s new emissions trading system (ETS) is about to grow massively under plans to include its heavy manufacturing industries, while India has pushed ahead with its national carbon credit market. The upshot of such developments is that the most progressive companies in an increasing number of countries will have the potential to materially supplement their revenue streams by selling credits. Meanwhile, the least progressive firms can expect their returns structures to be severely impaired by the need to financially internalise the costs of their foot-dragging.

The cost of capital will be affected too. We already see that some companies with the best disclosures and the most ambitious decarbonisation commitments are starting to enjoy lower costs of capital in the debt markets. That edge will become increasingly material as interest rates tick up.

2. Bigger carrots
The ‘sticks’ above entail penalising the negative externalities – the emissions. They can work to an extent, but their impact in isolation will be limited if viable alternatives don’t exist. So ‘carrots’ also have an important role to play. We continue to see emerging governmental incentives that encourage the scaling and updating of fossil fuel substitutes to drive down costs.

Recent examples from Europe include the Fit for 55 and RePowerEU packages, which focus on areas such as hydrogen and energy efficiency. In the US, meanwhile, the beguilingly named Inflation Reduction Act offers grants and tax credits for technologies as diverse as electric school buses and carbon capture.

3. Increased reporting
Over the last four years, we’ve watched closely as countries worldwide have mirrored the EU’s General Data Protection Regulation (GDPR). These privacy and security laws have affected the business models. Positively in some cases, adversely in others. In the coming years, we’re likely to witness a similar phenomenon with climate regulation.

The European Parliament and Council provisionally agreed on the Corporate Sustainability Reporting Directive (CSRD) with relatively little fanfare this summer. But it’s very meaningful because it will place new requirements on European companies with more than 250 employees and €40m in turnover. They will have to report extensively on a vast range of environmental, social and governance impacts, including:

• greenhouse gas emission
• internal risks and control
• climate change mitigation strategies
• pollution
• impacts on biodiversity and ecosystems
  
  

Regulation along these lines will have a meaningful impact on any company found to be greenwashing or claiming to be ‘net zero’ by relying excessively on low-quality carbon offsets. It highlights the importance of focused engagement in this area.

4. Litigation
Environmental litigation continues to ratchet up apace. There are about 1,200 active cases against large companies in the US alone. That’s double the number of five years ago. Cases are coalescing around four core issues:

• Climate rights: litigants assert that insufficient climate action is violating plaintiffs’ rights to health, food and liberty
• Domestic enforcement: litigants assert that relevant laws and regulations are not being enforced
• Corporate liability: plaintiffs attempt to attach causal responsibility for climate-related harm, and in some cases specific temperature increases, to the actions of particular companies
• Climate disclosures and greenwashing: plaintiffs allege that defendants have failed to disclose information on climate issues properly
  
  

At best, cases of this nature present a significant distraction for corporate management teams. At worst, they point towards significant potential liabilities further down the line for companies that aren’t on the front foot.

The equity markets are not pricing in these cost overhangs. But that will change. That is why we need to be on top of the portfolio holdings’ potential exposure to them through the prism of their climate adaptability.

The implications for LTGG

The factors above highlight the importance of the climate commitments that we implemented for the Long Term Global Growth strategy in 2021:

• Currently, we commit that 100 per cent of our companies are aligned, or under engagement for alignment, with an appropriate net zero pathway.
  
  
• By the end of 2023, we expect most (90 per cent-plus) of the companies in the portfolio to report scope 1 and 2 emissions. If they do not, they will be on a specific engagement pathway for such disclosure. Any new companies entering the portfolio will have two additional years to meet this expectation.
  
  
• By 2025, we expect that at least two-thirds of the portfolio by number will be positively aligned with global net zero goals. For most, their preparedness, or indeed leadership, will be demonstrated through public net zero-aligned targets and strategies encompassing scope 1 and 2 and material scope 3 emissions. However, if we own an exceptional company that does not yet have net zero-aligned targets but already has or possesses the potential to be a transformative enabler of successful decarbonisation, we will provide specific research demonstrating this element of its alignment while we continue to work with it around the appropriate level of disclosure.
  
  
• By 2030, we commit that over 90 per cent of the portfolio will be net zero-aligned. Any new companies entering the portfolio will have two additional years to meet this commitment. 

As things stand, none of the above expectations or commitments has impacted the shape or constituents of your LTGG portfolio. Indeed, we hope and anticipate that we will never be forced to sell a company because it failed to meet the expectations above. That is because we view positive climate alignment as a critical driver of competitive advantage over our investment time horizon.

To ensure that the portfolio holdings are on top of potential competitive, financial and regulatory risks around climate, our engagement in this domain has focused on some key areas. Some examples follow.

Raw material inputs

For some of our holdings, high-level climate targets are important. But their impacts on biodiversity and land use are more material and therefore critical to address.

In this regard, we are pleased with the climate progress of Hermès. We now class it as being a ‘leader’ among the companies we have assessed.

Given Hermès’ ongoing reliance on leather, however, we’re cognisant that the firm’s ability to decarbonise is still tied to the agriculture supply chain. Hermès could play a role in shifting consumer perception of quality and durability away from a dependence on intensive raw materials, offering alternatives that don’t compromise the brand’s luxury appeal.

Disclosures and targets

We are following up on outstanding questions about the broad investment case for Alibaba and Tencent. But in the context of environmental initiatives over the last year, we’re happy to see both companies have grasped the nettle around carbon disclosure and established sophisticated targets.

This progress provides a helpful engagement context for other online commerce holdings, such as Coupang, Meituan and Pinduoduo. The levers of influence for these companies pivot around securing green logistics and influencing the value chain, as both suppliers and customers.

Our role is to share the lessons and contacts we’ve made through our engagement with the leaders in this area, such as Amazon, Shopify and the global shipping companies we own on behalf of clients in other Baillie Gifford strategies.

Tensions between business models and climate considerations

Our conversations with Amazon have been less about the details of its operational decarbonisation – which we think it is doing well – and more about the broader climate issues that affect its business. How can a business model dependent on consumption continue to grow while remaining aligned with climate targets?

The bulk of Amazon’s impacts is from the life-cycle emissions of the products it sells. How might the company adapt as consumers increasingly aim to buy less and think harder about their own footprints?

There is no easy answer to this question, and we continue to encourage and support Amazon’s efforts to help us consume in a less extractive manner.

Energy efficiency

ASML is a lynchpin in the global semiconductor industry. All the major players use its lithography machines to produce chips.

As it continues to drive innovation, its impressive commitment to incorporating energy and material efficiency into its design process remains critical. That’s true for its own competitive position and for its customers’ decarbonisation efforts, including the semiconductors manufacturer TSMC, as well as their own clients, such as Apple.

Our engagement with ASML has provided us with helpful broader industry insight as its actions and targets have developed. We’re encouraged that ASML is now targeting net zero across all scopes by 2040. 

Influencing consumers

Within the sphere of advertising, we have previously highlighted that Meta’s most material impact on the pace of transition probably relates to its role in preventing the spread of climate-related misinformation and promoting access to good science. 

The Trade Desk, meanwhile, occupies a slightly different space within the advertising ecosystem. It has been helpful to engage with the company to learn how it thinks about its influence.

The company is keen for its advertising clients to see it as a trusted partner. Premium brands do not want to be associated with misinformation. They care deeply about product placement and want to ensure their advertisements are kept distant from those of climate change laggards. The Trade Desk has a vital role to place in this regard.

The electrification of transport

The tailwinds behind the used car market are likely to be intensified by the shift towards electric vehicles (EVs). In the longer term, the online used-car dealership Carvana has an opportunity to act as the sales point for new EVs. Internal combustion engine-based dealerships, by contrast, will retreat without the profit line of frequent maintenance and servicing.

One risk to watch pertains to direct regulatory intervention to take old cars out of the market – compulsory scrappage or penalties for city driving, for example. Such measures could leave Carvana stock heavy.

Our engagement has explored the company’s thinking about this point and how it might please customers by adding a fuel efficiency option into its search functions.

Exerting influence through finance

This is the second summer we have engaged with the banking and financial services provider HDFC on climate issues. We see a positive progression in reporting, board awareness and on-the-ground engagement with developers.

There’s enormous potential for the firm to encourage its customers to adopt energy-efficient practices and address the physical risks posed by climate change. We look forward to continuing conversations with the company.

The Overall Picture

The diagram below illustrates our current perspective of the portfolio’s ‘transition fitness’.

Overall, we’re encouraged by the number of holdings showing year-on-year improvements, as depicted by the green arrows.

Our view remains that the portfolio is relatively well placed to navigate the transition, but there is no room for complacency. In the coming months, our engagements will continue.

We’re keen, for example, to explore Affirm’s potential to influence consumers through the carbon labelling of purchases within its buy-now-pay-later ecosystem. We also plan to discuss CATL’s approach to sourcing raw materials for its batteries more sustainably.

Throughout the process, we’re working to balance our climate engagements with other priorities. That will ensure we don’t blindly push for a climate transition without considering the broader social implications.

Understanding supply chains is crucial, especially when the raw materials essential to the transition – such as cobalt and silicon – are sourced from regions with ethical supply chain questions we need to explore.

Future Opportunities

We remain of the view that the climate transition represents a tremendously powerful structural growth tailwind. In this vein, we continue to uncover new investment ideas in this area.

We have recently written 10 Question research reports on:

• SolarEdge – a maker of solar inverters and smart energy solutions
• Samsara – a specialist in Internet of Things optimisation
• Rivian – an electric vehicle manufacturer

More broadly, we continue to investigate more nascent opportunities in the domains of electric aviation via Joby and Lilium.

Recent discussions have also considered the growing field of entomophagy and the notion that the market for insect protein may just be greater than the market for beef within our investment timeframe.

We look forward to further discussing these areas with you in the months and years ahead.

Risk Factors        

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in October 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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