Environment: making sense of the E in ESG

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Humanity’s relationship with the natural world is shaped by naming what we consider important and counting what we think is scarce or over-abundant. This builds awareness that then leads to solutions. While these solutions may bring costs for a few, they create growth and opportunity for others.

Take the example of chlorofluorocarbons. The thinning ozone layer became a topic of everyday conversation when scientists discovered CFCs used in refrigerants and aerosols threatened the protection it provides us against excess ultraviolet radiation. From scientific proof in 1974 to the first picture of the atmospheric ‘hole’ over Antarctica in 1983 to the first international treaty for CFC phase-out in 1987, the chemical industry went from denial and obfuscation to a solution.

By 1985, Du Pont, supplier of a quarter of the world’s CFCs in the 1970s, had pioneered an alternative compound. To outpace rivals, the company and the US government quickly shifted their stance to support regulation. Broader innovation then followed in replacement products.

By 2009, every country in the world had endorsed the Montreal Protocol, pledging a phase-out of ozone-depleting substances. CFC use is now about one per cent of its peak, and full ozone recovery is expected by the 2040s¹.

Ozon-economics

The ozone story, from naming the problem to finding the solution, is a great example of the intertwining of planet, society, government and companies – both incumbents and innovators.

In the 50 years since that CFC discovery, we have seen many similar stories of innovation solving pressures we put on the natural world. But against a near-doubling of the global population and a quadrupling of economic activity², the science suggests we are far from a sustainable relationship.

There are signs that basic systems of climate, water and foundational biodiversity are in danger of tipping into irreversible instability. It’s clear society is aware of this: my late 20th-century childhood was dominated by talks and treaties to limit nuclear weapons, my children’s early 21st century by climate and biodiversity COP meetings.

This matters to investing because a benign climate and sufficient natural resources have too often been perceived as effectively limitless, free inputs into economic activity (ie their natural supply will far exceed demand and using them won’t restrict other activities).

Society has viewed them as the global commons: a shared resource we generally take for granted. That is changing and will almost certainly change more. Our success in outpacing environmental stress will see more inputs priced, behaviours changed and new technologies created. Whatever your ethical perspectives on the challenges we face, there is a strong transactional need for investors to understand and assess environmental issues.

As we look to invest well for our clients, pursuing exceptional companies that can deliver excellent long-term returns, the ‘E of ESG’ (environmental, social and governance) has to be integrated into our investment practice. This includes both the direct impact of the environment on company activities and the impact each company can have on the environment, whether posing a problem or providing a solution.

Aiming to assess and understand this effectively is our minimum baseline across all the assets we manage.

This process follows the same one we apply in conventional financial analysis: gathering information, developing insight and making and managing investments.

Filling information gaps

It feels like we are awash with information about climate science, the energy transition and biodiversity risks. More companies are reporting on more aspects of their business than ever, and innumerable consultants are offering to estimate and recut the environmental data into all sorts of new metrics.

That’s great, but as company analysts trying to look longer term, we still find the information stack incomplete and uncertain. It remains difficult to figure out the scale and extent of carbon embedded in products and services. And we need to understand the actual geographic locations of activities essential to company value chains to assess businesses’ exposure to physical and biodiversity changes.

We hope to compensate for these gaps by trying to lean into our relative advantages.

Direct conversations with companies help us assess the environmental issues that are actually most relevant to their long-term prospects and their ability and willingness to address them. In addition, this contact enables us to provide support for the companies’ reporting and disclosures, which should improve transparency and overall market efficiency.

We don’t filter these conversations with a sector-based risk lens. Climate, energy and the environment could be important to any company when viewed from the perspective of opportunity.

For example, our engagements with the Latin American ecommerce and fintech leader MercadoLibre, immunotherapy specialist BioNTech and video streamer Netflix have been as useful to us as investors as those with miner BHP, airline Ryanair and technology giant Amazon.

Read more about our company engagements and our expectations for company disclosure

We can also get close to unfiltered science and economics at the macro level through our well-established relationships with universities. Some of the areas we are currently working on include:

• understanding the economic and social disruptions posed by impending changes in physical geography and climate, with the universities of Exeter and Edinburgh
• the implications for food systems, with the James Hutton Institute
• the characteristics of socio-economic systems change, with the Deep Transitions collaborative of Utrecht and Sussex universities
• complexity economics and technological innovation, with the University of Oxford and the Sante Fe Institute

Through these partnerships, we aim to challenge ourselves and see a future that might not be a straight-line continuation of today.

Read more about our academic relationships

Developing insight

The most important insight that we bring to our integration of ‘E’ into our research process might be that we don’t know what’s going to happen: it probably won’t be what we expect, and that many things – including the strategies and capabilities of the companies we invest in – will likely change.

To address this, we have found it useful to work with scenarios. These are plausible, internally consistent but distinctly different views of how climate change and the energy transition might unfold. Approached as narratives, they can capture all the complexities of the real world and test extremes.

Investment teams can use the scenarios and creative stories about possible future events to challenge their assumptions, generate new ideas, and – perhaps most importantly – ask better questions of companies.

While we may select some investment ideas geared to a particular solution or outcome, we will mostly invest in companies that, like us, are navigating the changing world. We need to know that they are aware of their environmental risks and opportunities and have the potential to adapt their businesses as required.

Read more about our climate scenarios

Looking for better insight can involve trial and error. Our various investment teams have taken on the role of pioneers in developing different elements of our environmental work. Examples include work on:

• our ‘climate audit’ assessments by our Long Term Global Growth and Global Alpha strategies
• the practical application of fair-share regional emissions pathways for different sectors (ie what level of emissions reductions each region should be responsible for to equitably contribute to meeting global targets), involving a collaboration between our central Climate Team and our sovereign debt investors
• supply-chain practices in the mining sector, which plays a critical role in enabling the shift to renewables, in which our Emerging Markets Team has been very active

• water risks, with our Health Innovation Team
• deforestation and biodiversity pilots, with our Positive Change Strategy

Experiences that we then judge useful are shared and help develop insights across the investment floor.

Climate audit assessments of our top 50 holdings

Read more about our climate audit and portfolio metrics

Investment questions

Assessing the materiality of ESG’s E to all our holdings is our baseline. We are looking for companies that can thrive and grow over the long term to deliver great investment outcomes for our clients. We think success requires us to keep the underlying, interlinking trends in environment, technology and society front of mind. Whether answered formally or mentally, we aim to first assess materiality and then, if necessary, dive deeper, asking:

• What does this company do?
  Is it likely to be a direct player or material influencer in the transition to a low-carbon economy?
  Is it exposed to actual physical change or biodiversity loss?

And if so:

• Does the corporate culture suggest the adaptive capacity to thrive through a period of potentially high volatility related to environmental issues?
  Can we see recognition of the challenges?
  Does it have the vision to exploit new competitive advantages?
• What risks and opportunities relating to climate and the natural environment are inherent in its business model?
  How might it contribute to solutions or adaptation?
  How have we tested or measured this potential?
• Is our thinking joined up?
  How might changes in climate, energy and the environment reinforce or conflict with our core investment thesis?

Few, if any, companies will be perfectly equipped to manage the future or fully financed to bring forward the environmental solutions we need. As active stewards of our clients’ capital, we will engage and support investee companies on their material climate, energy and natural environment issues. In this, we’ll recognise that different companies in different sectors and regions will move at different speeds. Our expectations for disclosure and planning should be ambitious but appropriate.

Learn more about the foundations for this approach

For some client mandates, our strategies will take a more proactive stance. They will seek out and support companies moving to the leading edge of environmental solutions and stewardship, and aim, over time, to bias their portfolios towards such holdings.

At the end of 2023, 25 per cent of our assets under management had a specific focus on supporting and aligning with the achievement of global net zero emissions by 2050.

Into the future

The scientific consensus offers a pretty negative outlook for the natural world and our dependence on it. As long-term growth investors, we are conditional optimists on the hunt for companies aiming to generate great returns by creating solutions to all sorts of challenges.

Renewable energies, advancing AI, and complex logistics might let societies become more adaptable and, ultimately, environmentally sustainable. Understanding the E of ESG as an investment factor will be an important part of the puzzle and material to delivering the best outcomes for our clients.

Research projects to keep us moving in the year ahead include the further integration of physical climate change into our company analysis and the development of bespoke decarbonisation pathways for particular regions and sectors. In addition, we aim to deepen our understanding of the role of companies relative to the concept of a just transition. This addresses the importance of balancing environmental and social objectives if society is to maximise its chances of achieving a successful transition.

We are also extending our work on biodiversity (prioritising deforestation and water), avoided emissions (as a source of potential revenue growth) and the integration of climate metrics with conventional financial indicators alongside our Investment Risk Team.

But, above all, direct conversations with companies will remain core. These extend our knowledge, keep us focused on real-world impact and raise the bar of ambition for ourselves and our investee companies.

[1] With thanks to Hannah Ritchie for highlighting the work of Maxwell and Briscoe at Penn State on the important role of Du Pont in the development of the global ozone response: There’s money in the air: the CFC ban and Dupont’s regulatory strategy — Penn State (psu.edu)

[2] Measured by change in Gross Domestic Product (real terms)

Recommended reading

To explore these topics further, we suggest visiting these third-party links:

• Nature’s contribution to the human economy (Fred Lewsey)
• The reality of exponential technological progress (J Doyne Farmer et al)
• Understanding the facts behind the energy and climate transitions (Hannah Ritchie’s Substack)

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