Sustainable investing has become mainstream over the last 2 years or so. Every other email we receive from brokers has “ESG” or “sustainable” written all over it. Clearly, without any doubt the world should take action to combat climate change by reducing greenhouse gases in order to limit temperature increases by at most 1.5C° from a 1990 baseline and to become climate-neutral by 2050. Therefore, it is encouraging to see that large institutional investors are embracing this goal and are tweaking their investment policies and processes to incorporate ESG/sustainability. Question is whether they go about it in the most effective way.
One strategy that is often used is to tilt the portfolio towards companies with high ESG scores and/or low carbon emissions. The investor then sells bonds or shares of companies with a low ESG score or high emissions and buys bonds or shares of other companies with a better score or lower emissions. But this change in ownership in itself does nothing to reduce the problem (high carbon emissions, for example). Actually, it could aggravate the problem as the new owners of bonds or shares (a private equity operator, for example) may be more lenient towards the company in respect of reducing carbon emissions. Proponents might argue that future financing costs for these companies would become more expensive, which eventually would discipline them to follow a more sustainable course, but there is not much evidence for this. Bonds of Norilsk Nickel maturing in 2025, for example, trade at a 150bp z-spread whereas bonds of other issuers with a similar credit rating (BBB) trade at 170bp. Likewise, 10-year bonds of Saudi Aramco, the world’s largest emitter of carbon dioxide and methane, trade at z-spreads of 115bp only slightly above bonds with a similar credit rating (A).
It may emit some SO2 but then Norilsk does provide free illumination of the Arctic…
Better would be to engage with the company to see how an effective carbon emission reduction policy could be enacted. Engagement should be done in a smart way. Simply telling a company to reduce its carbon footprint might not generate the desired result. That is what shareholders told Shell, for example, which then sold its controlling stake in a Texas refinery to Pemex. We don’t think Pemex will be better than Shell in managing the refinery and, anyway, is too cash-strapped to make investments to reduce carbon emissions. Selling carbon-intensive assets to poor operators, especially companies that don’t have to respond to responsible shareholders, probably only makes matters worse. Better would be when shareholders, for example, would have asked Shell to draw up and execute an investment plan to reduce methane emissions, which is a very effective way to reduce global warming whereas methane itself has value as a fuel (according to IAE 40% of methane emissions could be cut at no net cost).
Another issue with “tilting” is that Emerging Markets companies are likely to be hit harder as their electricity companies use more coal-fired plants. So many investors will reduce their exposure to these utilities, even though they urgently need funding to reduce their carbon footprint by investing in renewable capacity. We would argue that these projects deserve encouragement and not punishment. Instead, tilting would underweight these companies in favour of banks. These banks might actually fund coal plants but that is presently not picked up by most ESG raters. Moreover, many companies have offshored manufacturing to Emerging Markets (China and Mexico, for example), which is one of the reasons why carbon emissions in Emerging Markets have risen rapidly, now accounting for more than two-thirds of global emissions, according to IEA. Many of the manufactured products there are exported to advanced economies, but most ESG measures are based on production instead of consumption, hurting EM companies disproportionally by denying them access to funding.
The quality of ESG ratings is questionable. Ratings can differ significantly amongst rating agencies for the same company. For example, on August 25th, 2021, Adecoagro, a company close to our heart, was rated “Severe” by Sustainalytics (part of Morningstar) and “A” by MSCI. Severe is the worst rating and would be comparable to a CCC-rating by MSCI. It seems puzzling that a company which produces 727,000 MWh in renewable energy and is one of the most efficient food producers in respect of carbon intensity would be labelled a severe risk but this also shows that more work is required to establish credible ESG ratings. For credit rating agencies, like S&P and Moody’s, it is relatively easy to measure the quality of their ratings by conducting a historical analysis of events of default. This will be more difficult for ESG ratings, but given its importance should nevertheless be pursued, in our view. Likewise, certain ESG measures need further improvement. For example, the UN-IPCC methodologies only allow for limited accounting of soil organic carbon (the carbon that remains in the soil after partial decomposition of any material produced by living organisms). For Adecoagro full accounting of SOC would probably make it a net sequester of carbon, whereas now it is seen as a net emitter, reporting 734,000 tons of GHG emissions in 2020. The tilters would sell bonds and shares issued by the company, whereas if they considered the full picture and include the company’s carbon sinks they should be buyers.
How do you mean Adecoagro is not green…?
If institutional investors really want to make a difference, they should not focus on tilting (which is akin to rearranging deck chairs on the Titanic) but spend more time on improving ESG metrics and reporting and pushing governments to introduce a well-designed carbon tax, which ultimately is the best way to instill action to reduce global warming. Also within investment mandates, we think that institutional investors can do more to combat climate change. Many of these investors have allocations to private equity but instead of investing in the latest KKR Leveraged Buy-Out fund, which is what they typically do, some money should be diverted to fund new technologies to address the challenges ahead, for example in new carbon sequestration solutions, low-carbon home construction and agricultural technology. New money should be allocated to create real impact. That may imply running more risk (and lower return) than with conventional investing (at least in the short term), but it is a more meaningful way to address climate change. As poker players may know, “tilt” is a term for a state of confusion or frustration in which a player adopts a less than optimal strategy. So, stop tilting and do the real thing…