investment viewpoints
Which companies are prepared for the environmental transition?
Three powerful systems changes are accelerating one of the most drastic economic transformations in modern history. These forces are reflected in every sector of the economy and will lead to widespread sustainable changes becoming entrenched. The planetary transition demands a radical rethink of how we approach global equity investment.
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All change
History teaches us that large-scale transitions start slowly, then happen all at once. Thirty years ago, companies were debating the importance of IT infrastructure. Now it is an unalloyed essential for businesses. Today, the amount of investment expected to be deployed into electrifying the power supply, improving energy efficiency and reducing carbon this decade is at about the same level as IT expenditure over the last few years.
Our core sustainability conviction is that the economy is transitioning to a Circular, Lean, Inclusive and Clean – or CLIC® – model. This is being driven by the transformation of three global systems and the pricing of environmental externalities, or 3+1 systems changes:
- Energy: the energy system is being rewired by mass electrification
- Land and Oceans: the need to restore nature and harness its regenerative capacity for sustainable food value chains is changing the land and oceans system
- Materials: decoupling the production of goods from primary-resources extraction while reducing waste underpins the drive to circularity, which is overhauling the materials system
Finally, robust pricing of externalities – chiefly carbon at present – provides financial incentives for companies to pollute less or not at all.
These 3+1 systems are integral to restoring and preserving the planetary boundaries. For example, within the land and oceans system, the food industry and overall land-use changes impact five boundaries by causing:
- 24% of greenhouse gas emissions
- 90% of deforestation
- 25% of biodiversity loss
- 70% of freshwater use
- 52% of degraded soils2
We calculate that 95% of our equity investment universe will be affected, which has important implications for investors. To understand the full extent of the sustainability transition, we believe investors need to focus on all industry sectors to find companies whose products, services and business models are aligned with these shifts. Across the global economy, we define these companies as either solution providers or transition leaders.
Solution providers
Companies whose products and services, when applied by customers, help create sustainable outcomes. They typically harness the technologies making the transition economically favourable, and help clients prepare for regulatory and market change. In aggregate, their influence contributes to reversing the damage caused by the transgression of planetary boundaries, changing our economy to help prevent further breaches and, ultimately, restoring a margin of safety. These firms, which can count governments, corporations and consumers among their clientele, are solution providers.
- In the energy system, solution providers deliver technologies to renewables firms, transitioning energy suppliers, or carbon companies active in carbon reduction, carbon avoidance and carbon capture. The global renewables market is projected to reach USD 2 trillion by 2030, up from USD 882 billion in 2020, to drive the electrification of grids across the world. We expect the share of renewables in power generation to increase from 17% to 80% by 2050 at the expense of fossil fuel use.3
- In the land and oceans system, they enable the transformation of eating habits and food production to reduce the intense pressures of modern consumption and agriculture on the environment. For example, the chronic inefficiency of meat production is a sizable issue. To produce just one calorie of beef mince requires 54 times the volume of carbon emissions as one calorie of banana.
- In the materials system, we anticipate that dematerialisation, resource efficiency and the rise of new sustainable materials will decouple production from current levels of primary-resources dependency, while minimising waste and pollution. Embedding circularity in the materials system reduces the need for extraction of raw materials, as it enables creating of new goods through reuse, repair, and recycling of products. Leveraging the bioeconomy and its regenerative materials is essential to achieving this. For instance, wood is a sustainable building material that can be strengthened enough to replace conventional building materials in large-scale construction projects. The market for wood products is expected to grow from USD 350 bn to a USD 750 bn market by 2030.
US environmental engineering and services firm Tetra Tech is an illustrative example of a solution provider, given its work on developing water infrastructure compatible with mounting climate risks.
Transition leaders
Companies that operate in carbon-intensive industries – such as energy, steel or construction – but have credible emissions-reduction plans, are on course to adapt to a decarbonising world. Similarly, firms dependent on natural resources – like wood, soil or water – that leverage bio-based or recycled inputs, are supporting nature’s regenerative powers. Such businesses have a material impact on the progress towards a CLIC® economy, and their positive actions make them transition leaders, in our view.
Transitioning companies in sectors where emissions are hard to abate – such as steel, cement, transport, chemicals, power generation and real estate – are required for future economic growth but urgently need to decarbonise.
We look for opportunities among carbon-intensive companies that understand the need to transition and the commercial advantages in doing so. We assess their net-zero commitments and track their progress though our implied temperature rise methodology, the Lombard Odier Portfolio Temperature Alignment framework.
In the energy system, these would be companies which have set out a credible plan to exit coal power generation, for example. Global coal-fired generation reached an all-time high in 2021, and currently accounts for more than a third of global electricity generation. Coal power plants produce a fifth of global greenhouse gas emissions.
- Power companies leading the transition are demonstrating an ability to divest decisively and consistently while investing in renewables. In the US, coal-plant closures are accelerating, and coal-generation capacity is expected to fall 45% by the end of the decade from 2020 levels. New renewable generation is now expected to cover almost 90% of additional electricity demand through 2025.
- The land and oceans system. Modern agricultural techniques rely on ploughing and tilling the land which releases carbon stored in the soils, while the fossil fuel-based fertilisers pumps more emissions into the atmosphere. The overuse of synthetic pesticides causes vast amounts of agrochemical waste which further degrades soils and pollutes water. Large-scale purchasers of produce, such as food manufacturers, can influence the transition by dealing with farmers signed up to approved sustainable agriculture programs, and tracked pesticide use. The market for bio-based fertilisers, such as microbiological, bio-organic and mineral-organic fertilisers, is expected to double by 2030, from USD 9.4 bn in 2021 to USD 19 bn in 2030.
- In the materials system, we anticipate enhanced end-of-life recovery for products, as well as recycling of materials. As much as 60% of our economy’s inputs can be derived from biological processes. Existing nature-based products may replace less sustainable industrial alternatives, with timber, for instance, capable of substituting as much as 20% of steel and concrete in construction in the European Union. Biorefineries may also process organic raw materials such as lignin and cellulose to produce bioplastics, biochemical, biomedicals, and other bio-based materials such as textiles.
With climate and nature-related solutions moving higher up regulatory and investment agendas, taking responsibility for corporate decarbonisation goals is key, both to mitigate reputational, financial and transition risks and to identify investment opportunities. Our active stewardship across the market targets such candidates and supports their development.
Aggressive decarbonisation by Stellantis, a Dutch multinational automotive manufacturer formed in 2021 by the merger between Fiat Chrysler5 and PSA Group, makes it an illustrative example of a transitioning company.
Adapt now
The scale of the planetary transition is matched by the speed at which it is unfolding. This creates a limited window of opportunity for readjustment. We believe investors cannot afford to be complacent in the face of such widespread change. The risk of stranded assets will grow within a relatively short space of time, and the unprepared will find themselves stuck with the consequences, in addition to being unable to reap the benefits.
Our Planetary Transition strategy aims to identify growth opportunities, thereby capturing what we define as green alpha: companies which we believe are likely to perform better financially in an environmentally-aligned scenario.8
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sources.
[1] 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
[2] Sources: LOIM analysis; based on (Rockstrom et al., 2018), (Crippa et al., 2021), (Sumaila et al., 2022), (FAO, 2021), (ELD Initiative, 2015), (World Bank, 2021), and (Campbell et al., 2017). *This figure reflects the average of various assessments that vary between 52% and 86%. Under threatened species, we include extinct, critically endangered, endangered and vulnerable species, a definition based on the International Union for Conservation of Nature (“IUCN”) Red List classification.
[3] Source: LOIM research
[4] The case studies provided in this document are for illustrative purposes only and do not purport to be recommendation of an investment in, or a comprehensive statement of all of the factors or considerations which may be relevant to an investment in, the referenced securities. The case studies have been selected to illustrate the investment process undertaken by the Manager in respect of a certain type of investment, but may not be representative of the Fund's past or future portfolio of investments as a whole and it should be understood that the case studies of themselves will not be sufficient to give a clear and balanced view of the investment process undertaken by the Manager or of the composition of the investment portfolio of the Fund now or in the future.
[5] 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
[6] Scope 1 emissions comprise all those emissions directly under the control of a company. They are typically linked to emissions from its own buildings and facilities (for instance, through heating or the burning of fossil fuels as part of industrial processes and companies’ own power generation) and its own vehicles. Scope 2 emissions comprise emissions that come from the generation of power, heat, steam and cooling purchased by a company. For instance, a manufacturer may draw large amounts of electricity from the grid to power its business model, from machinery to data centres, that would typically generate significant emissions – unless the source of that power is from renewable energy. The third and perhaps most elusive part of a company’s emissions include those linked to its wider value chain, known as its scope 3 emissions. These emissions comprise a number of different sub-categories but can roughly be divided into those linked to the company’s upstream supply chain (i.e. emissions linked to all the products and services it has sourced to produce its finished goods) and those linked to the downstream lifecycle of the company’s products and services once it leaves the company’s gate – which includes emissions generated during the distribution, use and end-of-life processing of the product.
[7] An absolute target refers to a target that aims to reduce GHG emissions by a set amount. An intensity target is a normalised metric that sets a company’s emissions targets relative to some sort of economic output.
[8] We refer to ‘green alpha’ where companies are likely to perform better financially in an environmentally-aligned scenario, compared to consensus. To assess green alpha, we assess market tipping points linked to emerging regulation, cost-down curves, and the pricing in of environmental externalities. Based on this analysis, we aim to describe, quantitatively or qualitatively, total addressable market (TAM) potential. Where companies are exposed to TAMs that are likely materially in excess of market consensus, we consider such companies to be exposed to green alpha. Although we believe there are investable opportunities related to these transitions, there can therefore be no guarantee of excess performance.
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