investment viewpoints

3 years of LOIM Climate Transition

3 years of LOIM Climate Transition
Paul Udall - Lead Portfolio Manager, Global Equities

Paul Udall

Lead Portfolio Manager, Global Equities
Peter Burke-Smith - Co-Portfolio Manager

Peter Burke-Smith

Co-Portfolio Manager
Pascal Menges - CLIC Equities, CIO Office

Pascal Menges

CLIC Equities, CIO Office

In the three years since the launch of the LOIM Climate Transition strategy, we have targeted opportunities arising from the transformation of the global economy. Mounting evidence of the ubiquitous nature of climate-related issues, and how they are interconnected with other sustainability challenges, has led us to embrace an enlarged opportunity set.

 

Need to know

  • The net annualised performance of the strategy since launch on 16 March 2020 is 16.7%, compared to 18% for the reference index1
  • US, European, Japanese, Chinese and others commitments to integrate environmental considerations into industrial policy provide tailwinds for companies we focus on
  • Our understanding the intricacies of climate change and the Planetary Boundaries has led us to define an expanding opportunity set for the strategy

 

Towards a planetary transition

As the sustainability transition accelerates, we have broadened our investment universe to better reflect the scope of economic change taking place. This encompasses the shifts within industries in response to humanity’s encroachment on the planetary boundaries, which define the limits within which we can thrive for generations to come.

Six planetary boundaries have already been transgressed – including biodiversity loss, agrochemical pollution and toxic waste – threatening the stability of ecosystems essential for human development. This reinforces the imperative of progressing towards a sustainable economic model. Understanding the policy, market and technological drivers in play, we believe the transition to a CLIC® economy that is circular, lean, inclusive and clean is in motion, generating sources of green alpha that forward-thinking investors can capture.2

 

Climate in the sustainability transition

The transition to a CLIC® economy is being driven by transformations in three systems: the mass electrification of the energy supply, the natural restoration of significant land and ocean resources, and embedding circularity in materials usage. Further, robust carbon pricing accelerates these monumental shifts, which we believe will reshape the global economy. All these system changes will contribute directly or indirectly to solving the climate crisis.

As a result, these 3+1 systems changes will impact industries in our investment universe – from energy to mining and engineering – forcing business models and supply chains to adapt. Profit pools across sectors will shift as new leaders emerge, making it essential to understand both the innovations gaining scale and the inflection points at which they achieve mass-market adoption, in our view.  

Since launching in March 2020, the Climate Transition strategy has targeted companies across sectors that we believe should benefit from the mitigation and adaptation required in a carbon-constrained and carbon-damaged world. Expanding this remit to include companies aligned to the 3+1 systems changes, we categorise firms as either solution providers, adaptation or transitioning companies.

In doing so, we maintain a high thematic purity. For instance, companies contributing to the reduction of greenhouse gas emissions, which we classify as solution providers, comprise 44% of the portfolio.3

 

The journey so far

There have been sizable breakthroughs in mitigation and adaptation efforts since the strategy launched, as cleaner energy and investments in climate resilience make greater economic sense as well as being environmental necessities.

In the automotive sector, for example, economies of scale have driven down battery costs, enabling car manufacturers to more profitably make the electric vehicles needed to help reduce aggregate transport emissions and comply with regulatory targets. At the same time, technological advances have improved the overall battery lifecycle, making more efficient use of the materials involved.

Climate change policies and efforts to limit global warming to well below 2°C are critically dependent on the decarbonisation of our energy system. The conflict in Ukraine has further emphasised the need to transition away from fossil fuels and promote more independent or domestic sources of energy, considering the disruption to energy supply. Consequently, commodities required for clean technology have been a keen focus of the strategy.  Electric cars typically require six times the mineral inputs of a conventional car, while an onshore wind plant requires nine times more mineral resources than a comparable gas-fired plant.4 These examples indicate how the demand for minerals vital to the climate transition stands to grow substantially. For instance, demand for battery materials such as lithium is expected to be around 40 times higher by 2040 than in 2020.

The energy sector’s transition to net zero is creating a profound transformation, with renewables technology increasingly beating fossil-fuel power on both emissions and cost. For example, the International Energy Agency (IEA) observes that solar is becoming the lowest-cost option for new electricity generation in most of the world. Its forecasts suggest that solar capacity is on course to triple within the next four years, overtaking that of natural gas by 2026 and coal by 2027. By 2050, 74% of global energy is expected to be sourced from electricity – and 80% of this supply should come from renewables.5

Policy action, together with soaring energy costs, is driving unprecedented investment in low-carbon technologies. Total investment in the clean-energy transition reached a record high of USD 1.1 trillion in 2022, putting it on par with fossil-fuel investment for the first time.6

 

2022 key metrics

Last year was not an easy one for investors, due to a myriad of factors including geopolitical tensions, an aggressive rates shock, high inflation and soaring energy prices.

Yet the strategy remained resilient compared to the market due to its focus on value quality companies and secular trends. Our focus on the decarbonising economy helped return -18.7% in 2022, compared to -18.1%for the reference index. This performance defied a sectoral headwind for the strategy in the form of the energy sector, particularly traditional oil and gas companies. Energy was the only sector to finish 2022 in positive territory, to a very material extent, but our thematic focus meant we did not invest in oil and gas companies.

The strength of our strategy is its focus on secular growth trends and quality companies, in our view. We define quality companies as those with strong financial characteristics across market cycles – capital efficiency, strong cash flow and a low level of dependence on capital markets – using our Excess Economic Return methodology.

In the portfolio, we hold a diversified mix of solution-provider businesses with strong growth characteristics in the clean-technology space, as well as cash-generative transition leaders across broad end markets, from green metals (such as low-carbon aluminium produced using renewable energy) to next-generation building materials (such as recycled concrete). Among the best performers in the strategy last year were specialists in the fields of renewable energy, smart agriculture and green steel.

In addition to investment performance, our holdings together generated further positive outcomes. Portfolio companies accounted for USD 60 billion in revenue linked to low-carbon products and/or services, such as low-emission air-conditioning units from Daikin,8 which generate USD 23 bn in annual revenues for the firm.They also recycled, reused, or diverted from landfill the equivalent to 7 million tonnes of waste, which is enough to fill 538,000 garbage trucks. Over the same period, our holdings were responsible for supplying and treating 1670 trillion tonnes of water.10

 

Temperature check

We aim to understand the decarbonisation trajectory of the strategy by assessing the implied level of global warming that it is aligned to, based on the expected, cumulative owned emissions through to 2050. Using our proprietary implied temperature rise methodology, Lombard Odier Portfolio Temperature Alignment, we calculate the estimated temperature alignment for the strategy is 2.3°C, compared to 2.8°C for the reference index.

As an active manager, we engage with companies to encourage positive business practices and ensure the long-term sustainability of their enterprises. Implementing the Oxford Martin Principles for Climate Conscious Investors, in 2022 we undertook 50 engagements with 42 companies (representing 73% of portfolio names). Engagements were still open with 27 companies as of December 2022, reflecting that the process is typically conducted for at least 12 months to allow for changes to take place and results measured.11

 

Policy tailwinds

Key policy initiatives have the potential to amplify the secular trends we invest in, creating capex pathways for companies which are aligned with the climate transition. This presents investors with growth opportunities as profit pools shift.

The Inflation Reduction Act, for example, was signed into law by US President Joe Biden in August 2022 and will accelerate green industry. A combination of grants, loans, rebates, incentives, and other investments will target clean energy and climate action. The Act will introduce a wide range of measures, including support for sustainable agricultural practices, preservation of coastal biodiversity and forest conservation.

In Europe, the RePowerEu plan focuses on creating a more energy-independent economy by drastically improving energy efficiency and accelerating clean energy. The European Commission has proposed increasing the headline 2030 target for renewables from 40% to 45%, as part of an additional investment of €210 bn between now and 2027.12 In addition, the Net Zero Industry Act proposes green production targets and potential barriers to imports of raw materials.

The UN High Seas Treaty will provide a legal framework for establishing protected marine areas and create accountability on issues such as governance and biodiversity. The goal is to safeguard 30% of international waters by 2030, and it has attracted a EUR 40 billion grant from the EU to help developing nations protect marine environments and their biodiversity.

Meanwhile, China’s 14th Five-Year Plan outlines aims to build an “ecological civilisation” with more efficient usage of energy, reduction in pollutants discharge, improvement and expansion of environmental infrastructure.

 

Expanding the universe

As the economy adapts to the climate imperative, our understanding of its ramifications also evolves. To capture further opportunities as the transition progresses, we have broadened the strategy’s universe to reflect climate’s interconnectedness with major sustainability challenges.

The opportunity set will expand by up to 20%, with the addition of water, biomaterials, life sciences and food-production sub-themes. In doing so, we aim to embrace more formally all environmental opportunities arising from the 3+1 system changes, seeking what we define as green alpha: a source of equity outperformance that is linked to the environmental transition but not yet priced by investors.

For example, by scaling up our investment universe, we stand to incorporate a greater number of companies focused on new food systems, reflecting their growing importance to regenerating finite land and ocean resources. Companies embedding circularity in their use of materials will also play a greater role. This broadening reflects the fact that most climate solutions also help to address related environmental problems, including unsustainable resource extraction, deforestation and biodiversity loss.

In the three years since the strategy was launched, we have seen the transition to a CLIC® economy build momentum. This has created clear investment opportunities in the form of companies whose products and services are fit for a carbon-constrained and carbon-damaged world, and whose business models are aligned with the 3+1 systems changes.

We believe the transition will accelerate faster than the market anticipates, reshaping the economy and providing opportunities to capture green alpha2 as the sustainability imperative drives returns.

 

Sources

[1] Benchmark: MSCI World. Past performance is not a guarantee of future results. Where the strategy is denominated in a currency other than an investor's base currency, changes in the rate of exchange may have an adverse effect on price and income. All performance figures reflect the reinvestment of interest and dividends and do not take account the commissions and costs incurred on the issue and redemption of shares/units; performance figures are estimated and unaudited. Net performance shows the performance net of fees and expenses for the relevant strategy class over the reference period. Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
[2] 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.  
[3] Source: LOIM
[4] International Energy Agency: The Role of Critical Minerals in Clean Energy Transitions. Accessed March 2023.
[5] Source: International Energy Agency: Solar. Published 2022. Accessed March 2023.
[6] Bloomberg NEF: Global Low-Carbon Energy Technology Investment Surges Past $1 Trillion for the First Time. Published 26 January 2023, Accessed March 2023.
[7] Source: LOIM. Past performance is not a guarantee of future results. Where the fund is denominated in a currency other than an investor's base currency, changes in the rate of exchange may have an adverse effect on price and income. All performance figures reflect the reinvestment of interest and dividends and do not take account the commissions and costs incurred on the issue and redemption of shares/units; performance figures are estimated and unaudited. Net performance shows the performance net of fees and expenses for the relevant fund/share class over the reference period. Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
[8] 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
[9] Source: Lombard Odier Investment Managers. Data as of 31 December 2022. Past performance is not a guarantee of future results.
[10] Source: Lombard Odier Investment Managers. Data as of 31 December 2022.
[11] Holdings and/or allocations are subject to change
[12] European Commission. REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition. Published 18 May 2022. Accessed in March 2023.
 

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