Sustainable Investing weekly blog: 23rd July 2021 (Issue 1)
Our weekly summary of the key news stories, developments, and reports that are impacting investing in the wider transition to net zero carbon .
As this is the first of our restarted weekly blogs, I hope you will briefly indulge me while we cover why we publish this. First – the who. It’s intended for portfolio managers and generalists. Having done both jobs, I know that you have different requirements from specialist analysts. You need the commentary to be brief, to the point and at the same time, not just interesting but also potentially actionable. Much of what we write should also be useful to asset owners as they try to navigate the increasingly complex link between investing choices and their values.
Second – the what. The aim is to help you make more informed investment decisions. So we focus on news flow, developments and reports that challenge and potentially change consensus investment case views. This is not the place to come for an understanding of why we need to act on our climate, our environment, and our society. We assume that you already understand the why, it’s the what & how that you want to understand better. Our focus is on electricity generation, electrification applications, our built environment/circular economy and agriculture/natural capital plus demographics, social/legal, and the future of the firm. The format is simple, first the story (click on the green link to read the original) and then what we think it means for investors.
You should only rarely see company results referred to and we aim to stay away from the plethora of company, regional and country net zero and UN SDG targets and aspirations. Many of these are either too vague or too distant to be useful from an investing perspective. The exception is where the announcement contains concrete details that change how companies and industries will look in the future. Occasionally we will not be able to resist the temptation to say “that sounds like a great plan but we have no belief that it can be delivered”.
One last point – we have a long term focus. We examine what companies and industries will likely look like in 5 and 10 years time. After all, this is the period when most value is created and hence where stock calls will succeed or fail. Its where much of the market mispricing comes from (predicting the future for an industry in change is tough) and it’s also where most sell side analysis is weakest.
For this “first” weekly, we have limited the stories covered, we start to ramp up over the coming weeks. If you would like to subscribe, please contact Dan at email@example.com. Enough of the chat … let’s get down to the news flow
Social & governance
First up – a shameless piece of self promotion. Sustainable Investing is very excited to announce that we have teamed up with a leading Swiss boutique legal firm BST Impact (BST Impact website). They are a group of experts with a strong background in international public law (including human rights law, labour laws and anti-trafficking legislation), sustainable finance and sustainability. They have real world experience working on compliance issues, sustainable investment, modern slavery, due diligence, and results-based reporting, as well as monitoring and evaluation.
The legal, social and governance side of sustainable investing has been, quite rightly, getting more attention. Its become increasingly important to investors that the companies they are involved with have high social and governance standards. This is partly a value alignment issue, but there is also a financial angle – the costs of not meeting appropriate international standards can be high.
The background of the partners in Sustainable Investing is in investing. Although we have spent many years analysing sustainability from an investing, social, political, regulatory and technology perspective, we know our limitations. Areas such as human rights law are well outside our scope of expertise. The good news is that the team at BST Impact not only have impressive legal CV’s (covering the UN, the Red Cross and the Italian government) but they also share our passion for helping asset managers and asset owners make good investment decisions around the transition to net zero and the improvement in our social and environmental world.
The BST Impact team will be contributing to our research product, via a subscription, and they are also available for bespoke consultancy work. They are running a series of master classes on avoiding the financial and legal risks around non compliance with international standards – details and how to register can be found here. They are offering a 15% discount to clients of Sustainable Investing.
Our compliance team want me to remind you that the products and services offered by BST Impact are separate from those offered by Sustainable Investing LLP, and specifically that they do not constitute Investment Research as defined in COBS 12.2.17 of the FCA’s Handbook of Rules and Guidance (“FCA Rules”). Hopefully that is clear.
Carbon capture and storage, or CCS, is getting more attention. The chart above is from the recent IEA report Net Zero by 2050. While their comments on the requirement to stop new oil and gas exploration got lots of attention, the sections on CCS slipped slightly under the radar. CCS is rising up the political agenda.
Inside Climate News reports that the US Senate is expected to vote (delayed) on a bipartisan infrastructure bill that includes billions in government support for carbon capture. CCS, has taken on an increasingly central role in climate policy discussions over the last couple of years. It is one of the few climate actions that draws bipartisan support.
Most major labour unions support CCS, arguing that its deployment could provide new jobs and help extend the life of some gas or coal-burning power plants, which often provide high-paying union jobs. And the fossil fuel industries have promoted the technology for decades.
With only a small political majority, the Biden administration needs to build consensus. This may mean that to get the rest of the green energy package through, they will provide financial support to technologies, such as carbon capture, that are generating material opposition from some environmental groups.
As with so many US national policy discussions this year, much may revolve around Sen. Joe Manchin, the West Virginia Democrat who is a moderate, a long-time supporter of the fossil fuel industry and chairman of the Senate Energy and Natural Resources Committee. Plus, last week, Sen. Tina Smith (D-Minn.) issued a statement saying her proposed clean electricity standard, which counts fossil fuel plants with CCS as clean, had made it into the agreement.
Our take on this
Why be interested in carbon capture and storage, after all its currently small, with only a handful on plants outside of the traditional chemical and gas processing industries ? The answer is simple, it could become a really important technology for the production of blue hydrogen (fossil fuel plus carbon capture) and to extend the life of coal and gas fired powered electricity generators.
Up front: we are sceptical on the potential of CCS. Yes, the technology works (we successfully used it decades ago when I worked in the LPG industry) and it can be set up to extract nearly all CO2. But the economics look challenging (costs at c. $50-$90/tonne) US costs of CCS (Royal Society report 2020), with the IEA coming in only slightly cheaper is carbon capture too expensive (IEA 2021).
More importantly, expanding CCS out of its traditional core into coal/gas power generation and blue hydrogen seems to be harder than expected. A recent S&P Global report came to a stark conclusion ….”carbon capture at aging U.S. coal plants has always been a long shot financially, and the outlook for such projects appears to be dimming“. They highlighted five US projects that were either behind schedule, over budget or both coal-fired plant carbon capture projects face headwinds (s&pglobal 2021)
Finally – its not as good as you might think at reducing carbon emissions (if you include the upstream impacts – an issue we discussed in our recent green hydrogen research – ask for a copy). And it brings with it a material energy penalty, it’s estimated that up to 20-30% of the plants energy production will be used for decarbonisation.
Its hard to see the costs and energy use will come down materially. The mainstream amine based technology is well understood and expensive to scale up, and new technologies are only at an early stage. By the early to mid 2030’s we should have enough cheaper renewable electricity that alternatives such as green hydrogen are more economic – so not much time to amortise expensive plant retro fits.
So why might US politicans support CCS. Its about jobs (again, the same point that we made in our research report on green hydrogen). One key imperative for many politicans is jobs. In their world, closing fossil fuel power stations “destroy’s” jobs. Keeping them open does not (we think they are wrong, but what we think doesn’t matter). This political reaction seems to be the primary motivation for this North Dakota power station project lifeline for a coal plant (inside climate news 2021).
Net net – CCS might have a future. But its likely to be based on politics rather than economics. Given the importance of CCS to blue hydrogen and carbon reducing life extensions for fossil fuel power stations, this is a theme that investors really need to watch (with caution).
On 14 July, the European Commission launched a blizzard of draft legislation (Fit for 55) proposing measures for cutting the bloc’s greenhouse gas emissions by 55 per cent (compared to 1990 levels) by 2030. Included was a globally unprecedented carbon border adjustment mechanism (CBAM) for pricing imported carbon. Due to its diplomatic and economic ramifications, the CBAM will largely determine the Fit for 55 package’s long-term impact on global climate policies.
Given the diplomatic storm the CBAM has already caused, is it still sensible? Yes, probably – if done well. Critics see the measure as trade protectionism in disguise, and they are right to be concerned. But, given the absence of alternative options, it is a viable way to meaningfully price carbon in larger parts of the global economy.
Under current proposals, the European CBAM covers five emissions-intensive industries: aluminium, steel, cement, electricity, and fertiliser. Controversially, the documents published by the Commission do not grant exemptions to the least-developed countries (LDCs) or make compensatory financial commitments to the economies that the CBAM would affect most.
The technical challenges are only part of the story. Diplomatic tact and attention to detail will be critical in preventing the CBAM from undermining the EU’s climate leadership role. To be workable, the CBAM must comply with World Trade Organisation (WTO) rules – or we could see them tied up in the dispute resolution process for many years, and see retaliatory tariffs being imposed.
Our take on this
From a longer term investing perspective, this is probably one of the most important elements of the European Union’s Fit for 55 project. Why is it so important ? It’s because of the second order impacts. Europe is a relatively small contributor to global warming, at least in terms of emissions generated within its own borders. But what it buys or sources from the rest of the world is more material.
If Europe can encourage its suppliers to become greener, this will make it more likely that many of the technological advances needed for the hard to decarbonise sectors, including aluminium, steel, cement, and fertiliser, get commercial traction.
We think a global agreement on carbon pricing is unlikely. So, in the absence of some sort of CBAM, the financial incentives for European companies to invest in decarbonisation technologies are less, especially as the current state of development implies a substantial cost disadvantage for the greener product.
But – we need to be aware just how tough this will be to implement. This report border carbon adjustments in the EU (ERCST 2021) sets out some of the practical implications. They highlight the fact that many (high employment) industries in Europe ” face the need of many billions of Euros of investment over the coming decades, and the challenge is to ensure that investment actually creates ambitious reductions in European emissions without simply transferring those emissions abroad“.
It’s the World Trade Organisation (WTO) rules that are the biggest barrier. The EU officials say they have taken this into account, but legal analysts have identified a myriad of issues, including treatment of the Least Developed Countries (LDC’s). Perhaps the most important issue is the apparently arcane one about the need to show that carbon leakage (emissions-heavy industries moving abroad) is a real thing. This will be hard, because there’s no agreed methodology to prove leakage -the EU talks about risks rather than certainty.
Additionally, if the European Commission goes around giving the impression that the EU is banking on CBAM revenues as a significant ongoing contribution to so-called “own resources”, money raised centrally rather than by the member states, it’s going to hand ammunition to opposition lawyers in any future WTO action. So think before you tweet.
Interestingly, on the trade front, the response from the US to the CBAM was more muted than expected, as highlighted by this FT article will the US now think more about carbon pricing (FT). One suggestion is that it’s actually a plan the Biden presidency and the Democrats like (at least in concept – with talk of a border pollution levy), while the Republicans are more focused on battles within the US House.
The UK seems to be heading down a different route, at least if the statements of the International Trade Secretary Liz Truss are to be taken at face value. At the launch of the UK Board of Trades report on green trade (which can be found here) she was quoted as wanting to “challenge the narrative that free trade is a threat to the environment”, and argues ‘green protectionism’ – such as proposed levies on imports from countries with high carbon industries – could be “used as a cover to enact damaging protectionist policies“.
Net net, this could be a really important issue for investors as they think about some of the major industrial sectors, but until we see the real detail of the plan, its just a good idea that may not actually happen.
Agriculture & Natural Capital
Charl Folscher from unsplash
At the risk of having just too much politics, another EU story. In our defence, its been a busy time politically on both sides of the Atlantic, and politics and regulation really do matter to investors.
As part of the Fit for 55 proposals, the Commission reinforced its commitment to present a carbon farming initiative – already announced in the EU’s flagship food policy, the Farm to Fork strategy (F2F) – as well as a certification scheme for carbon removals.
However, there is currently no targeted policy tool to significantly incentivise carbon removals and the protection of carbon stocks. The main goal of the new carbon farming approach is to create new business models to increase carbon sequestration, with the positive side-effect of creating opportunities for new jobs and providing incentives for relevant training, reskilling and upskilling.
The first legal proposal is expected by the end of the year with the carbon farming initiative, while a carbon removal certification mechanism, already announced in the Circular Economy Action Plan, is due to be presented by 2023.
And as a regenerative practice, ‘carbon farming’ has been included among the main Good Agricultural and Environmental Conditions (GAECs) of the eco-scheme, the new green architecture in the EU’s post-2020 Common Agricultural Policy (CAP). In particular, GAEC 2 aims to protect carbon-rich soils such as wetland and peatland, considered among the most effective carbon sinks.
However, the idea of an agricultural carbon market largely remains taboo as European farmers have so far been prevented from participating in such markets – that would allow them to get paid for storing carbon in their farmlands by trading greenhouse gases.
Our take on this
The EU is slowly creeping toward setting up some form of carbon farming system. The idea is simple, farmers get paid, via the EU Common Agricultural policy and possibly by the private sector, to capture carbon.
Agricultural soils in the EU contain around 14 billion tonnes of carbon in the topsoil, which is considerably more than the 4.4 billion tonnes of greenhouse gases (GHG) emitted annually by all the EU’s 27 countries. At the same time, carbon sequestration has the effect of restoring organic matter in cropland soils, a regenerative ‘gift’ that can boost soil fertility biologically.
Back in April, the EU published its catchily titled “Technical Guidance Handbook – setting up and implementing result-based carbon farming mechanisms in the EU”. Next steps include setting up of pilot projects, which can be used to improve design aspects. So years away rather than months.
The big debate is around action-based vs results-based. Action-based schemes reward land managers for putting in place climate-friendly agricultural practices. In result-based schemes the payment to land managers is directly linked to measurable indicators of the climate benefits they provide. The first is easier from an administrative perspective, the second is better for investors.
Net net, while carbon farming is still time away from becoming real, from an investor perspective its worth tracking, partly as it could create a verifiable asset class, and partly as it could change the financial shape of European agriculture, removing some of the volatility.
Interestingly, there is also talk in some quarters about setting up similar schemes for ground water, the absence of which is becoming an increasing problem in major agricultural regions such as California.
And one last thing …
We could not go without highlighting this discussion document from Norges Bank, published earlier in July (the asset pricing effects of ESG (Norges 2021) . To quote “we show that when investors incorporate ESG into their portfolios as a non-financial consideration, this leads to lower expected returns on higher ESG-scoring ‘Green’ assets, and higher expected returns on “Brown’ assets. As the presence of ESG-motivated investors in the market grows, however, increased flows into Green assets can lead to them outperforming Brown assets.”
Putting this in investor speak – as assets go into ESG positive stocks, all other things being equal, the price gets bid up and the expected return falls. So short and mid term gains as inflows dominate but, longer term the returns will be lower.
The correct response to this paper, which we like by the way, is to say, “yes but all other things are not equal” – which makes identifying which ESG factors are important contributors to financial performance at an individual stock level essential.