The value of a green transition

The ‘E’ in ESG (environmental, social and governance) has come a long way; conveying the urgency of our climate crisis is no longer where the battle stands. Governments, companies and investors are all pushing forward with green plans, but we believe the most important global emissions metrics are still moving in the wrong direction.

Is it too early to expect results or are our common efforts ineffective? The effectiveness of investors' portfolio tilts and exclusions is increasingly being questioned, and for valid reasons. Therefore, the frontier of climate investing is shifting beyond superficially ‘greening’ portfolios to greening the assets in them. We believe that investors can and should support polluting companies in their green efforts and thereby play an active role in solving the climate crisis, in our view. Furthermore, we believe this is a great commercial opportunity, aligned with the fiduciary duty of asset managers to deliver returns and manage risk.

Abatement efforts can be made to offset the, in some cases, escalating cost. These efforts are modelled systematically with Marginal Abatement Cost Curves (MACCs). The MACC is a clever translation mechanism between corporate investments in abatement levers and emission reductions. They are sector-specific and all investments come with associated CAPEX, OPEX and technical life – everything needed to bring them into our discounted cash flow (DCF) valuation framework.

This part of the framework has been developed in collaboration with Material Economics, a leading management consultancy on the link between sustainability and business performance. All-in, despite its simplicity, the framework captures the valuation dynamics well. Showing that green transitions drive financial value is essential for us to justify these investments and to support companies in their climate efforts. The framework forms a foundation for company-specific climate engagements, to identify gaps where announced targets are not aggressive enough and in those cases encourage companies to go further.

For heavy industry (aluminium, cement, chemicals and steel) the meaningful emissions are linked to actual production. Smelting processes and kilns are energy demanding and still predominately fuelled with coal. The products are commoditised but essential to society.

Without any commercial substitutes in sight, an end to our cement or steel dependence is today unthinkable. Steel is essentially infinitely recyclable, an important circular lever in developed countries with scrap metal but we still need to add new steel in developing countries.

Emissions from heavy industry are material and referred to as ‘hard-to-abate,’ a toxic combination. In Europe, the full EU ETS price would force many of these companies out of business, or to relocate to other regions. Production in other regions is by no means greener and therefore most of these sectors are EU’s carbon leakage list, i.e., they get free allowances. Luckily, it turns out that substantial abatements are not only possible, but value accretive. We believe this is one of the most misunderstood opportunities in today’s markets, both from an investor and climate point of view.

In our view, the MACCs suggest abatement potential of around 30% by 2030 for most of these sectors. When abatements are achieved, free allowances no longer needed can be sold and turned into profits. This is how the EU ETS is intended to incentivize abatements. Not realizing these abatements is economically suboptimal and leaves companies exposed to unnecessary risks. We believe that pushing forward with aggressive green transformation programs is in the interest of companies, investors and the climate.