Tipping points

As we mentioned in last week’s Soapbox, the direction of travel of greenhouse gas emissions is far from good – even BP agree! Which means that the longer governments delay, the more forceful and urgent the policy response needs to be.

In her last hurrah as PM, Theresa May’s committed the UK to a zero carbon target by 2050. The cost? Huge, obviously! Our energy infrastructure is vast and complex and has take more than 150 years to build. But the cost of doing nothing is even greater and the longer we do nothing the more expensive it gets! And anyway, as the advisory group on the costs and benefits of net zero sets out in its report, it’s pretty much pointless trying to estimate what the cost might be; economists struggle to estimate GDP more than a year or two out.

However, all is not lost. What we do know is the remarkable speed with which renewable energy costs have fallen, rendering those earlier forecasts of the costs of decarbonisation extremely pessimistic. How quickly? Since 2010, solar PV prices have fallen 83%, wind turbines 25%. LED lighting has gone from 5% of the global lighting market to 40% in six years and renewable investment now outpaces fossil fuels. In the UK,

It’s the first time since the Industrial Revolution that more electricity has been produced from zero and low-carbon sources rather than fossil fuels. It’s tremendously exciting because it’s such a tipping point.”  John Pettigrew, CEO of National Grid, recently.

It’s not unreasonable to expect similar cost reductions in other key technologies, such as batteries, fuel cells and electric vehicles:

“Once a technology becomes sufficiently competitive, it starts to change the entire environment in which it operates and interacts. New supply lines are formed, behaviours change, and new business lobbies push for more supportive policies. New institutions are created, and old ones repurposed. As costs fall and expectations of market size increase, additional investment is induced and the political and commercial barriers to a transition begin to drop away. A tipping point is eventually reached where incumbent technologies, products and networks become redundant.”    -Source – Report to the Committee on Climate Change of the Advisory Group on Costs and Benefits of Net Zero

The economics of clean energy are increasingly compelling and the scales are tipping in its favour as the diagram from Carbon Tracker shows below.

And once the economic tipping point is reached, the opportunity for politicians to act is enhanced. The energy incumbents’ ability to obfuscate and lobby is increasingly overwhelmed by financial reality. A political tipping point becomes a possibility. In enacting more sustainable energy policies, politicians are, after all, simply aligning themselves and policy with the economics of a rapidly changing energy landscape.

We would therefore argue that it feels like we are at, or are approaching multiple tipping points. New energy technologies are cheaper than fossil fuels for electricity and will soon be cheaper for transport. For the reasons set out above, anchoring views around concrete climate change policy commitments is not appropriate as the process of decarbonisation will not be linear. Companies that sell unsustainable products will face strategic dilemmas. But the biggest problem we face also creates enormous investment opportunities… and those companies providing solutions that address climate change should benefit from secular tailwinds.

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.  *As at 30 April 2019.

Sign up to receive our fortnightly Soapbox email

We beg to differ

The Kames Global Sustainable Equity Fund was set up to be deliberately different from other sustainable strategies already in the marketplace.  Three years in, despite all the interest in ESG, new fund launches and rebranding of existing stuff, it still feels like that’s the case. Why?

Difference 1 – Disruptive growth
Take an existing investment approach, overlay with an off-the-shelf ESG rating product and yee-haw, get on board the ESG bandwagon. But as we’ve outlined before, these approaches tend to result in vanilla funds with similar investment outcomes – a tilt towards low volatility and quality and away from momentum. Fine. Let the me-toos keep investing in all the same best-in-class stuff and we’ll focus on those parts of the market where considering sustainably has been proven to add the most value, but requires more intelligent thinking.

Active Factor: ESG vs. Benchmark (Feb. 2019)

Active factor exposures: Difference in exposure between the index and its benchmark. Eg: MSCI World ESG Leaders vs MSCI World for the year ending Feb 2019
* While Momentum for 1 year ending Feb 2019 is high, historically its low
Source: Bloomberg Intelligence

 

Difference 2 – Highly active
44% of US domiciled funds are passively managed today. Passive share has more than doubled since 2009. Vanguard, one of the biggest passive asset managers, now owns more than 5% of almost all S&P 500 stocks. Passive ESG is the latest thing and maybe passives can be effective stewards of the economy. Or maybe not. Regardless, perhaps we should view it as an opportunity. Much like vanilla active ESG, as passive ESG grows, perhaps so will the need for complementary concentrated highly active alternatives (99.5% active share and actively engaged) like ours.

Difference 3 – Honesty
We have always been candid with ethical fund clients about the portfolio impact of the client-led exclusions that we apply. We need to be similarly honest about ‘impact’. Despite what companies might tell us about themselves, everything is not awesome or aligned with the UN Sustainable Development Goals (SDGs). We are happy to tell you the fund’s carbon footprint (it’s great btw), but we would rather spend time explaining our philosophy and chewing over the nuances of how we think about sustainability.

To end, I know we have talked about Everbridge before, but if we must put a number to ‘impact’, how about the following, taken from the company’s recent earnings call…powerful stuff

Just this past Friday, a major cyclone landed on India shores, directly impacting our recently won customer, the state of Odisha.

To highlight the relevancy and value of our solutions, let me read from a recent New York Times’ article entitled: How do you save a million people from a cyclone? Ask a poor Indian state. Appearing in the Times on May 3, 2019, and I quote “Flights are canceled.  Train service was out, one of the largest biggest storms in years was bearing down on Odisha, one of India’s poorest states, where millions of people live cheek to jowl in low-lying coastal areas in mud and stick shacks.  The government authorities in Odisha, along with India’s – along India’s eastern flank hardly stood still.  To warn people of what was coming, they deployed everything they had: 2.6 million text messages in local languages and very clear terms, a cyclone is coming, get to shelters.”

 The article goes on to detail, all of these efforts and ends with the following. And I quote, “Seems to have largely worked, Cyclone Fani slammed into Odisha on Friday morning with the force of the major hurricane, packing 120-mile-per hour winds, trees ripped from the ground and many coastal shacks smashed. It could have been a catastrophe.  But as of early Saturday, mass casualty seems to have been averted. While the full extent of the destruction remains unclear, only a few deaths have been reported in what appears to be at early warning success story*.

*Everbridge’s 2019 Q1 Earnings Conference Call transcript

Disclaimer – At the time of writing, we held a position in Everbridge.

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.

*As at 30 April 2019.

Sign up to receive our fortnightly Soapbox email

Saintly Central Bankers

The legal mandates of central banks (CB) typically include responsibility for price stability, financial stability and the safety and soundness of financial institutions (e.g. our banks and insurers). So they’re effectively tasked with scanning the horizon to identify and understand those structural issues that could impact our financial systems …. and the economy. Importantly, they are also generally autonomous from our political systems.

Climate change is a market failure; carbon isn’t assigned its necessary economic cost.  Which means CB’s, led by the Bank of England Governor Mark Carney, are increasingly discussing the financial stability implications of climate change and the required appropriate response. Many are concerned that without further mitigation, cumulative emissions pose significant risk of economic disruption.  CB’s views on what constitutes an appropriate time horizon for considering risks seem to be changing.

For instance, historically, weather related ‘shocks’ to the financial system have been short-term, the impact on output or inflation has been temporary and policy-makers have been able to ‘look through’ them. However, some are now beginning to think that the increased frequency and amplitude of adverse weather shocks can no-longer be ignored if we are to avoid more extreme outcomes, the financial impacts of which would be difficult for central banks to manage. Separately, the impact of climate related employment shifts on wage inflation or energy price shocks as we shift to renewable energy are other considerations which could make CB inflation targeting more difficult in the future.

In their regulatory role, CB’s perspectives are also changing. Insurers have long been on the front line of dealing with the weather related impacts of climate change. They have adapted their modelling and pricing accordingly. This is less the case for banks. Late last year, the ECB indicated to the Euro-zone banks it regulates, that it had identified climate-related risks as being among the key risk drivers affecting the euro banking system. Similar messaging has come out of the Bank of England.

What are these risks? Both the banks and their regulator are still exploring this. But basically they are either physical risks e.g. mortgages of homes at risk of flooding or consumer loans on diesels cars etc., or transition risks i.e. those relating to the shift to a low-carbon economy. Responses to a Bank of England survey last year suggested that relatively few of the UK banks are managing these risks in a strategic fashion, principally because their business planning horizon only stretches to a few years out.


Examples of climate-related financial risks to bank assets
Source:Transition in thinking: The impact of climate change on the UK banking sector, sept 2018.

Time horizon is the common link between a lot of these considerations for CB’s and the financial institutions they regulate. Think short-term and there is little incentive to address climate change. Do too little, too late and you might not be able to manage the impact. But do anything too radical in the short-term and you risk materially damaging your business or the systems financial stability. This is the balance that our national and central banks must find. However, they are now undoubtedly giving more consideration to using the tools they have to address climate change.

 

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder. *As at 30 November 2018.

Sign up to receive our fortnightly Soapbox email

Supply chains: Materiality materializing

‘Supply chain’. You might think you’re safe to assume that this phrase implies a direct link between a company and its suppliers. However, in reality, supply chains are more like a network of waterways, with thousands of tiny tributaries converging into large rivers of production and sale. This complexity and scale is one of their strengths; when you have a problem in one part of chain, you simply reroute elsewhere. And the best supply chains are also the best kept secrets– you only have to see the success (and secrecy) of Amazon for this.

Scale brings speed. You’ve forgotten a friend’s birthday, and you need that present tomorrow, no problem. But scale also makes addressing sustainability concerns challenging.

But how do you manage the risks associated with labour conditions or the environmental impact of a distant company manufacturing on your behalf? You also need to bear in mind that the environmental impact of a corporation’s supply chain often far exceeds that of the organisation; CDP estimate that supply chain emissions are typically 5.5x more than a company’s direct emissions.


Source:CDP, Supply Chain Report 2019

But it’s not all bad news. The complexity of supply chains can make sustainability difficult to address, but that doesn’t mean it’s impossible. Companies are increasingly targeting their largest suppliers on sustainability. In many industries, corporations share the same suppliers with their peers which offers the opportunity to collectively leverage better supply-chain sustainability. Especially in the technology sector, where the likes of Apple, Microsoft, and Salesforce all buy products from the same semiconductor and hardware manufacturers who are mostly based in Asia-Pacific.

So this is why, when we think about supply chain issues for a given industry, we always consider the nature of the customer-supplier relationship and what are the incentives for both parties to address sustainability concerns. Suppliers that are financially dependent on customers with strong sustainability practices are also likely to be under the most pressure to adopt similar practices themselves. This dynamic is strong in tech, whereas, in sectors like apparel, relationships tend to be shorter and incentives therefore typically less (although there are always exceptions).

At the cutting edge of all this, the most advanced corporations are working on enabling innovative financing mechanisms to support their closest suppliers efforts to adopt more sustainable practices. (In return they are required to report on various sustainability metrics.)

Suppliers therefore ignore sustainability at their peril.

  • This year, 43% of CDP supply chain program members confirmed that they currently deselect existing suppliers based on their environmental performance. 
  • A further 30% indicated that they were considering this in the near future.

Let’s hope these broad efforts slowly ripple upstream through the many tributaries of supply chains.

Source:Bloomberg, Greening the supply chain: New moves companies are making, March 2019

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.  *As at 30 November 2018.

Sign up to receive our fortnightly Soapbox email

The Forward Thinkers

As Kames approaches 30 years of ethical investing, one of the questions we’re being asked the most is essentially what’s changed in that time and why?’

The answer to this is multi-faceted. For many industries, sustainability has become a commercial imperative (see mining example below). But multiple drivers now mean that the sustainable investment opportunity set has increased. Or to put it plainly, there’s more sustainable stuff to invest in. In part this has been technology enabled and we have written about sustainable disrupters frequently (e.g. here, here and here).

But technology can be enabling too. Specifically, enabling traditional industries to seek out operational (and therefore sustainable) efficiencies, which in aggregate can be significant.

Sensors are now pretty cheap, so they can be used to create ‘smart’ industrial equipment- able to monitor their own performance or that of their physical environment, e.g.  temperature, pressure, humidity, vibration.

Then you have cheap computing power (combined with communication networks) which is enabling the capture, management, analysis (machine learning) and storage of increasingly large amounts of data (from those handy sensors I told you about). Machinery and industrial assets are becoming digitalised. Welcome to Industry 4.0 and companies like Kames hold* UK-listed Aveva Group Plc and Paris-listed Schneider Electric SE.

Imagine you could predict the future? That’s literally one of the services that Aveva and Schneider Electric are trying to do for their clients using predictive maintenance. Rather than follow a simple calendar-based schedule, using the data generated from the sensors on your physical asset, predictive maintenance uses machine learning to spot problems before they occur. Companies are better able to identify underperforming assets, plan and prioritise maintenance, reduce downtime, avoid costly (and possibly catastrophic) events and improve safety and regulatory compliance. Sensors and computer chips now measure and collect information from jet engines to wind turbine gearboxes.

A ‘digital twin’ – the digital representation of something physical- no longer the stuff of science fiction. Digital twins are now employed in a variety of industries at a multitude of scales. Mining is becoming increasingly energy intensive as ore grades decline, forcing companies to become increasingly efficient. Like a number of others, UK-listed miner Anglo-American** is digitising its mining fleet and using machine learning to improve precision and efficiency.

Less energy and water in + less waste out = less costs + more productivity.

At a completely different scale, Singapore (yes, as in the whole city!) is working on a digital twin. Singapore is known for its efficiency, but its density provides little room for physical infrastructure experiments. A digital model would allow designers, planners and policymakers to explore future city-scapes. Static locational data of every building to bus-stop, alongside dynamic data of where the buses are and even things like dengue fever clusters. The UK wants to do something similar for the whole of the country’s infrastructure network. Incredible.

*As at time of writing 08/03/19 Kames Capital holds
**As at time of writing 08/03/19 Kames Capital does not hold

 

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder. *As at 30 November 2018.

Sign up to receive our fortnightly Soapbox email