In last month’s ARCUS, featuring Part I of our portfolio climate goal setting roadmap, we covered some high-level questions, such as the why and how of setting climate goals. In Part II, we go deeper and more granular. We will share our own enhanced portfolio climate goals/guardrails for our Global Panvest Fund (GPF) and highlight some tools that we are using to monitor and deliver on them.
Recap of Part I
The fundamental debate can be summarized quite simply: Are portfolio-wide climate goals necessary, and can they be implemented without significantly changing an investment strategy’s risk-return outcome?
Climate goals are becoming a must-have for asset owners and asset managers with various reasons to justify their adoption.
There are many types of climate goals to choose from. The best approach is to not adopt a reporting standard as a climate goal, but to develop a framework that is consistent and actionable within an existing investment strategy.
Adopting enhanced investment guardrails with climate features can be a good climate goal. Using enhanced investment guardrails with climate features can enable managers to target realistic climate outcomes while preserving investment flexibility. That is what we have implemented in our GPF.
Legacy vs. new investment strategies, and climate conscious vs. climate focused strategies will become a difficult decision that asset owners must make as they pursue their own climate ambitions.
Each strategy’s climate guardrails/goals should be guided by its own level of climate focus, team capacity and capability.
Establishing a baselinebefore adopting enhanced climate guardrails/goals
It is a “must” to know what one’s existing investment strategy is delivering in terms of climate credentials before committing to new or enhanced goals.
We kept it simple by measuring our overall portfolio’s past carbon trajectory as well as its projected path going forward. The chart below shows that the portfolio has, on a rolling 12-month basis, reduced its carbon emissions by a weighted average of 10.1% p.a. This is well ahead of reductions prescribed by IPCC or SBTi in their 1.5 degrees scenario decarbonization pathways.
As for the future, the graphic below illustrates the absolute reductions of carbon emissions expected of our portfolio companies’ operations (scope 1 and 2), based on their most recent disclosures made in 2022.
From the above analysis, it can be seen that our portfolio already has commendable climate targets and credentials: In aggregate, operational emissions are set to decline by 26% by 2030 on top of the 32% already achieved between 2019-2021. This is greater than the IPCC’s required 43% reduction by 2030, which would limit warming to 1.5°C from the base year 2019. However, this bottom-up analysis also unearthed some illuminating facts regarding individual climate aspirations and actions of our portfolio companies. Moreover, these revelations have climate guardrail-setting and investment universe implications:
15/23 portfolio companies have an absolute emissions reduction target; 3/23 have already exceeded their science-based targets; and 5/23 do not have ongoing absolute targets
For the 15/23 portfolio companies, they are expected to reduce their current emissions by 31% by 2030, or 3.4% p.a., (vs SBTi’s targeted 4.2% p.a.)
For the 3/23 portfolio companies that have exceeded their science-based targets, they have achieved a 34% reduction since 2019 (-0.58m tCO2e)
For the 5/23 portfolio companies with no ongoing absolute reduction targets, they have nonetheless achieved a 38% reduction since 2019 (-0.18m tCO2e)
One conclusion from our baseline-setting exercise was that an overall portfolio can still deliver reasonable climate credentials even though individual companies can be at different stages of their sustainability journey. Thus, a one-size-fits-all climate target for companies to follow is not practical nor is it needed for our strategy. The second conclusion was that - like financial performance - past performance on climate credentials does not ensure future performance. Finally, we also realized that there are gaps in our process of company selection which may lead to less desirable climate outcomes in the future. As a result, we felt the need to implement enhanced climate guardrails in our investment process. Our enhanced climate guardrails As shared in Part I, our climate conscious strategy should deliver the following five broad climate outcomes, with associated guardrails for company selection.
Example of a tool for guardrails
Monitoring and reporting environmental credentials at a company and portfolio level is no simple task. The issue of greenwashing by companies and investors has become a well-publicized, material risk to asset owners and their own environmental claims. One simple reason for this is that fund managers are still in the process of developing internal data collection, management, and monitoring tools for environmental capital. Our own experience suggests that the bottom-up strategy implementation and target delivery on environmental issues by portfolio companies requires continuous and highly specialized monitoring. We would further assert that from a practical perspective, legitimate and credible environmental claims by investors are most efficiently monitored in concentrated portfolios.
At Panarchy Partners we have established our own S.M.A.R.T target monitoring tool. For example, our Panarchy Partner’s Climate Target Mapping Framework is shown below. The Framework maps out the distinct boundaries of all GHG emission targets at the company, and therefore also the portfolio level. Here are some of the questions our framework seeks to have answered: Do a company’s GHG emissions targets cover the entire value chain, or only its own operations? Which scope 3 categories are included in the value chain targets? Have the targets been approved by SBTi, adding another level of validation by a third party?
By mapping out all GHG emissions targets of individual companies within the portfolio, we are better equipped to scrutinize the overall scope and track the progress of our portfolio as a whole.
The above analysis shows that eighteen percent of our portfolio (by weight) has set avoided/saved targets, and one of these portfolio companies is Schneider Electric (SE). The above diagram shows our climate target mapping for SE, which has set a target to help customers save and avoid 800mn tCO2e by 2025 from a 2020 base year. SE is also tackling emissions in its value chain and operations, with targets set to reach net zero GHG emissions across the value chain, and to achieve absolute scope 1 and scope 2 GHG emissions 90% by 2050, from a 2021 base year. SE’s interim 2030-targets are to reduce absolute scope 1 and 2 GHG emissions by 76% and absolute scope 3 GHG emissions by 25%. These targets have been approved by SBTi. There are additional climate related S.M.A.R.T. targets in areas such as renewable energy, suppliers and transportation included in the Schneider Sustainability Index (SSI) and Schneider Sustainability Essentials (SSE) strategies for 2021-2025.
Having such a comprehensive tool ensures that we can not only identify companies that are already travelling within our climate guardrails, but we can also use it to elicit engagement topics for those that are not. More importantly, sharing of this analysis with portfolio companies also helps those that are new on their decarbonization journey to prepare for the future.
Financial implication of climate guardrails
The climate guardrails highlighted above should steer our investing universe towards companies with positive climate credentials. Currently, thanks to academia, various valuation frameworks are being developed that aim to show the financial impact of such climate credentials. This topic is worthy of at least a master’s thesis in itself. Fund managers like Panarchy Partners are also considering various theoretical and practical approaches to assessing the financial impact of climate goals and guardrails at the company level.
For example, Panarchy’s 3P Impact Reserve is a theoretical framework, which we expect will become a practical analytical tool over time. This framework aims to capture the positive and potentially negative impacts (including climate) of a company’s business based on current policies and initiatives. These impacts are classified on a Proven, Probable and Possible scale, ironically inspired by the fossil fuel industry’s classification of oil reserves. In simple terms, the Proven row (in the diagram below) highlights actions that have historically added/subtracted financial value and will continue to do so in the short term. The Probable row highlights actions that may add/subtract value to a business in the medium term. Finally, the Possible Row highlights actions that may add/subtract value to a business in the longer term, with decreasing certainty.
In the renewable diesel company example shared below, we attempt to put financial values to actual and proposed actions taken by the company. These actions are driven by incentive schemes and regulations, such as the US Renewable Fuel Standard and Blenders’ Tax Credit. These incentive schemes provide higher rebates and incentives for increased efficiency and higher % of renewable fuel mix, i.e., lower climate impact alternatives. All things equal, these would provide (potential future) earnings growth for renewable diesel producers.
As sincere as they are, many Investors’ portfolio climate goals may have been made with limited data or analysis around their practical investment implications. In our two-part review, we hope we have shared some of the challenges with setting climate goals on investment strategies, as well as our own solutions. Factors influencing climate goals for investment strategies are whether it is an exiting or new strategies, how focused on climate the strategy is and what is the capability of the investing team in regards to monitoring and managing the investments climate credentials. It has taken us four years of reviewing our universes’ climate credentials and ambitions, engaging with companies, and developing climate-related tools to finally feel comfortable implementing certain climate guardrails in our own investment process. We acknowledge that we will need to review these guardrails over time as more sophisticated climate data and metrics become global benchmarks that are expected of companies and investors. That said we believe adoption of the above climate guardrails will allow us to deliver expected returns with climate impact.