In this months’ Arcus, I will share with you some “Sustainability Traps” that Panvestors like us have identified and that we should all watch out for. Some of these might actually turn out to be opportunities? With some live company examples we will explore where sustainable investing is not delivering (yet) and where financial outcomes are being questioned and rightly so.
For some investors sustainability actions of firms can provide short term financial returns by being alpha signals, while others are expecting sustainability efforts to deliver superior long term financial returns. Regardless of your motives, the Sustainability Traps that we have identified at Panarchy Partners are relevant for all investors.
The following are three sustainability traps we have either avoided, look out for or are dealing with even within our portfolio:
Sustainability Inflection vs Financial Inflection
Sustainability Fatigue
Sustainability Subjectivity
1. Sustainability Inflection Vs Financial Inflection
This first sustainability trap I share is misinterpreting the sustainability inflection point of a firm for some financial inflection. Sustainability inflection point should be an event or events that result in a significant change in the sustainability adoption and progress of a firm. The actual inflection point is almost impossible to identify but once passed, it leads to a dramatic change in a firm’s business model. Is the sustainability inflection point also a good signpost for financial returns improvement?
The sustainability inflection point for some firms is not an issue as they are born with a sustainability mandate. Beyond Meat, Plug Power, Nikola and Tesla come to mind. For investors in these companies, their financial inflection point becomes the main question or trap. A topic for a future edition of Arcus no doubt.
The sustainability inflection trap I refer to is the one found in industry incumbents that are becoming sustainability disruptors, not the unicorns mentioned above. We are seeing many examples of industry incumbents becoming significant change makers and that so in a very profitable way. For every Beyond Meat, Plug Power and Tesla, there is also a Trane Technology, Neste and 3M.
The latter list of names are companies that have been around for a while but don’t come to mind as sustainability investments until one realises that these incumbent disruptors have the ability to create greater impact because of their existing footprint and experience. The challenge for many investing in such incumbent disruptors is when does their sustainability initiatives hit that inflection point which is then also recognised by shareholders. It is in companies like this that one can fall into misinterpreting that sustainability inflection for financial inflection and thus have disappointing financial returns.
Let's take Trane Technology as an example. As one of the world's leading HVAC companies, it has only recently found recognition by shareholders for its sustainability credentials. Shareholders are now seeing it as a structural growth “Climate Control” company rather than a traditional cyclical industrial. As can be seen in the diagram below, Trane Technology started on its sustainability journey in 2007 when it scored only 5/20 on the Panarchy resilience score. By 2010, it was scoring 9/20 and then 11/20 in 2013. While sustainability was improving between 2007 and 2012, there was no recognition by shareholders. Investing then based on their pivot to climate control might have been too early. Things started to change from 2013 onwards and a faster pace of shareholder recognition seems to really kick in from 2018 onwards.
Source: Panarchy Partners
As the above Trane Technology experience shows, sustainability inflection point is not that easy to predict, and even then it is not the same as financial inflection. Even our proprietary resilience score improvements in Trane Technology were not recognized by shareholders until 2013, and since then resilience and financial returns have moved together.
The lesson to be learnt here is that sustainability score improvements in themselves don’t signal a financial inflection. To find the sustainability driven financial inflection one needs engagement with the company to determine causation. As recent investors in Trane Technology we have learnt much from its past which should help us avoid this trap in the future.
2. Sustainability Fatigue
As Panvestors, we must not forget that while we aim for progress and returns for all stakeholders including shareholders, shareholders are still the most influential. Shareholders not only influence board and management decision making but also a firm's share price and value.
One Sustainability Trap that we see emerging is that of shareholder’sSustainability Fatigue. This is where there is a mismatch of pace and/or magnitude of target setting and delivery between the company management and shareholders. When shareholders feel they are being sidelined for a firm's sustainability credentials, this mismatch leads to shareholder fatigue and in some cases even push back to a firm's sustainability efforts.
So far at Panarchy Partners we have identified two versions of this shareholder Sustainability Fatigue.
The first version is where we see a firm’s management upgrade its sustainability targets without incorporating financial return target upgrades. In this version the shareholder fatigue towards sustainability is due to a sense of under-promising and sidelining of financial returns by the management.
This mismatch trap occurs where a firm is sincerely and passionately committed to its sustainability efforts and has openly accepted the stakeholder model to deliver progress on all forms of capital. It incorporated it into its business model with promises of good financial returns as well. So far, the sustainability thesis is sounding good even for a shareholder. The firm then starts delivering on its sustainability promises with regular public upgrades to its targets and commitments on sustainability. However, as it improves its sustainability credentials its financial return targeting sees modest and somewhat disappointing upgrades. This is where a shareholder’s patience starts running thin. This is where the shareholder fatigue emerges. This is where despite strong sustainability credentials, a firm's financial performance can look mediocre. We are seeing this play out in the case of Unilever.
Unilever has been improving its S.M.A.R.T targets (Specific, Measurable, Attainable, Relevant and Timed) and commitments in relation to human, social and environmental capital since the early 2000s, thus becoming a poster child of sustainability. The same cannot be said of their financial capital target upgrades and also delivery schedule as highlighted in the red box below in Figure 1. Unilever has not only removed any specific financial targets (ROIC and Margins targets are now indicative) but also left their time of delivery fairly open to interpretation with a “multi-year financial framework” or “long term financial metrics” approach. This mismatch of financial targets and delivery vs sustainability targets is leading to shareholders asking whether sustainability comes at a price, a price that they are paying for. This shareholder sustainability fatigue has led to an underperforming share price thus putting Unilever management under pressure. Time will tell how Unilever handles this current sustainability trap it finds itself in.
Figure 1: Unilever’s progression of S.M.A.R.T. targets on four forms of capital. Source: Panarchy Partners
The second version of shareholder sustainability fatigue is where a firm’s management upgrades both its sustainability and financial targets, but does so without delivering on previous financial targets. In this case, the shareholder fatigue towards sustainability is created by a fear of over promise (probable under delivery) by the management.
In this version, a firm puts into question its sustainability improvements with the lack of operational and financial delivery and yet continues to upgrade its sustainability and financial targets. The firm in this case has shareholders questioning management's underlying ability to deliver on business as usual, let alone with all the distractions of their sustainability targets. The live example of this currently being judged by the market is Danone. Danone management’s financial returns over the last few years have been criticised. The underlying reasons have been the unfavorable dynamics of its water business, competition in milk business in China and its investment into new categories. As can be seen below, despite management's under delivery their sustainability targets have gotten more and more aggressive as have their financial targets in the red box in figure 2. These financial targets are being disregarded by the shareholders as being unachievable.
Figure 2: Danone progression of S.M.A.R.T. targets on four forms of capital. Source: Panarchy Partners
Shareholder fatigue with management is not new and now the incorporation of sustainability targets into corporate strategy is causing the angst. For both Unilever and Danone, the jury is out. We as investors in both these companies are expecting board and management to address these issues and help shareholders regain confidence in competitive financial returns as well. Until then these two seem stuck in shareholder’s sustainability fatigue.
3. Sustainability Subjectivity
The last sustainability trap is one that I have discussed in a previous Arcus’ and will be short refresh this time around. This is the Sustainability Subjectivity trap. This trap is most obvious in ESG ETFs and ESG Ratings. In the summer of 2019, we explored the pitfalls behind ESG ETF and ESG Ratings which can be accessed here.
ESG ETFs based on ESG ratings from third party service providers are being used by many investors. Some investors are in ESG ETFs for thematic exposure (e.g., renewables, hydrogen, etc.). Others use them as a proxy while they work out their internal frameworks around sustainable investing. Both understandable approaches.
Since our 2019 expose of ESG ETFs and ratings there has been much done to improve the ESG credentials of ETFs with greenwashing becoming a serious concern for regulators as well. Despite improved enforcement by regulators and compliance by ETF providers the underlying Sustainability Trap of Sustainability Subjectivity remains.
As an example. Is Tesla ESG compliant? How does an ETF or a ESG rating agency consider Tesla’s ESG credentials? Tesla has every reason to be in a Battery Electric Vehicle ETF but does that mean that governance/environment is secondary in a thematic ETF? Given Tesla’s Bitcoin investment and the accompanying carbon footprint, how will the ESG ratings change for Tesla and what impact will that have on it as a constituent of an ESG ETF? If Tesla is removed from an ESG ETF because of its Bitcoin Investment, will it be back in when Elon Musk decides to sell its Bitcoin position? These are just some of the Sustainability Subjectivity issues that cannot be incorporated in an ESG ETF investment.
For now, I maintain my view that ESG and sustainability factors cannot credibly or consistently be incorporated into an ESG ETF. This is because passive investing (through ETFs) represents a process without engagement, a process which is agnostic towards progress on non-financial capital, and will invariably create a portfolio of companies that cannot pass the increasingly complex sustainability credentials as we interpret and apply them. Therefore, I see ESG ETFs as the most basic sustainability trap for investors to be wary of.
Conclusion
Sustainable investing, whether it be basic ESG investing or our philosophy of Panvesting, is no longer considered a fringe strategy for do-gooders willing to accept lower returns. It is becoming mainstream, with investors not only looking for competitive financial returns but also impact. However, like many investing strategies before it, as it is deployed on a large scale there are many lessons being learnt. The above mentioned sustainability traps are just some we have identified so far and hope they will prepare us well for the future.
Happy Panvesting!
Munib Madni,
Founding Panvestor