253. The investments lowering your carbon footprint

30 April 2023 (pre-recorded 24 April 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Today’s episode is about climate change and specifically carbon emissions — or our carbon footprint — both as individuals and companies. We consider a range of topics from the growing opportunity set in climate finance to the impact of legislation in China, Europe and the US when it comes to achieve long term goals, such as net zero, by 2050.

Darius McDermott (DM): I’m Darius McDermott. Today, I’m absolutely delighted to have Deirdre Cooper, who is the co-manager of the Ninety One Global Environment fund. Deirdre, good afternoon.

Deirdre Cooper (DC):

Lovely to be here.

[INTERVIEW]

DM: So, look, that’s a big title for a fund, a Global Environment fund. We live in a world where the industry is creating many more responsible or social type of funds, but this, to my mind, this is an impact fund with a set target of what it’s investing in companies that are trying to make money and do something else. So, maybe that’s a nice opportunity for you to give us a bit of background on what it is that this fund is actually trying to achieve.

DC: That’s exactly right. So, the Global Environment fund only invests in companies that have products and services that avoid carbon. So, that means that those companies are selling things that are either generating clean electricity; so, we know wind, solar, maybe investing in the electricity networks that use those clean electricity and bring it to our houses; maybe investing in electrification, so, things like electric cars, which we all know about, but also heating industrial processes. In the longer term, we’re going to have a hydrogen economy. And then, of course, we’ve got a big bucket of companies that are effectively energy efficiency companies.

So, we’ve talked about the supply side, making energy cleaner. Then we need to talk about the demand side, which is using less of it.

So, that includes making buildings, factories, more efficient. It also includes changing the way that waste is disposed of, making consumer products that are built not from fossil fuels, but perhaps from biologics. And, of course, more efficient agriculture and changing the way that the food we eat are consumed.

So, that’s a pretty big set of activities. And interestingly, in 2022, for the first year ever, all of the investment in those areas altogether topped one trillion dollars, for the first time in history. So, that’s pretty interesting. Also, the first time in history that the investment in climate finance was bigger than the investment in the fossil fuel ecosystem. And I think that’s quite important and it’s just a tick, just a tiny little bit more. But when I started doing this – I started Morgan Stanley’s Cleantech Investment Banking Group in Europe in 2005 – at that point in time, the investment in climate finance was about 200 billion dollars. So, you’ve just seen this enormous growth. And of course, at that point in time, the investment in the fossil fuel ecosystem was many multiple times bigger. So, I think what we’re going to see from here, it won’t be linear, it won’t be every sector and every country every year, but what we’re going to see going forward, is continued growth in that climate finance.

In fact, if we as a planet were investing in line with net zero, that trillion dollars would need to be 6 trillion dollars. And that’s really why we developed this bespoke investment universe that we’ve worked on over the five years we’ve been running the strategy, working with external partners like the Carbon Disclosure Project, which is the biggest database of carbon data in the world – it’s a nonprofit organisation, and other sources – to try to find those companies that have products and services that avoid carbon because those companies are selling into what is already a trillion dollar end market, but has that structural growth tailwind, so, we think that will help those companies to outperform over the medium term.

But then to go back and actually answer your question, those companies have products and services that are having an impact, and the impact they’re having is helping the world get to net zero. And we report on that impact every year, for every company, when we report the carbon avoided by its products and services. And there’s a real feedback loop between that carbon avoided and our investment process. So, if companies aren’t increasing their carbon avoidance, over the medium term – mightn’t be every year – they might have a big backlog for products, but they haven’t sold many yet, so, this particular year or quarter, it doesn’t grow – but if over a reasonable period of time it isn’t growing, then that will cause us to question our investment thesis and ultimately, will cause us to change our minds. And that to us is what real sustainability means.

So, the Global Environment strategy sits within the Ninety One Sustainable Equity team where we have sister strategies – global sustainable, emerging markets and UK – and they look more broadly; they look at healthcare, digital inclusion, education, etc. But everyone does the same thing: we report on impact KPIs for our companies. And if those don’t move in the right direction, then we question our investment thesis.

DM: So, you touched briefly on the reporting, and I think this is because this is still a fairly young part of the asset management industry, when you have an impact fund and you measured carbon – I mean you’ll correct my language here – the carbon improvements or the reduction in carbon, so, you can say at a fund level every year, that the fund has achieved carbon targets.

DC: So, the way we look at it is more at the underlying holdings. So, if you were to pull up our impact report – and there’s four of them on the website, within a month or two there’ll be a fifth – you’ll see that we report on every underlying holding. And the reason we focus on the underlying holdings is that the carbon at the portfolio level is more dictated by the types of companies that you hold, than it is by the direction of travel of the companies. So, last year at a fund level, last year the utility sector did very well. Utilities, as you can imagine, own lots of assets. So, utilities have a high carbon footprint, even if they’re the cleanest, greenest utilities in the world. So, we own Iberdrola [, S.A.], NextEra [Energy Resources, LLC.] and Ørsted [A/S]. Together, Iberdrola and NextEra are the two biggest owners of renewable energy in the world, Ørsted’s the biggest owner of offshore wind. They’re pretty carbon intensive. Last year, they performed well, defensives did well relatively, so we sold them, and we bought some software companies, companies like Ansys and Autodesk.

So, Autodesk, you know, make the software that’s used by the construction industry to design, to build every building in the world almost is designed on Autodesk software. But of course, that software also allows you to reduce the footprint of the business, of the building, and it has a key role in 3ecarbonizing construction. But Autodesk doesn’t really have any carbon footprint because it’s really just a bunch of software engineers in California, as opposed to power plants all over Spain and the UK and Mexico like Iberdrola. So, you switch a bit of your Iberdrola into your Autodesk, your portfolio footprint goes then, but I haven’t changed real world carbon. You know, nobody’s getting any closer to net zero as a result of that perfectly reasonable portfolio construction decision.

So, what we want to focus on is how many of the companies in our portfolio every year reduce their own footprint? Because we do want Autodesk to make sure those software engineers are using clean electricity instead of dirty to power their data centres. We want Iberdrola to build more and more wind [farms] and have the footprint of every electron they sell go down. And at the same point, we want more of that carbon avoided. We want Autodesk to sell less of the generic software, and more and more of the stuff that tells you what the embodied carbon in your building is, that can help or address waste in construction through their building infrastructure management software and so on.

So, we want every company to reduce its own footprint every year and that’s its direct, but also its supply chain, which is very important. And we want every company to grow the carbon avoided that their products are having every year. And since inception it’s been about 60 or 70%. And I think that’s about right. So, there’ll be years as I said, [where] the backlog grows or maybe on reducing your own carbon footprint. You know, European companies this year are really going to struggle to reduce their carbon footprint because the European electricity grid has gotten a lot dirtier. And that’s not their fault, that’s because there was a war in Russia and Ukraine and that meant that the 35% of Europe’s gas that supplied from Russia became zero, and they had to use more coal. So, in a one-year basis, if you use electricity, which pretty much everyone does, your footprint went up.

Now, what we want to make sure is that in three years, you’re going to offset that with investments in renewable energy and source renewable energy. But it’s okay if your footprint went up this year, it’s out of your control. We understand that.

DM: So, look, I wanted to talk about a few external factors because that’s a really good introduction about not only what the fund is trying to achieve, but also the varying different sectors and sub-sectors that you can use to get either carbon avoidance, or making energy more efficient. And you have just touched there briefly on Ukraine. So, I mean that clearly hasn’t helped; I think you mentioned some countries have had to use more dirty energy, I presume that’s coal-powered fire stations, to try and keep sort of Europe warm whilst not relying on that gas.

But then there are other things which we can address around things like higher inflation, cost of living and recession. What does that mean for the net zero 2050 target or any of the other targets that come from the various governing bodies and COP and all those other fine establishments that set and try and get these targets pushed down? I mean, cost of living, people are more likely to go for the cheapest fuel they can get as opposed to necessary the cleanest. S

DC: So, look, there’s a lot in that question, so, let me try and take it piece by piece. Yeah, so the Russian invasion of Ukraine, what does that mean for decarbonisation? So, in general, it means that governments are much more conscious of how important energy security is. And you will hear – mostly from the oil and gas industry – that energy security means fossil fuels. And of course it doesn’t, right? If Europe was a hundred percent net zero and only used renewable energy, then Europe would not rely on any imported energy. So, energy security means wind and solar because nobody imports the wind, nobody imports the sun. If you electrify and you use that wind and solar, then you are completely energy secure. Imported, whether it’s oil instead of gas or LNG from America instead of gas from Russia, that’s still not a hundred percent energy secured. So, the governments understand that and the EU in response to the invasion, has accelerated and continues to accelerate their net zero plans.

You’ve actually also seen, which is much less widely reported, an acceleration in China, because energy security and security concerns generally have gone up the agenda. So, for example, in China, we’re now at a place where almost 30% of the cars sold last year were electric. And that number continues to accelerate into this year. And that, from a Chinese government perspective, is great because those are all Chinese cars. You know, Volkswagen’s electric penetration in China last year was only 4%. They’re using Chinese batteries and they’re running off Chinese electricity instead of imported oil. That is exactly what the Chinese government thinks about, when they think about energy security; they think about a domestic value chain.

And then in the US, you’ve seen in response – to some extent, not entirely – the Inflation Reduction Act, which passed last year, which is effectively an enormous step forward in terms of investment in decarbonisation in the US but also done in a way to encourage a domestic industry. So, huge tax credits for investment in EVs. You know, if China EVs are 30% of cars sold, in the US you’re only [in] single digits. So, there’s lots of room to grow and there’s been big tax incentives for that sector. Big tax incentives for wind and solar; you know, the tax credits for solar are so generous in the Inflation Reduction Act, there’s probably parts of the country where you make a return on the tax credits alone and you could actually give the power away for free. So, this bill really sets the US up for, first of all, reindustrialisation, massive investment in the economy, and decarbonisation. So, you’ve seen a response everywhere. It hasn’t always been easy to implement.

So, in Europe, you know, the drive to decarbonise electricity is still mired to some extent in planning and planning in Europe is going to be very hard to solve. You know, it’s hard to be that optimistic on that, as we know, it’s sort of crowded, just like the UK – hard to be optimistic in solving planning.

But on the other side of the ledger, energy efficiency in Europe has massively accelerated, you know, gas demand in Europe was down, you know, partly weather, but even weather adjusted, you were down high teens in terms of gas demand last winter. Now, everyone was worried, if you remember, back in September, would Europe survive the winter? What were we going to do without this Russian gas? And the answer has been, actually Mr. Putin, we survived just fine. And a lot of that is the low hanging fruit of energy efficiency investments. So, huge growth in heat pumps, for example, where we have exposure in the strategy in companies like Trane [Inc.]; huge growth in just energy efficiency investments in factories, where we have exposure to Schneider [Electric SE] and then some of that gas demand destruction was switching to other fuels. So, whether that’s heavy oil or coal, and that’s obviously less positive from a climate perspective, but there is quite a bit and we think will continue to be an enormous tailwind behind energy efficiency in Europe.

And then your next question, so, what about inflation? Look, the honest answer is, higher interest rates – all other things being equal – are not helpful, not from a stock valuation perspective, not that we only own super high duration unprofitable companies because we don’t; we own really attractively valued companies, but ultimately we’re investing in a sector where the world is currently investing a trillion dollars and we want it to invest 6 trillion dollars. We’d rather – all other things being equal – a lower cost of capital So, if you are of the view that actually global inflation’s going to be really hard to control and you know, the Fed is going to have to go much, much higher, you’re going to get sevens or eights [per cent interest rates], then it’s going to be hard for us to outperform in that environment. And we’d be very clear with our investors on that.

On the other hand, if you are of the view – and I think some of the leading indicators in the US, for example, are already starting to turn – that actually, we’re close to the end of the interest rate cycle, but we’re going to enter a period of much lower economic growth, that’s where our companies do a lot better, because they tend to have structural tailwinds behind them that are not cyclical. And those structural tailwinds are regulation, you know, that US Inflation Reduction Act that affects companies within our strategy across many different sectors, whether those are the renewable energy companies like Vestas [Wind Systems A/S], that is the market leader on wind in the US; energy efficiency companies like Trane that makes those energy efficient air conditioners; whether they’re the electric value chain like Aptiv [Plc] and TE Connectivity [Corporation] that have way more content in US [inaudible] companies, way more content in an EV. So, they all benefit from regulation.

We also see technological progress. You know, we hold CATL [Contemporary Amperex Technology Co. Limited], Chinese battery company, they were just at Shanghai Auto Show last week where there almost isn’t a combustion engine to be seen at Shanghai Auto Show. You have to go down the back and, and really root around to try and find a combustion engine. And, CATL are the clear market leader in those batteries and they’re talking about their next generation battery going at thousand kilometres.

DM: That must please you as a carbon impact investor, to see no combustion engines anywhere in sight!

DC: Absolutely! And just finally on cost of living, it’s not always the case that the cleaner is more expensive than the dirty. So, you know, on the power side, by far and away in every country in the world, the cheapest form of electricity is going to be renewable energy. Now, investing in energy efficiency, yes you might have to invest, but you’re going to save money over the medium term. So, that consumer dynamic, you know, much of what you do in your own life to save carbon will often always save money. It isn’t always the case. So, we do worry about EV penetration in Europe, particularly with higher power prices that have moved a bit more than the petrol prices. Is that going to change that dynamic? But broadly speaking, it’s not always true that the climate friendly choice is going to cost us fortune.

DM: Really interesting. Thank you. So, again, historically you’ve said that things like regulation, technology, change in consumer behaviour will help to drive decarbonisation. As we sit here today, which one do you think is the most important of those factors over, say, the next five years? And maybe you could just tell us a little bit about why.

DC: Look, I think it really depends on the sector and the country. So, there’s different drivers in different places. So, if we take each one in turn, you know, if you look for example, let’s start east, let’s start with China. The most exciting growth in China is, is clearly in that EV value chain. And, we have CATL, which I touched on [previously]. We also have Wuxi Intelligence [Wuxi Lead Intelligent Equipment Co., Ltd.] that makes the machines that they sell to CATL. So, those are the machines to make lithium ion batteries for electric cars, but also for energy storage. You know, the reason that the combustion engines are down the back at the Shanghai Auto Show is that my Chinese colleagues tell me they start to call combustion engine ‘zombie cars’. Nobody wants to buy a zombie car. So, there’s just a massive pace of change and the new products look really cool. The Chinese customer wants tons of infotainment in their car. So, you might have two or three iPads on the front screen in your Chinese electric car. They begin to look much more like consumer electronics, than like a car. So, that’s a sector that we’re quite bullish on in China.

We’re also actually quite optimistic on the pace of investment in renewable energy just because the economy is coming back. You know, obviously China’s in a very different macro place than the rest of the world, you know, much looser fiscal monetary policy, but there’s only so much infrastructure stimulus you can do. You know, one of the team is there traveling around at the moment on these 300 kilometre per hour trains, and has pointed out that some of the train stations are literally in the middle of paddy fields. So, the next step of infrastructure stimulus is going to have to go into our sector. So, in EVs it’s more consumer behaviour now. In power in China, it’s more regulation.

You know, you move to Europe, I think regulation has been disappointing. You know, we’ve had so many EU responses to Russia / Ukraine, EU responses to the Inflation Reduction Act, I mean we’re in this extraordinary position, which you and I have talked much [about] over the years, and it’s been a little while now, and I think when we started out, we never thought we’d have European leaders going to the US to complain that the US was being too generous on climate subsidies, right? But that’s what happened last summer, right? A combination of Emmanuel Macron and Ursula von der Leyen all complained; they’re giving all the money to these battery plants and the battery plants are moving and the hydrogen investments, from Europe to the US. So, you know, in policy, Europe’s been a bit disappointing, but the market environment – because of those much higher commodity prices – has led to that really, really strong driver on the energy efficiency side.

I wouldn’t write off policy. The most important thing that the EU did in the last three or four months was relax state aid rules. So, state aid means that if you are a member of the EU, if you are Germany and you want to give, you know, incentives to battery manufacturing or to companies that are building new semiconductor factories, you can’t do it because it violates EU law. So, those rules have been relaxed for our sector, which means I think actually, what will happen, is much more at the country level. It’s just so difficult to form agreement across all 27 [EU countries]. And we expect the Infineon [Technologies AG], for example, in Germany, which we hold [and] that is the key clear market leader in power semiconductors for electric cars, but also for all kinds of industrial efficiency, to benefit from some government subsidies in their big facility that they’re building in Dresden. And there will be other examples of that. But we need to watch that very closely.

And then we move to North America, and it really is policy; that Inflation Reduction Act, you just can’t underestimate how important it is. As an aside, I would expect the rolling back of the Inflation Reduction Act to be a bigger and bigger topic for Republicans. You know, so we’ve already seen Kevin McCarthy [Speaker of the US House of Representatives] as he talks about the debt ceiling, debate, you know, if we are going to agree to a debt ceiling, you need to change [the] Inflation Reduction [Act].

I think, you know, whoever is the Republican nominee – which looks increasingly likely to be a rerun of President Trump – I think will run on rolling back the Inflation Reduction Act. That’ll be a big plank. Having said that, I think it’s highly unlikely that they actually do roll back the Inflation Reduction Act. And the reason for that is that most of the investments are in red States, so the EV plants, the battery plants, 50 billion plus of capex [capital expenditure] that we’ve counted going into that sector alone, benefits the company we hold called Rockwell Automation [, Inc.], which is the clear market leader in the equipment for those factories in the US. It’s in Kentucky and it’s in Georgia. The hydrogen’s all been built in Louisiana. The biggest owner of wind and solar … the biggest location for wind and solar in the US, is Texas. Very sunny, it’s very windy and there’s no planning laws whatsoever. You know, it takes you seven years to get a wind farm permitted in most European countries, you can do it in six months in Texas. So, [DM: So, policy means they can get it done quicker!] <Laugh> Exactly! So, which is why I think it’ll be really hard to get any kind of change through the Senate.

And by the way, they’re all in tax credits, which is hugely valuable for Goldman Sachs and Morgan Stanley and JP Morgan, because they have to structure all those tax credits. So, there’s just way too many vested interests and money being committed and real jobs and employment, you know, which is really, really important. So, while we would expect lots of headlines on the end of the Inflation Reduction Act, don’t expect it to die.

DM: Deirdre, that’s all been really, really interesting. Thank you very much for taking the time to talk us through it. I think you’re absolutely right with the run-up to the next [US] presidential election; normally it’s healthcare as a sector that gets mentioned, but I think the Inflation Reduction Act is going to be a very noisy topic for whoever is running for President.

SW: Ninety One Global Environment is a global equities fund which has a unique approach of only investing in companies that are contributing to the decarbonisation of the world economy. It is set to benefit from the massive tailwind of the some $2.4 trillion of annual spend required to meet global temperature goals. For more information on the Ninety One Global Environment fund, visit fundcalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.