The ‘how’ of climate action investing

The following blog is an extract from our latest Climate Solutions paper: Climate change: Inaction is not an option.

We believe there are five primary levers for companies to pull as they aim to unlock shareholder value by accelerating their transition to net zero. Not all of these levers apply to any given company, but we believe at least one applies to the overwhelming majority. It is important to note that these levers are dependent upon the world implementing the policy steps needed to bring the world into line with a Paris-consistent climate outcome. Furthermore, these levers can typically be quantified.

Importantly, therefore, we believe that for most of the companies we look at, there is a clear financial case that accelerating their alignment to net zero could lead to better long-term financial outcomes for shareholders. Let’s consider each of these levers in turn:

Risk avoidance

In our view, failure to adapt to a decarbonising world exposes companies to risks, as carbon pricing impacts their margin and falling demand for their products thwarts growth potential. By decarbonising early, therefore, companies can look to avoid both demand and margin destruction. This lever is especially relevant for highly emissions-intensive companies. From the perspective of a universal owner, avoiding downside risks is critical to limit the portfolio impact of the energy transition. Yet for active equity owners, avoiding downside risk is not enough on its own to crystallise additional value relative to the wider market, so we consider risk avoidance to be a minimum condition for the companies we engage with.

Faster growth

The second lever companies could look to target is faster revenue growth. We believe the large reallocation of capital needed to enable the energy transition is highly likely to lead to significant differences in market growth rates between those sectors that enable the transition and those that do not. For instance, whether we compare the likely demand growth for copper to that of coal, or the likely growth for electric vehicles to that of internal combustion engines, it is clear that wide discrepancies could be set to open up between companies depending on how exposed they are to the fast-growing areas of the energy transition. We also think the same bifurcation may occur intra-industry – where those companies that invest today to build a sustainable advantage in lowering their carbon intensity may position themselves to access a faster rate of demand growth for their products than their peers.

Margin expansion

The third lever companies could look to target is margin expansion. This lever is closely related to the prevalence of carbon pricing or other regulatory mechanisms that impose a price on emissions. We believe carbon prices need to increase significantly to incentivise the potential emissions reductions associated with any ambitious decarbonisation scenario. In our view, companies that decarbonise early stand to solidify a margin advantage over their slower-to-decarbonise competitors, by investing in decarbonisation technologies that cost less than the expected carbon price. The timing of investment in decarbonisation is therefore critical.

Tapping the green premium 

Companies that provide low-carbon products and services can potentially capture a green premium. In other words, they can seek to charge a higher price for their products and services because they are lower-carbon than the prevailing alternative. Green premia are driven by companies across value chains reducing the Scope 3 emissions associated with their suppliers, known as ‘upstream’ Scope 3 emissions. This reduction could be delivered either by demand from end customers for low-carbon products, or by commitments and regulatory obligations to reduce Scope 3 emissions.

In the early stages of the transition, we believe only market-leading companies will be able to command a green premium. Such premia are already being observed in the market for low-carbon steel, with high-end automotive manufacturers paying 25% over the prevailing market price for automotive-grade steel to source very-low-carbon steel.[1] End customers’ willingness to pay a premium for ‘zero-carbon’ vehicles and the scarcity of truly low-carbon steel are driving this premium.

As the transition progresses, we expect that the green premium per unit will be diluted down as the market for low-carbon products expands beyond premium market segments. The lower bound for the green premium should be set by the price of voluntary carbon credits, which is an alternative way for companies to reduce their Scope 3 emissions. Additionally, the availability of green premia throughout the transition should reinforce the third lever of margin expansion that companies investing in low-carbon products can seek to capture. We see the likely declining trajectory of the green premium as another argument for companies to transition early.

Reducing cost of capital

We believe companies that are pro-active and well-aligned with ambitious decarbonisation scenarios will experience lower volatility of earnings relative to their peers, especially in sectors that are highly exposed to the energy transition. Furthermore, we expect lower earnings volatility to be rewarded with a lower cost of capital. High performers on ESG metrics already benefit from a lower weighted average cost of capital (WACC) by about 40 basis points,[2] and we expect that the divergence in WACC is only likely to increase as investors become better at pricing climate-related risks and evaluating the implications of companies’ transition strategies on earnings volatility.

While we are positive about the potential impact pulling one or more of the above levers could have on progress towards net zero and also in terms of unlocking shareholder value, we do have two principal caveats:

1.      In most cases these levers are likely to require a trade-off between short-term profitability and seeking to maximise long-term value creation. In some cases, they will require capital investment into new or additional production capacity. This constitutes a short-term reduction in free cash flow to equity yield, but will enable long-term enhanced profit if it unlocks one of the levers. In other cases, they may require the adoption of relatively early-stage technologies, which have higher costs currently than alternatives. However, by adopting early, we believe companies can secure learning benefits and economies of scale in advance of their competitors, and thus consolidate a long-term relative margin advantage (see chart below)

2.      As discussed above, the potential for higher long-term returns is dependent upon the world implementing the policy steps needed to bring the world into line with a Paris-consistent climate outcome

The above blog is an extract from our latest Climate Solutions paper:Climate change: Inaction is not an option.This paper is jointly authored by LGIM’s Climate Solutions team and AP7. The views and approach expressed within this paper relate specifically to their mutual investment strategy.

[1] Source: Bloomberg, June 2023
[2] Source: MSCI, February 2020