Bruno Bertocci

Bruno Bertocci

Head of the Global Sustainable Equities team

Adam Gustafsson

Adam Gustafsson

Quantitative Researcher, Quantitative Evidence & Data Science (QED) team

Investors have begun questioning ‘green investing’ strategies that merely employ tilts and exclusions to reduce high-emission companies in their portfolios. We believe the new frontier of climate investing is helping support the heavy emitters that are making key changes to their businesses to significantly improve their carbon footprint.

Time to take action

The ‘E’ in ESG (environmental, social and governance) has come a long way; conveying the urgency of our climate crisis is no longer where the battle stands. Governments, companies and investors are all pushing forward with green plans, but we believe the most important global emissions metrics are still moving in the wrong direction.

Is it too early to expect results or are our common efforts ineffective? The effectiveness of investors' portfolio tilts and exclusions is increasingly being questioned, and for valid reasons. Therefore, the frontier of climate investing is shifting beyond superficially ‘greening’ portfolios to greening the assets in them. We believe that investors can and should support polluting companies in their green efforts and thereby play an active role in solving the climate crisis, in our view. Furthermore, we believe this is a great commercial opportunity, aligned with the fiduciary duty of asset managers to deliver returns and manage risk.

Cap-and-trade empowering a greener future

The EU emissions trading system (EU ETS) is a cornerstone of the EU's policy to combat climate change. It is the world's first major carbon market and remains the biggest one, though carbon markets are being introduced in other countries. In April, EU ETS reached a record high above USD 60,1 and is expected to go higher. Predicting the future EU ETS price is not part of the framework.

Instead, the model works with a range of future EU ETS price scenarios to forecast the cost of emissions. In Europe, many of the most polluting sectors are protected and handed free allowances. Even if they don't pay the full price of emissions, there are still meaningful valuation implications.

Linking sustainability and business performance

Abatement efforts can be made to offset the, in some cases, escalating cost. These efforts are modelled systematically with Marginal Abatement Cost Curves (MACCs). The MACC is a clever translation mechanism between corporate investments in abatement levers and emission reductions. They are sector-specific and all investments come with associated CAPEX, OPEX and technical life – everything needed to bring them into our discounted cash flow (DCF) valuation framework.

This part of the framework has been developed in collaboration with Material Economics, a leading management consultancy on the link between sustainability and business performance. All-in, despite its simplicity, the framework captures the valuation dynamics well. Showing that green transitions drive financial value is essential for us to justify these investments and to support companies in their climate efforts. The framework forms a foundation for company-specific climate engagements, to identify gaps where announced targets are not aggressive enough and in those cases encourage companies to go further.

Green transitions drive financial value

Companies’ environmental externalities have always had a cost to society. An EU ETS allows for the emissions part to be expressed in monetary value, which in turn should be reflected in corporate valuations. Financial analysts go to great lengths in forecasting other value-drivers, but rarely account for emissions.

We believe this leaves risks and rewards vastly mispriced. Even worse, when investors don’t recognize the value of a green transition, it may indirectly hold companies back from taking the steps so desperately needed for the climate. Modelling the value of a green transition is challenging and associated with numerous assumptions. But since when has that stopped us from trying?

The DCF model has been around for hundreds of years and still rules the world of active investing. By adding three extra line items, the valuation impact of a green transition or lack thereof can be captured.

The three lines are: emission cost, green OPEX and green CAPEX. The cost of emissions which can be expressed as:

Emission Cost=(GHG Emissions-Free Allowances)∙ Price of EU ETS-Passthrough

When a company has free allowances to spare, the emission cost turns negative, i.e., they sell emission permits and make a profit. If a company cannot cover their emissions with free allowances, they have to buy additional emission permits at the market price. Part of the cost may be passed on to customers depending on competitive dynamics in the specific industry. How much is likely to vary over time and also to be dependent on achieved abatements.

Green OPEX and CAPEX are treated as incremental to business as usual (BAU) and simply layered on top of baseline numbers.

Green transitions in heavy industry

For heavy industry (aluminium, cement, chemicals and steel) the meaningful emissions are linked to actual production. Smelting processes and kilns are energy demanding and still predominately fuelled with coal. The products are commoditised but essential to society.

Without any commercial substitutes in sight, an end to our cement or steel dependence is today unthinkable. Steel is essentially infinitely recyclable, an important circular lever in developed countries with scrap metal but we still need to add new steel in developing countries.

Emissions from heavy industry are material and referred to as ‘hard-to-abate,’ a toxic combination. In Europe, the full EU ETS price would force many of these companies out of business, or to relocate to other regions. Production in other regions is by no means greener and therefore most of these sectors are EU’s carbon leakage list, i.e., they get free allowances. Luckily, it turns out that substantial abatements are not only possible, but value accretive. We believe this is one of the most misunderstood opportunities in today’s markets, both from an investor and climate point of view.

In our view, the MACCs suggest abatement potential of around 30% by 2030 for most of these sectors. When abatements are achieved, free allowances no longer needed can be sold and turned into profits. This is how the EU ETS is intended to incentivize abatements. Not realizing these abatements is economically suboptimal and leaves companies exposed to unnecessary risks. We believe that pushing forward with aggressive green transformation programs is in the interest of companies, investors and the climate.

Valuations and Abatements Grow as The EU ETS Price Rises

This chart is based on 14 European cement and steel companies. The 'violins', Barbapapa-lookalike charts, are showing how valuation impacts are distributed under different EU ETS price expectations for 2030. We have combined steel and cement companies, they are in many ways similar but cement tends to have a higher impact. If we assume the EU ETS will reach EUR 75 by 2030, the median company should invest 1.7% of annual revenue in green transition levers allowing them to abate 26%.

Marginal Abatement Cost Curves suggest abatement potential of around 30% by 2030 for most of these sectors. When abatements are achieved, free allowances no longer needed can be sold and turned into profits. This is how the EU emissions trading system is intended to incentivize abatements.

Explore more insights

Original articles and videos with expert analysis, views and opinions on a broad range of asset classes and themes.