Sustainability through transformation: from utopian ideal to process
 

 

Dr. Henrik Pontzen

Head of ESG

For a long time, asset managers regarded sustainability research primarily as a risk management tool. Companies were analysed for potential flaws in their governance, weaknesses in the supply chain or problematic production sites. The aim was to highlight risks that could not be identified through conventional fundamental research, such as potential lawsuits or environmental damage. It is not hard to understand the rationale behind this approach: By identifying such risks at an early stage, investors can avoid losses in their portfolios either by exerting pressure on the companies to implement improvements or simply by not investing in them. The same applies with regard to climate change. Here, the investor focuses on the associated risks and assesses how well companies are prepared for a rise in the global temperature. How high are its emissions? How far above sea level are the company’s production facilities and markets? What rise in temperature would jeopardise its business model or, alternatively, what does the two-degree goal agreed in Paris mean for the business model?

All these questions are important and investors are justified in asking them. But we have seen a shift in thinking in recent years, with investment opportunities associated with sustainability coming to the fore. In the area of the environment in particular, analysts are looking for new business models and companies that are set to benefit from climate change, such as through the manufacture of intelligent heating systems, energy-efficient building design or new transport concepts. By combining the two approaches, a portfolio can be created that minimises risks and boosts opportunities.

Three categories of company

Climate change offers huge opportunities both for companies and for asset managers. It directly influences business models and sometimes radically reshapes them. So even in this transition phase, there will be winners and losers: Some companies will find themselves rendered superfluous and others will thrive in the new age. Businesses can essentially be divided into three different types. The first category includes companies that are already very well positioned and have an excellent, sustainable business model. They and their products are either unaffected by climate change or will benefit from it because they offer particularly intelligent solutions. Such firms exist, although they are few in number. As a result, they are usually priced very highly, which means they are only of limited interest to new investors.

The second category contains businesses that are unwilling or unable to adapt. The entire coal mining industry falls into this group. Whichever way you look at it, coal will never be green. Most of these companies are facing enormous problems, including regulatory hurdles that will severely restrict the use of fossil fuels in the years to come. Demand will collapse, the products will become too expensive and fate will take its course. This is the main reason why Union Investment does not invest in companies whose revenue is generated through coal mining. There will be no long-term beneficiaries from climate change in this sector.

The third category is the most exciting. These are companies that are ripe for transformation, are willing and able to change and may already be starting to take their first steps in this direction. There are already blueprints for what these companies might look like. If we go back a few years, we can see in the Finnish group Neste Oyj a classic oil-sector company with a business model clearly focused on fossil fuels. Its revenue was generated from the extraction, processing and sale of oil products. Then the group began to see the writing on the wall. Around the end of 2010, the company started to place a stronger focus on its renewable energies segment. Neste decided that, going forward, it would invest more heavily in research and development with the aim of developing oil derivatives, i.e. new types of fuel that generate much lower carbon emissions during the combustion process than other comparable fuels. Its investment and innovation efforts clearly paid off for both the company and investors: Since 2011, the company has been outperforming the European oil sector by quite a margin with its clear, modern and sustainable business model.

Exclusion does not solve the problem

We do not need to look too far for examples of companies that could take a similar path. The German speciality chemicals company Covestro is not traditionally the type of business that gets the pulses of sustainability analysts racing. It harbours too many risks, its emissions are too high and it is too exposed to fluctuations in the economy. But this could soon change, as the company has used part of its research budget to develop next-generation plastics that not only are clean but can even bind CO2. One new product is capable of using CO2 as a binding agent and a raw material for certain synthetic materials that are then used to make products such as artificial surfaces for sports pitches or insulation. The possibilities seem almost limitless; the search for suitable applications is still in its very early stages. If the product, which is currently being trialled in many sectors, becomes established, then strong sales are guaranteed. It would also ensure greater diversification of the company’s business model, making it less sensitive to cyclical trends.

A number of companies are exploring similar avenues. Evonik is working on bioplastics that could be used for drinks bottles, for example, improving their lifecycle assessment. Cosmetics giants such as L’Oréal and Beiersdorf are teaming up with small companies specialising in natural cosmetics, not only because these companies do not use fossil fuels and so are greener, but also because the natural cosmetics sector is growing strongly and its products have considerably higher margins than conventional products. And Adidas is now making trainers from recycled plastic,– plastic bottles, in fact, that are picked up from beaches around the world before they can end up in the ocean. It takes around eleven plastic bottles to make one pair of shoes. This is also extremely lucrative, as the trainers are high-margin products that command premium prices and sell in large volumes.

As an active investor focusing on sustainable investments, the trick is to find these companies at the right time, before the market discovers the sustainable potential in the transformation story. We do this partly through conventional fundamental research, and partly through intensive dialogue with the companies. Members of the portfolio management team conduct around 4,000 discussions a year with companies’ management teams in order to find out what their business is doing and what measures they could potentially take towards greater sustainability and, where possible, to influence their future actions so as to achieve a positive outcome for all stakeholders. After all, the more sustainable a company is, and the better prepared it is for climate change, the more stable and profitable it will be for its investors.

At the same time, companies and investors are also helping to stem the effects of climate change. If sustainability is a process rather than a utopian ideal, then our role is to find companies that are making a genuine effort to transform and support them as an active investor. Indiscriminately excluding companies that have not yet made much progress on their journey ignores credible climate strategies and makes transformation that much more difficult. This does not help sustainability and it does not help the shareholders. Wholesale exclusions will not solve problems, but successful transformation can.

 

As at 3 June 2020