European Equities: a transition mindset on sustainable investing

Moving to a Transition mindset

We welcome the European Securities and Markets Authority’s (ESMA) recently announced guidelines for funds using sustainability-related terms in their mandates. We believe it to be a clear signal that the next chapter of the sustainable investing has started.

When we launched our Sustainable Eurozone fund in Spring 2023, we did so with a Transition mindset; focusing on a companies’ ability to reduce absolute emissions each year rather than looking for companies that are already clean. Following changes to the sustainable investment backdrop, including a more supportive regulator, we see Transition finally getting a full seat at the sustainable investment table.

What have we been through?

There are three key climate stakeholders that impact corporate activity; governments, customers and investors. Whilst all three stakeholders were swimming in the same direction at maximum speed this created the boom in sustainable investing.

However, these stakeholders have started swimming in different directions and arguably with different strokes.

• Governments are giving mixed messages
• Consumers have other concerns taking priority
• Active investors are becoming more discerning about the nuances of climate related investing

The sustainable bubble has therefore burst, but despite this more complicated backdrop, the need for sustainable investing remains. Climate change and energy security solutions still need to be funded and capital needs to be allocated effectively. Thus, we ask, what next for the sustainable investment community?  

​Where are we heading?

We think the boom and bust will force sustainable investors to think differently. A more pragmatic approach to the entire topic of sustainability would be more effective and have more longevity.

We’ve seen destructive dogmatism restricting the roll out of bridge technologies. New solutions get pushback if not perfect. For example, we see electric vehicles (EVs) criticised for the emissions linked to the mining of battery minerals. If we focus on the limitations of near-term climate solutions we’re at risk of ignoring the bigger questions e.g. how much lower are EV’s lifecycle emissions vs internal combustion engine vehicles and therefore how much capital should flow towards funding this specific transition.

Now capital is no longer ‘free’ we see even greater need for pragmatic capital allocation by governments and corporates. This is being facilitated by a more practical regulatory setting.

More than just a name change: The regulator now wants Transition

The first wave of sustainable investing matched the first regulatory frameworks. They adopted a ‘best in class approach’ thus invoking ‘the stick’– i.e. higher cost of equity placed on high emitters. Regulators are now offering ‘a carrot’ to promote change – i.e. reducing the cost of equity for high emitters that can transition to a low carbon business model. It is important to combine the ‘carrot’ with the ‘stick’ to facilitate change.

ESMA fund's guidlines are defining several categories of names

The formal adoption of the word ‘Transition’ by regulators will be important. It will make a clear delineation between those sustainable investment strategies that invest in already clean businesses and those who want to facilitate the decarbonisation journeys of high emitting companies. ​

What is Transition and how do we approach it?

A Transition mindset is the acceptance that greener pastures can only be reached by first wading through the shades of brown. Transition investing is managing a portfolio that is helping change the status quo.

Our Transition approach is built on engaging with the largest emitters and a focus on like-for-like absolute emission reduction. We do not believe the equity market should be rewarding divestments or putting too much emphasis on carbon intensity KPIs.

The biggest obstacle to Transition investing has been data quality.

Sustainable emission disclosures are improving

Scope 1 and 2 emission disclosures have improved considerably in recent years. The laggard has been Scope 3. Fortunately, as we’ve been getting into the weeds when building our bottom-up emissions models, we’ve seen progress accelerate.

Better input data allows corporates to give more granular disclosures. We’ve seen the first instance of a company giving guidance on current year emissions. As data and disclosure improves, more emphasis will be put on forecasting future emissions.

How do we forecast absolute emissions today?

There are no third-party data providers offering forward looking emission estimates yet. We believe this is therefore a key differentiator in our process. We have annual estimates out to 2030 for 30 high emitters, 18 of which we own. In aggregate, they account for 76% of the benchmark’s emissions.

Modelling the large emitters helps us assess their ability to deliver on their decarbonisation targets. We can compare our estimates to the company targets, as seen in the example below.

Conclusion: The sustainable investment landscape has changed

With more pragmatism, backing of the regulator and improving emissions data, we have the right ingredients for Transition investing to grow and plug the gap left by the first generation of sustainable funds. In doing so, Transition investing will accelerate our journey towards a low carbon society. It is up to active managers to embrace engagement and really push corporates on their medium term decarbonisation plans, not just their long term, or net zero, targets but more importantly the route in which they get there.