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The ESG Interview: Gearing up for the Decade of Transition

Adam Matthews, Co-chair of the Transition Pathway Initiative and Director of Ethics and Engagement for the Church of England Pensions Board, says investors need to dig into the detail to support investee companies.

The level of oversight required of asset owners to protect their investments as the global economy transitions toward net-zero emissions by 2020 is unprecedented. Far from appearing overwhelmed, Adam Matthews appears to relish the challenge of diving into the details required to understand how investee companies will incorporate climate policies into their business models.

“We’re into this fascinating ‘details’ phase of engagement and companies need to come to the table armed with much more information. Then you will see the investor being able to work with them to help achieve their objectives,” says Matthews, Director of Ethics and Engagement for the Church of England Pensions Board, which provides pensions and other support for more than 41,000 people who have served the church, and manages approximately £3 billion in assets.

Matthews is also Co-chair of the Transition Pathway Initiative, a global grouping led by asset owners and supported by asset managers, which uses publicly disclosed data to assess the progress of companies on their transition to a low-carbon economy.

The scale of the transition challenge still facing carbon-intensive sectors was laid bare in a recent TPI report covering diversified mining, steel, cement, paper, aluminium, chemicals and other industrials.

“This is the transition decade,” notes Matthews, the ten years during which key decisions will be made in these sectors that will determine if they are able to actually transition, decisions related to technologies and the funding they require.”

Challenge laid bare

Using a methodology developed by the London School of Economics’ Grantham Research Institute on Climate Change, the TPI report found that just 14% of large publicly listed industrial firms have adopted emissions-reduction pathways aligned with the goals of the Paris Climate Agreement, i.e. keeping climate change below two degrees Celsius by 2050. The sectors covered by the report, many of which use processes which inherently emit carbon dioxide (CO2), account for nine gigatons of annual CO2 emissions, or 25% of total energy emissions.

In market capitalisation terms, the 95 large firms across the industrials sector not aligned with keeping climate change below two degrees represent US$856 billion of risk to investors, the TPI asserts. For the companies themselves, the risk is that investors will decarbonise their portfolios by divesting their direct exposure, if they can’t decarbonise by persuading investees to reduce their emissions through changes to their business practices and processes.

Matthews emphasises engagement rather than divestment.  As a member of the Climate Action 100+ investor engagement initiative, the Church of England Pensions Board partnered with asset manager Robeco to engage with Shell, which recently announced a strategy to accelerate its transition to net-zero emissions. This included giving shareholders an advisory vote on its Energy Transition Plan, the first such move by a corporate in the energy sector.

Although energy has been front and centre of investor engagement on climate risk, Matthews and peers recognise the need to support and engage with firms in ‘hard to decarbonise’ industrial sectors.

“When you look at sectors like steel, you’ve got companies that are producing materials that are absolutely critical for the transition and the way we live. There are emerging solutions, but we are at the point where investors need clarity around the transition plans of individual companies,” he says.

“Within those transition plans, we also need clarity on which technologies will play which roles, and to what extent, within the delivery of firms’ overarching targets. We’re getting into that level of granularity in terms of engagement with sectors like steel.”

Variations in transition progress

The TPI report notes variations both between and within sectors, with aluminium and paper reporting poor overall carbon performance, a quantitative measure of individual firms’ emissions pathways benchmarked against three scenarios. Six steel firms, including the world’s largest, Arcelor Mittal (which accounts for more than 5% of global steel production), are aligned with a two-degree-or-below pathway by 2050. In certain sectors, notably cement and aluminium, a high proportion of firms do not currently disclose sufficient information for the TPI to benchmark their performance.

The TPI report also flags the potential to reduce emissions through use of new processes that increase recycling and cut down on waste and pollution. For example, replacing emissions-intensive clinker in cement production with steel blast-furnace slag and coal ash could eliminate up to a quarter of current clinker usage.

Other technologies and innovations being deployed include carbon capture and storage projects and a variety of efforts to introduce greater circularity and recycling. Broadly speaking, emissions can be reduced through development of a more circular economy in three ways: lowering demand (e.g. through longer product lifespans and substitution of low-carbon alternatives); increasing process and management efficiency along the supply chain, including for customers; and greater post-consumption recycling, e.g. remelting secondary aluminium.

Overall, these initiatives give scope for optimism, as well as opportunities for investment, but they also reflect the complexity of the challenges facing companies and their investors.

It’s not for the investor to assert a preference on the precise nature of the path chosen by investee companies, suggests Matthews. Instead, it’s more a question of exercising oversight or providing feedback. “I’m agnostic about the technology a company chooses,” he says.

“But I would want to have evidence of the feasibility of its application and a practical demonstration that it can play the role envisaged. On that basis, you can have confidence in that company having a credible plan. And then responsible investors can look to play a very important role in providing the potential transition finance.”

Embedding climate strategy

Whilst the main body of the report focuses on the carbon performance of 111 publicly listed firms across the core industrials sub-sectors, the TPI also assesses the ‘management quality’ of a wider sample of 169 firms, encompassing chemicals and other industrials, including firms such as Boeing and General Electric.

The management quality assessment considers factors such as governance to provide an indication of management commitment to taking steps to address climate risks and to embedding climate strategy within the firm’s business model and objectives.

Firms including Air Liquide, BHP, Anglo American and Klabin have reached TPI’s highest management quality score. Overall, 24 firms improved their ranking since the previous report in February 2020, reflecting partly the increasing number of firms devolving responsibility for climate policy to a board member or committee.

More than a quarter of firms assessed for management quality were ranked in ‘Level 4’, meaning they had reached or conducted a strategic assessment of their climate challenges. But most strong performers were in the chemicals, diversified mining and other industrials. Cement was the weakest performer of all sectors.

A common factor in downgrades of management quality was “failure to disclose on an ongoing basis involvement in trade associations active in climate lobbying”.

Matthews says the report reflects the spectrum of transition readiness, with leaders clearly engaged in setting targets and going into that next phase of providing the strategy and the options for achieving it.

“What’s concerning is that there is such a significant number of companies that aren’t even engaging or giving the confidence that they have the intention to have a target to meet net zero. From that perspective, they pose a clear risk to investors,” he says.

Opportunity to form partnerships

Matthews downplays the potential for conflict between investors and executives over the pace and credibility of companies’ emissions reduction plans, suggesting instead that the transition to net-zero represents a chance to forge a deeper relationship that benefits both.

“For those companies with intent to transition, there is an opportunity to form partnerships with investors, to be able to understand what they need to achieve it, and to work together in a constructive way for them to succeed and achieve their targets.”

Matthews is encouraged by the changes already being witnessed in the dialogue between investors and companies on climate risks. “You’re seeing a lot more companies commit to net zero, you’re seeing companies now putting their strategies to a vote in their AGMs. There is a lot of momentum behind engagement and there’s a lot of expectation from investors,” he says.

Investors recognise the complexity and scale of the challenges facing the companies in which they invest, insists Matthews. “Some of these things are not simple. There’s still a lot of work to be to be gone through to understand the net-zero path for a sector like steel. We’re saying, “Look, there’s a number of solutions that have been identified and it’s now time to have conversations around the detail of feasibility and practicability of those technologies and plans to enable the conversation to move forward, so that finance can play its role in the transition.’”

No silver bullet for steel

Given that steel alone is responsible for 10% of global energy emissions, the recent TPI report pays particular attention to its transition. More than two-thirds of the steel manufacturers analysed are not aligned with a two degree or below pathway by 2030, rising to more than three quarters for 2050.

Half of the world’s two billion tonnes of annual steel production comes from China, where most producers are not publicly traded and out of the scope of the TPI report. The least carbon-intensive production process, which heats recycled scrap steel, releases just one third of the emissions of steel produced by either blast or basic oxygen furnaces. Some Chinese steel firms use recycled steel, but the proportion is smaller than any other major steel-producing country.

According to TPI, all steel producers globally need to reassess their approach. Using more recycled steel is a start, but it needs to be paired with greater energy and material efficiency, as well as more investment in green hydrogen, as an alternative power source, and carbon capture and storage technologies.

Separately, a new report from UK think tank Common Wealth has called for government investment to offer the UK steel industry a future in a low-carbon economy. The UK has two blast furnace-based steel producers, based in Scunthorpe and Port Talbot, both at a critical point in their investment cycles, which could lead to decommissioning. Noting the high levels of scrap steel exported by the UK, the report argues for the ‘greening’ of existing blast furnaces, rather than relying on imports to meet primary steel requirements.

Toward a collective understanding

Investors can play a role in supporting policy or regulatory changes alongside investee companies, says Matthews, but this depends in part on an ever-deepening understanding both of firms’ transition plans and their underlying assumptions.

Changes in regulation play their part in improving visibility and understanding for investors, he says, such as the UK government’s decision to mandate reporting in line with the recommendations of the Task Force on Climate-related Financial Disclosures. Industry initiatives are also making a contribution. As well as the TPI’s tools and reports, Climate Action 100+ is due to unveil a new benchmark tool next month, which Matthews hopes will “set the standard for disclosure”.

“There still are data gaps, but I think we’re now understanding what the transition means in sectors like these and we’re making more sophisticated data requests,” he says underlining the asset owner’s increasing need for sector-specific information to evaluate the transition plans of investee companies.

“With today’s engagements, we’re getting into a level of complexity where you really do need sector analysts and independent academic expertise to help shape investor understanding. And we need a collective understanding, because if everybody interprets the transition in lots of different ways, we end up with sort of perverse results,” he says.

This information will allow investors to develop an understanding of the strategies of the individual investee companies to achieve their targets, based on an appreciation of what is a credible path to net zero in their particular sector.

“Collectively, the knowledge needs to grow as we walk down this path with companies. As they’re starting to reveal what their plans are, we’re starting to scrutinise them, and beginning to have ways in which we can independently verify whether they are credible. There’s going be a continuum of increasing our knowledge and understanding that needs to be matched with a ‘standing up’ across investor interventions and tools,” he says.

“There’s an inevitable continuing need to scale up capacity, but I would underline the importance of common views on the transition, so that we’re all working to the same objectives and not different goals.”

 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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