The shift to a sustainable economy is irreversible
Hubert Keller, Managing Partner

in the news

The shift to a sustainable economy is irreversible

Interview by Albert Steck and Pierre Weill in NZZ am Sonntag, published on 17 May

The climate transition will only continue to accelerate on the back of powerful market forces and will create and destroy value across the whole economy, says Hubert Keller of the Geneva-based private bank Lombard Odier.


Have financial markets factored in the problems surrounding global warming?

We are seeing the first signs that markets are pricing the transition to a net zero emissions economy. This is affecting various sectors and we see an increasing focus by companies to achieving net zero emission within some pre-determined timeframe. 


Why is the zero emission target so important for investors?

We have a problem of stock and flow of emissions. To prevent temperature from rising by 1.5 to 2.0 degree C, the targets of the Paris Agreement, there is a maximum stock of CO2 and other greenhouse gases with which the atmosphere can cope with. However, with our current emissions flow from our global economic activity, we will reach that maximum stock within 10 years. The solution to this conundrum is to rapidly transition to a low carbon economy and eventually to reach total carbon neutrality. There is now a wide-ranging consensus on these facts among policy makers, business leaders, and consumers and in fact, an increasing number of countries, states, cities and companies are committing themselves to net zero emissions by or before 2050. Therefore, investors need to understand how robust a company business model remains on the path to and at net zero emissions.

The climate transition will only continue to accelerate on the back of powerful market forces and will create and destroy value across the whole economy

What are the consequences of this goal?

The pathway to achieving net zero by 2050 requires a 50% reduction in CO2 equivalent emissions by 2030. In other words, to achieve carbon neutrality by 2050, we need to drastically curb emissions now and this is quite challenging given the very strong link between economic activity and CO2 emissions. Fortunately, powerful forces are pushing this transition forward. One of them is market dynamics as economies of scale and technological innovation are making lower-emission solutions increasingly cheaper. The transition to net zero will require profound adjustments of a variety of business models across most industries; and these changes need to occur quite soon.

Do you have any examples?

In a number of sectors, it is becoming clearer how the net zero transition is driving a re-pricing by the market. For example, in the last 10 years, the oil sector has declined from over 10% of global stock markets indices to just above 3%. Or, in the automotive industry, those companies that have been slow on the transition to electric vehicles have seen their relative valuation suffer. Or, businesses that are exposed to physical risks of climate-change are also being re-priced; in fact, we have seen companies fall victim to climate-intensified wild fires and floods around the world. But, like for many major economic transitions, the shift to a net zero economy is also creating major investment opportunities.


How do you identify the winners and losers?

Aligning portfolios to the climate transition is a complex equation. Indiscriminately, excluding heavy polluting sectors is not the solution. Quite the contrary, in the transition to net zero, we need the carbon-intensive companies that are essential to our economy but we need those that have a plan to drastically cut their direct and indirect emissions. These companies that are able to operate effectively in a carbon constrained world will be more competitive and gain market share. We also need those companies that are bringing solutions to build the net zero economy and those that are able to deal with the consequences of climate change.

In the transition to net zero, we need the carbon-intensive companies that are essential to our economy but we need those that have a plan to drastically cut their direct and indirect emissions.

Isn’t it just greenwashing to remove coalmines from a portfolio?

It depends on your investment objective. You could decide to exclude coal companies or the tobacco sector based on ethical considerations because you think both are harmful to people and the environment.  However, if your objective is to align your portfolio to the transition to net zero, just excluding coal companies will not achieve it. Emissions are deeply entangled in all sectors of the economy as we have built our economic engines around the convenience of fossil fuels.
 

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Sustainable investment is in vogue, but how do you invest sustainably?

As investors, we think that we should invest in companies that can demonstrate a successful business model at or on the way to net zero emissions. This concept should apply across all sectors, especially within the heavy polluting ones. For example, cement and steel manufacturing are typical brown industries but they produce goods that are essential for our economy. The investment opportunity in these polluting sectors lays with those companies that can find a way to produce steel or cement profitably but with much lower C02 emissions. In a carbon-constrained economy, those companies are likely to be major winners.


Why?

Companies that will not reduce their CO2 emissions could find it hard to be profitable in the future because their cost of doing business would increase, as would their cost of capital. They run the risk of losing market share to those that are able to operate in a carbon-constrained world as customers shift to better positioned companies. As investors, we think we should focus on temperature trajectory of individual companies and assess the risk to the business model of that trajectory. This means understanding the total direct and indirect emissions of a company today and projecting them into the future. This gives us an emissions trajectory, which we can then align to the 1.5, or 2.0-degree temperature goal set by the Paris Agreement. Depending on the steepness of this trajectory, we can also try to assess the risk and opportunities to the business model and ultimately to the profitability of that company. At Lombard Odier, we have taken on this work for each investable company across 160 industries.

The investment opportunity in these polluting sectors lays with those companies that can find a way to produce steel or cement profitably but with much lower C02 emissions

How do you determine whether a company is one of the winners or losers in the transition to a cleaner future?

For us the key criteria is whether a company can generate attractive excess economic return on the path to or at net zero emission.


Do you have any examples?

One company we currently like is a manufacturer of air conditioning systems. Today, approximately two billion people need air conditioning and this number will continue to increase because of global warming. From an environment perspective, AC systems create two problems: they require a substantial amount of electricity and, if they leak, they release a gas that is quite harmful to the atmosphere. The company we like has created an AC that consumes 40% less electricity and uses a gas that is harmless to the atmosphere in the event of any leak.


Are there other industries you can recommend?

There are parts of the Steel Industry that could be quite interesting. This is a highly polluting or hard-to-abate sector but we need steel for our economy. Today, there are companies that use scrap iron and rely on electric furnaces to produce steel, which is a process that reduces emissions by 70% to 80%. In a carbon-constrained world, these companies could gain real market share and be major winners of the transition to net zero.


Is impact investing more promising than exclusion?

Today, impact investing relate primarily to green bonds and private markets opportunities. Whilst it is growing fast, it will take time before it becomes mainstream in investors’ portfolios. For listed securities we can derive impact from stewardship and engagement with companies.


Was Lombard Odier's decision to invest in sustainable assets triggered by a sense of responsibility towards the environment and future generations, or did you simply see this as a business opportunity? 

Sustainable thinking has a long tradition at Lombard Odier. It is part of our DNA as an independent partnership and is still one of the foundations of our success today - 224 years later. As active investors, we firmly believe that sustainability is a key driver of long-term return.


Why?

A company can only remain profitable over time if its business model and the way it operates is sustainable. You might think that this is obvious but today, we have reached a tipping point in relation to many sustainability issues across a wide range of industries, the environment being one of them. Some companies are adjusting fast, but some are ignoring them, and as a result, there should be many winners and losers, as we are already seeing.

A company can only remain profitable over time if its business model and the way it operates is sustainable

How do the Paris climate targets affect global economic development?

From a macroeconomic perspective, working towards achieving the targets set by the Paris Agreement should be a source of economic growth itself. It is increasingly well established that smart policy action on climate is growth-enhancing and many countries and cities around the world are experiencing it. It will require massive investments and profound transformation of existing business models. Economic revolutions can be a real stimulus for growth, as evidenced by the Internet Revolution some 25 years ago. But also, not achieving the goals of the Paris Agreement could be a real drag on economic growth. Today, the cost of climate damage is already more than USD300bn p.a. and is rising exponentially.


With regard to the climate targets, do you fear a setback in view of US policy?

The transition to net zero emission is becoming a reality for the world of business globally driven by many powerful forces, some of them greater than political will. Whilst the position of politicians differ greatly between Europe and the US, the actual progress achieved in these two regions are similar. US companies, US states and major US cities have remained committed on achieving the targets of the Paris Agreement and have achieved great results despite the position of the Federal Administration. Whilst China remains the largest polluter, they are taking massive action on domestic air pollution, and many Chinese companies are also leading the transition to net zero emissions.

…working towards achieving the targets set by the Paris Agreement should be a source of economic growth itself

Is the shift towards climate-friendly solutions irreversible?

I fundamentally believe so because there is no plan B. The only question for debate in my mind is the timing. If we move fast, the transition to a low carbon economy could be smooth. If we wait too long, it could create shocks to our economic framework. This is one of the many reasons central banks around the world are so concerned with this particular topic.
 

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How does Lombard Odier encourage its clients to invest more in sustainable investments?

Our fiduciary duty remains first and foremost to generate returns for our clients. The advice to our clients to endorse sustainability-driven investment strategies is primarily driven by our conviction that it will deliver superior returns for them.

Our fiduciary duty remains first and foremost to generate returns for our clients

Sustainable investments are predominantly passive. But can passive investments be sustainable?

If we take the environmental issue as an example, it is very difficult to align a passive portfolio to climate transition. There are two main reasons. Firstly, there is no real transparency today on total direct and indirect CO2 emitted by a company, let alone their avoided emissions or susceptibility to climate damage. This is why initiatives such as TCFD (Task Force on Climate-Related Financial Disclosure) are so important. Secondly, assessing the transition pathway of a company requires multiple judgements that go inherently against any construction of passive portfolios. Institutional investors are increasingly recognizing this challenge and willing to shift part of their portfolio to actively managed strategies.


How do you start investing sustainably?

There are basically two options. The first one is to integrate sustainability into existing strategies without changing substantially its source of return. This can be done through a variety of approaches ranging from exclusion of some sectors, through to corporate engagement, all of the way to using ESG (Environment, Social and Governance) tools to adjust the positions in the portfolio.

[To invest sustainably one can] integrate sustainability into existing strategies without changing substantially its source of return…the other option is to rely on strategies where the main source of return comes from sustainability

What is the second option?

The other option is to rely on strategies where the main source of return comes from sustainability. Today, this represents still less than 5% of the sustainable investing industry but is growing fast as clients realize the investment opportunities created by sustainability.


Don’t we need significantly more than CHF 1 trillion invested actively and sustainably in order for these investments to have a positive effect on the climate and the environment?

That is true, but it is also growing much faster than the other investment strategies.


Are ESG criteria rightly regarded as a benchmark for sustainable investment?

Indeed ESG criteria have become a real standard, particularly for passive portfolios. However, the risk is that these tools are used as a “box ticking” approach providing inaccurate answers to very important questions. ESG tools focus primarily on business practices rather than business model and rely on a vast number of criteria, some of them not always material to companies in certain industries. Most of these criteria are backward looking and thus static. And finally, only a few of these criteria relate to carbon footprint and those which do remain incomplete. Today, large ESG databases have been purchased by index providers because they provide a very convenient – but yet ineffective - way to integrate sustainability in passive investment strategies.


Don't these ESG criteria help?

The tools available in the market through the main databases provide little insight on how a company is positioned against some of its major sustainability challenges. There are many examples of poorly positioned companies with high ESG scores, or companies that had great ESG scores and yet suffering from an ESG disaster. As investors, this is what we need to be able to do, to identify the winners and avoid the losers. We believe that a robust ESG approach is one that can assess how a company is tackling the major sustainability challenges faced by its own industry and how it is approaching its broad range of stakeholders. These are highly judgmental questions where data will only provide part of the answers.

As investors… we need to be able… to identify the winners and avoid the losers

What are the best sustainable investment opportunities for investors with a long-term investment horizon?

As investors, we believe that the transition to a more sustainable economic model will generate many investment opportunities across a wide range of industries. Our own internal analytical framework looks at 10 major sustainability challenges that are affecting 160 industries. Our scenario-based analysis then helps us determine how companies are positioned to face each of the relevant challenge and what impact it could have on their profitability in the years to come. We use this approach to build all of our actively managed portfolios across bonds and equities.

…the big take-away of this pandemic is that the world was not prepared and, as a result, we are now suffering the healthcare and economic consequences

What are the potential COVID19 consequences on the climate transition agenda?

I think there will be many consequences but I can immediately think of at least two. Firstly, it is now clear that when the world hits a Minsky Moment – i.e. a moment where everything changes – and the choice is between humanity and economy, the world chooses to protect humanity even if the economic consequences are devastating. Thus, it is also clear to me that when confronted with the risk of an abrupt climate-related shift that could endanger large part of our population, the world will choose to protect humanity again, even if it comes again at the expense of economic interest. Secondly, the big take-away of this pandemic is that the world was not prepared and, as a result, we are now suffering the healthcare and economic consequences. I believe that we will learn our lessons and we will want to make sure that we are prepared against climate-related risks and the only way to do this is through a smooth but rapid transition to a net zero emission economy.

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