How do fund managers approach environmental sustainability when investing in the industrial-heavy UK market?
(Morningstar) The UK market has received its fair share of flack for not being as environmentally friendly as others. It is a country that historically has been very reliant on industrials and commodities, and with the growing awareness around environmental, social and governance – or ESG – risks, it raises questions about whether the UK index is green enough.
On the fund management side, there are several reasons why this topic is taking up space. One reason is, of course, increased investor interest, but for the first time, managers are also having to report on ESG risks and the negative impact of their investments under the Sustainable Finance Disclosure Regulation (SFDR).
This will hopefully help create a transparent environment around green investing, but do we really want to see how green (or not) our portfolio is, and is the UK market green enough for investors looking to invest both sustainably and locally? What is ESG investing?
The UK stock market is heavily skewed towards commodities stocks, and that can present a dilemma for sustainably-minded investors. How can you get exposure to your home market when it is dominated by the likes of Shell and BP? UK funds take varying approaches; some choose to exclude the heavy polluters and focus on companies driving the green transition, while other select stocks with lower ESG scores in the hope of driving change from the inside.
“It comes down to interpretation or how you apply ESG regulation to your investment approach,” says Ben Russon, manager of Franklin UK Opportunities and Franklin UK Managers' Focus. Rather than divesting, his approach is to remain invested and engage with companies rather than exclude them, to promote increased transparency and convince them to improve their working practices and reduce their carbon footprint. He explains: “Then you get the twin benefits; you are working towards achieving the goals that you want for impact on climate or society, but also, you would hope that the financial markets would reward that […], and you get the financial benefits as well. To our mind, that seems like a more sensible approach to take.”
Martin Walker, who manages Invesco UK Opportunities, agrees that responsible oil and gas companies have a critical role to play if we want to solve environmental problems. They have a duty to maintain a sustainable decline in production of fossil fuels while also ensuring that cash generated gets invested into new low-carbon solutions, he believes.
“Investing in oil companies that set out to achieve these objectives – and holding them accountable – is we believe entirely consistent with true responsible investing,” Walker says. “BP turning the taps off tomorrow would have negligible effect on global carbon emissions. The same emissions will still be made but fuelled by output from another supplier who is less accountable to investors. While some might point to any such drastic action (hypothetically) forced on companies such as BP as a ‘victory for investor pressure’ on environmental issues, others might also call it ‘investor nimbyism’.”
Choosing Sustainable Options
Nimbyism or not, another option is to invest in a slightly more sustainable backyard, like Dunedin Income Growth Trust aims to do. It invests in oil companies only where more than 40% of the upstream revenue comes from more sustainable sources. Co-manager Georgina Cooper is unable to invest in either BP or Shell – neither meets that criteria. While both are looking to improve the sustainability of their portfolio, the efforts will eat up a lot of the returns.
“From a financial point of view, the further you are away from that energy transition the more financial risk there is, as well as ESG risks,” she says. The trust, however, is able to invest 20% of its portfolio overseas, so has been able to take advantage of what the managers consider better opportunities from both a financial and ESG perspective. This is why Cooper looks to Total Energies (TTE), which she considers a leader when it comes to exposure to renewables and lower carbon fuels such as natural gas.
“I think relative to emerging markets and the US, the UK actually isn't that bad," she says. "It's definitely further along that curve, but I would say that Europe is leading. You can look at Europe as a vision of where the UK is on a trajectory to get to.” That view is certainly backed up by the Morningstar Sustainability Atlas, which looks at which countries lead on ESG.
Russon agrees that the UK index has a way to go. It is GDP-sensitive with several challenged sectors, which is even more apparent when compared at the tech-heavy US market. But equally, it also presents opportunities, because companies know they need to change: “You can see everyone making strides to work towards better outcomes. The old oil majors have got plans to get away from fossil fuels towards more environmentally sound practices: it is being built into management teams and long-term incentive plans. And, from an investor point of view, there’s potential to benefit from that, from achieving outcomes as well as the financial reward and improvement in stock ratings.”