How to manage the unsustainable parts of your portfolio

Panta rhei, i.e. everything flows, the Greek philosopher Heraclitus said. Likewise, economies have always transitioned and companies have always needed to change or falter.

But some periods are more turbulent than others. Think of the decades leading up to World War I, when all kinds of inventions dramatically changed people’s lives.

Similar things are happening now. For example, the lifespan of large companies has dropped to a historical low, and pressures are building to transition to a more sustainable economy.

People are starting to recognise this: over the past months, clients have increasingly been asking questions about investing in transitions. A large part of their investment universe faces serious transition challenges (including decarbonisation) and cannot be called sustainable.

Yet, as universal owners they cannot ignore that part of the universe, given both risk and return goals and the responsibilities many recognise to sustainability goals. Unfortunately, transition has been the neglected child of sustainable finance regulation. Although there are signs this might change, for example with the planned “Improver” category in the UK’s Sustainability Disclosure Requirements regulation proposals, most sustainable finance regulation and tools are focused on current performance, rewarding what is already good, with limited attention to transition pathways.

That is a pity, since what matters most, is to transform currently problematic companies and industries. However, let’s take a step back: what are transitions? How do they work? And how to invest in them?

Think of startups that develop new products and solutions that make existing products less attractive. An example is the emergence of electric vehicles (EVs) in the car industry, driven by players like Tesla and helped by societal pressure from emissions regulation. A crisis is typically needed for the regime to really change, and to phase out its unsustainable components– think coal, insider trading, money laundering and internal combustion engines.

The new regime tends to be a combination of old and new – for example, in automotive, quite a few of the current players could still be around a decade from now, along with new ones, but they will look quite different, perhaps selling mobility as a service.

Transitions cannot really be managed smoothly and their trajectories are unpredictable. However, one can assess the likely outcomes (given the societal needs being addressed) and prepare for them by mapping a course to that future state: determining the likely needed preceding steps.

In the transition to more sustainable models, it is likely that negative externalities will increasingly be internalised – i.e. their costs to be borne by the ones who cause them, and then to largely disappear. Channels of internalisation include: 1) regulation; 2) technology; 3) consumer demand – and all three are in play in the abovementioned EV example, where emissions regulation, better batteries, and the emergence of new players forced incumbent carmakers to switch to EVs.

However, these channels play out in different ways across sectors. In energy, it is relatively straightforward, away from fossil fuels and towards renewable energy sources. But it happens to many other sectors and value chains as well, e.g. transport, utilities, food, financial services and consumer goods. Within transport, the car industry is much further in transition than the airline industry.

What are the investment implications of transitions?

In the Journal of Sustainable Finance & Investment, Professor Schoenmaker, Lars Kurznack and I model long-term value using parameters for 1) companies’ transition exposures; and 2) their capabilities to navigate transition exposures. In further analysis here at Schroders, we found that 15-20% of the value of current equity markets is at risk of loss due to the changes that will be needed to meet Paris-aligned climate goals.

So it makes sense to assess transition exposures in stock selection. Transitions create winners and losers, also within industries that are on the losing end. For example, in a climate context, we have seen evidence that 1) companies that can reduce emissions faster than sector peers have materially outperformed and 2) that “green technology” companies have outperformed (albeit in a volatile way) in recent years.

This effectively points to the importance of forward-looking active management and selectivity, rather than assuming that past drivers of business success will lead to continued outperformance (which index investing to some extent relies on). For this kind of analysis, environmental, social and governance ratings do not suffice, while analyst judgement can be very valuable. Analysts can map companies’ exposures to transitions. These are often driven by negative externalities, for which our SustainEx* tool is a good basis. Products, companies, and industries can be mapped on the x-curve and be analysed on competitive pressures. Ideally, analysts also succeed in mapping companies’ transition preparedness and pathways.

Here are five key considerations for investing in transitions.

1. Investing in niches

The “easy” way to invest in transitions is to invest in the companies that build the new solutions, for example, through thematic equity funds. A tougher but more fundamental route is likely through private assets: it is especially in early stage venture capital that one finds the emerging niches that innovate and challenge the incumbents to change. In fact, a large share of future leaders are not yet listed companies or investible opportunities, given the losses are generally to the laggards among mature companies and assets rather than the wider market per se.

2. Investing in the companies that experience transitions

However, most of the global economy (and most of the investment universe) is both part of the problem and part of the solution. Large established companies (“transition issuers”) will have to reinvent significant parts of their business models, which brings risks and opportunities. This is harder to invest in, but can be more rewarding if done well. In this way, active managers allow investors to participate in the value unlocked through effective and successful transition – which is already a source of alpha in places and likely to become more so if the pressure to adapt increases and the costs of failing to adapt grow.

3. The crucial role of engagement and credibility

Engagement on transition pathways is valuable to both society and investors. In fact, some asset owners are already suggesting to shift the basis of performance fees from alpha to engagement results on material issues. In practice, however, the supposed trade-off between alpha and engagement might be misplaced, and the relation is likely a reinforcing one: as we argued many times before, the effectiveness of our influence and engagement is becoming increasingly important to our ability to deliver alpha. Managers of engagement-focused funds are expected to build very concentrated buy-and-hold portfolios capable of generating market-rate financial returns, but outperforming on engagement. This would represent a massive shift in the value proposition and purpose of asset managers. Patience is key. At the height of transition challenges, companies can face large (but hopefully temporary) drops in profitability and rises in capital expenditure. At that stage, companies could be significantly undervalued, and they need the support of committed long-term investors that back their path.

4. Credibility

A major challenge is to invest in a credible way: after all, you can invest in problematic companies and claim to invest in transitions, yet do nothing to actually help them improve. Therefore, so-called “transition washing” is lurking, which might be the explanation for the lack of inclusion of transition investing in sustainable investing.

There is a way to fix this though: by defining a separate transition category with sufficient safeguards on transition efforts. Safeguards could include minimum standards on engagement intensity, reporting, and expectations for the necessary intensity of engagement with each holding in a fund. We expect the UK’s Sustainability Disclosure Requirements (SDR) plans to prove important in defining criteria like these.

5. Demonstrating progress

Another challenge, which is related to the credibility challenge, is how to demonstrate progress. What is the transition pathway, what are the targets and to what extent are they being achieved? At Schroders, we require analysts and portfolio managers to undertake at least three high quality engagements per year, to ensure we have the most effective engagement possible and the best chance of encouraging change. Moreover, transition is already a feature of a number of funds.

Achieving a more sustainable economy requires investing in transitions. So please look beyond ratings and current footprints: it’s the way forward that counts. And hopefully the regulators are reading this as well.

*Schroders uses SustainEx™ to estimate the net impact of an investment portfolio having regard to certain sustainability measures in comparison to a product’s benchmark where relevant. It does this using third-party data as well as Schroders’ own estimates and assumptions, and the outcome may differ from other sustainability tools and measures.