Focus on Outcomes
David Byrns, Portfolio Manager at American Century, explains why transition investing is fundamental to achieving net zero.
While global sustainable investments reached US$30.3 trillion in 2022, at the same time greenhouse gas (GHG) emissions have hit an all-time high. According to the World Meteorological Organization, global averaged concentrations of carbon dioxide, the “most important GHG”, were a full 50% above the pre-industrial era for the first time in 2022 – and continued to increase in 2023.
“There is so much emphasis on net zero [emission targets], but we’re not seeing real-world outcomes despite funds flowing into sustainable assets,” David Byrns, Portfolio Manager at American Century Investments, a privately-owned investment management firm with more than US$30 billion in assets under management, told ESG Investor.
To understand the paradox, American Century analysed publicly traded companies and split them into quintiles based on emission footprint, both in terms of absolute emissions, i.e. Scope 1 and 2, and emission intensity, adjusting for business size. “The research showed that incumbents are the highest emitting businesses,” explained Byrns.
“Therefore, excluding such businesses from portfolios is not the best way to help them decarbonise. Instead, the solution to reducing emissions in these brown businesses is active ownership and engagement,” he added.
While green funds once avoided emissions, policymakers, regulators and investors are increasingly realising the need to embrace incumbents in order to reduce emissions.
According to a survey by BlackRock, more than half (56%) of global institutional investors polled expect to increase their allocations to transition strategies over the next one to three years.
The labelling framework being introduced by the UK’s Financial Conduct Authority under its Sustainability Disclosure Requirements regime includes a transition-focused fund category. The ‘sustainability improvers’ label is for products investing in assets that may not yet be sustainable, “with an aim to improve their sustainability for people and/or planet over time”.
Meanwhile, the UK government and regulators have been seeking to help investors identify firms that are on credible transition pathways by supporting the work of the Transition Pathway Taskforce, which completed its delivery of sector-specific transition guidance in April.
In Europe, a consultation on the future of the Sustainable Finance Disclosure Regulation, which classifies and sets rules for green funds, found considerable support for transition funds. In fact, 72% of respondents backed the idea of creating a specific category for products with a transition focus, aiming to improve the sustainability profile of the assets they invest in.
In the US, the Securities and Exchange Commission only delineates between ESG integration funds, ESG-focused funds and impact funds. But the range of transition planning frameworks being developed to support organisations on their path to net zero is inevitably driving demand for assets turning from brown to green.
Best-in-progress approach
American Century launched a new strategy called Global Sustainable Value in November 2023. Its ‘best-in-progress’ approach is a departure from the best-in-class or thematic approach employed by many sustainable investors. “The difference is that the companies that we invest in may not have the best sustainability attributes today, but they are improving the sustainability of their business models over time,” he explained.
According to Byrns, the best-in-progress portfolio has three advantages relative to other forms of sustainable investing: the ability to drive real-world outcomes; a differentiated alpha proposition; and the opportunity to eliminate style biases and reduce the risk of overconcentration in large-cap growth stocks or specific sectors. And while he used climate change as an example, the strategy is applicable to other sustainability-related issues.
As part of this approach, American Century actively engages with incumbents, accelerates business model progression and drives change in the company and across the industry. “It is a big differentiator relative to other forms of sustainable investing, most of whom will exclude these businesses and therefore have limited ability to help them decarbonise,” said Byrns.
A second differentiator from many other ‘green’ funds is the source of alpha. “A unifying viewpoint among sustainable investors globally is that more sustainable businesses are also more valuable, almost by definition,” he said. “Therefore, if we invest in companies that are improving the sustainability of their business models in an economically rational manner, then we can share in the value created for all stakeholders, including shareholders, during their business model evolution.”
For example, NextEra Energy is a utility company that has slowly built out its renewable generation capacity. The firm’s valuation multiple increased over time, trading anywhere from 10 to 15 times earnings from 1995 to 2012. “As the company increased the percentage of its portfolio coming from renewable assets, the equities valuation multiple rerated higher. It has proved the high-level economic logic that more sustainable businesses are more valuable,” explained Byrns.
To address the style bias inherent in more established sustainable investment strategies, American Century looked at the percentage of sustainable equity assets which are managed consistent with the value investment style. It found that this portion totalled only about 10%, which means 90% sit in either the growth or core investment styles.
“As such, sustainable investors have what we call style tilts, or a high concentration in the growth investment style, in their public equity books,” said Byrns. “This can really cost investors, as it did in 2022, whereas the value investment style outperformed.”
A best-in-progress approach is highly congruent with value investing, with the potential to “eliminate style biases” that often arise in sustainable investors’ equity positions, according to American Century
Performance metrics
In the Global Sustainable Value strategy, American Century focuses on businesses that can “survive and thrive” during their net zero transition. It created a key performance indicator (KPI) framework to measure progression, and uses it throughout the due diligence process with the companies that it could potentially invest in.
Four types of companies are included in the portfolio: sustainable committers, which are committed to actively improving the state of their business and investing through capex or opex; operational improvers, which may have been neglected or mismanaged from a sustainability perspective, but are addressing those issues and improving; unrecognised leaders, which aren’t receiving credit for their leadership position in their valuation multiple, perhaps because there’s something else going on in the sector; and sustainability enablers, whose products or services might not appear sustainable on the surface, but play an important role in helping their customers, or end users, improve the sustainability of their business models.
An example of the latter is a packaging company which may not appear to be on a sustainable path, but offers recyclable or compostable forms of packaging. It can help consumer packaged goods companies improve the recyclability of their packaging, addressing the world’s plastics problem.
Ahead of launching the strategy, American Century consulted its analysts on how to measure the sustainability improvements of the industries that they cover. This resulted in a long list of industry-specific KPIs.
The KPIs are important for three reasons, according to Byrns. “First, they provide us with something to hold ourselves accountable to when owning a stock. Second, they help the team set clear expectations for how they expect the business to progress from a sustainability perspective and also hold management teams to account. Third, they are transparent and give us the data required for reporting purposes.”
The sustainability-specific process to the strategy is the engagement and escalation framework. Importantly, American Century has created a time-based framework and engages with all of its holdings on an annual basis. “This is important because the goal of this portfolio is to drive real-world outcomes within a reasonable time period,” he said.
If American Century doesn’t see the business model progression that it outlined in the KPIs within 12 months, it will engage with the management team. If it doesn’t see meaningful progress in 24 months, then it will escalate engagements to the board level and use its proxy votes. And if it still doesn’t see success through using its shareholder rights, then it will think about exiting the position, according to Byrns.
But Byrns sees divestment as unlikely outcome because American Century does a lot of work up front in finding companies that have well-defined improvement pathways relating to its KPIs, has consistent dialogues with the companies and has a long track record with its other strategies.
“We’ve been managing value portfolios for 30 years and investing in some of the same companies during time, so we have deep relationships with many of the management teams,” he said.
Real-world outcomes
Additionally, while other firms might split discussions with management teams between portfolio managers and a separate ESG team, American Century’s conversations include both financial-oriented and sustainability engagements.
“Plus, we have aligned the KPIs with value creation,” he added. “When we’re engaging with management teams about a sustainability-related topic, it’s because we think it is best for their business longer term so they are receptive [to engaging in dialogue].”
According to Byrns, the KPIs incorporated into the Global Sustainable Value strategy are important to tackle any hint of greenwashing.
“The KPIs ensure that we are not hanging out in a brown business model that we thinks will be better in 30 years,” he said. “The KPIs keep everyone – ourselves, the management teams and the end-users of the strategy – focused on business model progression and real-world outcomes.”
The post Focus on Outcomes appeared first on ESG Investor.