Currently, the most common practice is for funds to use a mixture of positive and negative screens to identify and invest in companies providing solutions to sustainability challenges and avoid those doing harm.
So-called 'transition' investing is different. It is a concept that focuses on investing in, engaging with, and supporting companies that are looking to shift away from having harmful business practices to become a company that helps drive the shift to a more sustainable global economy.
Not typical ESG
An example of transition investing could involve investing in a traditional oil and gas company that is looking to move towards renewable power generation, or a traditional car manufacturer looking to move away from internal combustion engines to producing electric vehicles (EVs).
While this often leads to investing in companies that are typically excluded by purist ESG strategies, there are several reasons why investing in transitioning companies can, in fact, be beneficial for society and the environment.
You can make a big difference by investing in and engaging with an imperfect company. A great example of this is a Danish utility provider called Ørsted. Today, Ørsted is one of the world’s leading providers of offshore wind power, accounting for approximately 25 per cent of generation worldwide.
A decade ago, however, Ørsted was known as Dong Energy and was a traditional oil and gas company with further exposure to coal powered generation. Ørsted is still in the process of completing its transition, with approximately 11 per cent of power generation still from non-renewable sources (8 per cent coal and 3 per cent natural gas) but there is a clear plan in place for a complete phase out of non-renewables by 2025.
Ørsted’s transition has already led to a reduction in the level of carbon emissions of more than 72 per cent, with a target of 98 per cent by 2025 – a massive positive environmental impact. Crucially, without the capital and shareholder support provided by investors during Ørsted’s transition, the process would not have been possible, and the level of emissions avoided not achieved.
There are several reasons why investing in transitioning companies can, in fact, be beneficial for society and the environment. Incumbent companies must change
If we are going to solve the many sustainability-related challenges we face, we need more than just new companies providing 'green' solutions, we also need the incumbent companies that are causing harm to change and improve.
Another good example is road transportation, which accounted for 21 per cent of global emissions in 2020. While Tesla is leading the way in terms of EV production, in 2020 the company sold just 500,000 EVs – less than 1 per cent of the 70mn cars sold globally.
Traditional car manufacturers such as Toyota, Volkswagen and Renault Nissan on the other hand sold more than 30mn vehicles combined (43 per cent of worldwide sales). As a result, a large part of the solution to road transport emissions lies in these companies transitioning away from internal combustion engines to zero emissions vehicles such as EVs or hydrogen fuel cells.
No solution without investment
The alternative to investing in and supporting companies in transition is to exclude them entirely until they have fundamentally changed. The issue with this approach is that if you do not invest in the solution, then it may never arrive.
For a company to complete a wholesale change of its business model it requires capital in the form of investment, expertise in the form of engagement, and pressure from shareholders to do so. Excluding companies entirely provides none of these and may result in new owners that are more comfortable with existing harmful activities.
Potential for outperformance
The benefits to investing in companies in transition can extend beyond just environmental and social. From an investment perspective, there is also the potential for outperformance.
Comparing Neste Oyj to BP, who at the start of the last decade were both traditional European oil and gas companies, provides an example of this. Neste Oyj, having transformed from an oil refiner to a renewables-focused company, has seen its share price increase more than 200 per cent in the past five years. Conversely, BP, which is still mainly focused on oil and gas, has seen its share price fall over the same period.
Investment can drive change
>The alternative to investing in and supporting companies in transition is to exclude them entirely until they have fundamentally changed.
Overall, while investing in companies providing solutions to sustainability challenges and excluding companies with harmful business practises is the most obvious way to support the global shift to a more sustainable future, it is not the whole story.
While it may seem counter-intuitive, the reality is that investing in, engaging with, and supporting companies in their transition can also generate large positive social, environmental and financial impact.
Oliver Jones is an investment analyst at Portfolio Metrix
