05 May 2023
Kyle Williams, Ian Butler & Tom Buckingham
On the face of it, cultivating an SFDR Article 8 crop from the arid environmental, social and governance (ESG) ground that is the value benchmark can appear tough. Many of the most obvious ESG-friendly companies, such as those leading the renewable energy transition (for example, Vestas in Europe and SolarEdge Technologies in the US), trade on valuations that put them well outside the value universe.
By contrast, value benchmarks are dominated by companies in so-called “dirty” sectors, such as energy, materials, industrials and utilities (Exhibit 1). Integrated oil group Exxon Mobil, for example, looks very cheap, but has a significant carbon footprint and therefore ranks poorly on many ESG metrics.
Exhibit 1: MSCI world value and MSCI world growth sector breakdown
Source: J.P. Morgan Asset Management, Factset, as at February 2023.
Despite this challenge, value investing is not incompatible with SFDR Article 8. On the contrary, value stocks, including those in “dirty sectors”, will need to play a crucial role in the energy transition, as the world won’t be able to reach net zero without their support. At the same time, many of these companies are already taking action to mitigate financially material ESG risks.
To illustrate, Exxon Mobil has committed to invest over USD 17 billion through to 2027 in order to lower emissions, expand biofuels, and develop carbon capture and hydrogen solutions. In addition to its net zero goals, the company recently achieved its target to eliminate all routine gas flaring (which historically has been a significant source of greenhouse gas emissions for the industry) across 700 of its sites in the US Permian Basin oil field. Exxon aims to eliminate all routine flaring globally by 2030, a goal shared by its peers Chevron, BP and Shell.
As the Exxon example shows, understanding how companies are managing major ESG risks, such as the transition to net zero, and encouraging them to take action to mitigate those risks, has the potential to create significant value for clients over time.
Such an approach can be more effective at generating returns and promoting sustainability than simply excluding (or divesting from) stocks in sectors that rank lowly on ESG measures, which may cause returns to suffer as the investment universe becomes more restricted.
As a result, we believe the key to building value portfolios that meet the SFDR Article 8 criteria is not to exclude or divest, but to engage. Specifically, we want to be able to differentiate between those companies that are acting to mitigate the financially material ESG risks that they face, and those that aren’t.
However, engaging with companies on ESG issues can be complex. Take the low carbon transition, for example, which requires a holistic, rather than a tick box approach to avoid unintended consequences. We want to invest in companies that are working to reduce emissions, not simply selling off their most polluting assets to meet decarbonisation targets – a strategy that simply shifts emissions around the system, and can lead to increases in real world emissions if buyers are private operators who may lack the commitment to take action and don’t attract the same level of oversight as public companies.
Active value managers are in a powerful position to help push for change that can reduce ESG risks and add value for clients. Using engagement to drive real change at the lower end of the ESG spectrum not only incentivises firms to take action to mitigate their exposure to financially material ESG risks, but also has the potential to achieve more significant action in absolute terms.
The gains to be made from improving energy efficiency in the insurance industry, for example, pales in comparison to the opportunity for decarbonisation in the transportation sector, which accounts for 16% of global energy-related CO2 emissions.
Exhibit 2: Share of greenhouse gas emissions by sector
Source: Climate Watch, Our World in Data, World Resource Institute, J.P. Morgan Asset Management. Greenhouse gas emissions include CO2, methane, nitrous oxide and fluorinated greenhouse gases. CO2 equivalent tonnes standardise emissions to allow for comparison between gases. One equivalent tonne has the same warming effect as one tonne of CO2 over 100 years. Guide to the Markets - Europe. Data as of 31 December 2021.
Case study: Lufthansa
Lufthansa is Europe’s second largest airline. We wanted to gain more clarity on the company’s ambitious decarbonisation targets and its efforts to enhance climate risk reporting, with Lufthansa aiming to be carbon neutral by 2050 and reduce emissions by 50% by 2030, compared to 2019 levels. Through engagement, the company has explained how its planned investment in fuel-efficient aircraft will account for the lion’s share of the reductions targeted this decade, with each new generation of aircraft reducing CO2 emissions by up to 30%.
In addition, the introduction of sustainable aviation fuels (SAFs) will play a key role in reducing Lufthansa’s aviation emissions from 2025, pending European Union legislation on their usage. While waiting for the legislation to be finalised, Lufthansa is taking the initiative with the announcement of a USD 250 million investment in SAFs by 2024.
Since meeting with Lufthansa, the company has had its decarbonisation targets validated by the Science Based Targets Initiative (SBTi), making it the first airline in Europe to do so. However, our engagement doesn’t stop there. We have plans to continue engaging with the company around its climate change risk reporting and decarbonisation strategy implementation in 2023.3
At J.P. Morgan Asset Management we use active engagement to not only help us understand how companies consider financially material ESG-related issues, but also to try to influence their behaviour and encourage best practice. Engagement is one of the best ways of gauging how seriously a firm actually takes their ESG commitments. Crucially, engagement gives us access to forward-looking insights, which can be hard to get from standard ESG disclosures and is especially important for stocks in the value universe, which are more likely to be at an earlier stage in their ESG journey.
Our engagement efforts complement, and expand upon, the stock-level information gained from our 100+ fundamental equity analysts, who cover approximately 85% of the MSCI World Index (by market capitalisation) in great detail. Our deep stock-level analysis includes a thorough understanding of each firm’s ESG profile. Additionally, we have developed a proprietary ESG scoring system, which combines third-party data with our own in-house research to capture, systematically, our insights into nearly every stock in the value universe.
The insights gathered from our in-depth bottom-up research gives us a fantastic base from which to start our ESG engagement, and is the reason why J.P. Morgan Asset Management is among a minority of global value managers (41%) that are able to evidence ESG characteristics that adhere to the SFDR Article 8 classification. (Source: Morningstar, January 2023)
Exhibit 3: J.P. Morgan Asset Management 2021 Climate Risk Engagement Activity: Firm level – Climate change
Source: J.P. Morgan Asset Management; data as of 31 December 2021.
The reason for the long-term outperformance of value stocks, is that investors can be overly pessimistic about some sectors or individual firms, as they focus on their current problems and over-extrapolate recent trends. A small change in outlook can then have outsized effects on share prices. The rate of change, in other words, is more important than changes in absolute levels.
Value investors, therefore, have to be comfortable owning uncomfortable stocks. As disciplined value investors, we look to remove emotional biases and focus on the fundamentals of each firm that we cover. Understanding a company’s ESG characteristics and strategy is a crucial part of that analysis.
Those companies that recognise ESG risks, and take appropriate action, have the potential to create significant value, while those that don’t are cheap for a good reason. Identifying those companies that are embracing ESG opportunities can, as a result, make particularly attractive contrarian investments for the long-term value investor.
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