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ESG series: Environment under siege

Victoria Harris of Devon Funds explains the issues we should be thinking about to make sure our investments are protected against climate change.

9 March 2022

Climate change is a term that’s sometimes wilfully bashed around – and it’s widely misunderstood.

In simple terms, it’s a long-term change to the temperature of the atmosphere which has been accelerated by human activity.

Since the start of the 19th century, we’ve released ever-increasing amounts of greenhouse gases into the earth’s atmosphere by burning petrochemicals and by large-scale agriculture, among other things.

These emissions mean more heat is being trapped within the atmosphere, and the rising temperature is affecting the world we live in.

A warming atmosphere has us worried for two reasons.

Firstly, it leads to more extreme and unpredictable weather events.

Secondly, it accelerates the melting of glaciers and ice. This leads to rising sea levels, which in turn worsens flooding and erosion during extreme weather events.

We can see climate change-driven events becoming more frequent and having a bigger impact on our lives. Think the Australian bushfires in 2020, Hurricane Katrina in 2005, and the Amazon wildfires in 2019, which are just a few examples.

These environmental disasters and others like them are a very real risk to many of the local companies within our investment universe and they’ve become a very real concern within our investment process.

For this reason, over the past few years, environmental, social and governance – commonly termed ESG – factors have become important within the local and global investing landscape.

Given climate change and how conscious investing principles are rapidly being adopted, many companies have seen the light and adopted voluntary ESG reporting, but this varies in its depth, quality, and usefulness.

NZ leads the world

So, in April this year, New Zealand became the first country in the world to legislate mandatory climate-related disclosures, a step which will come into effect in 2023.

These climate disclosures will be in line with the global best practice set out within the Task Force on Climate-Related Financial Disclosures (TCFD) guidelines.

Within the NZX50, an index of New Zealand’s 50 largest share market-listed companies, over half are still non-TCFD compliant, which shows that we still have a long way to go.

But some are leading by example. Take Air New Zealand, Fisher & Paykel Healthcare, Spark, and A2 Milk.

TCFD disclosures will help New Zealand towards our 2050 net-zero emissions target, but they’ve also become an important resource within the investment process.

Risk and returns

When portfolio managers like me are considering an investment, we have a research process that consists of two core objectives to set a valuation for the company.

First, we must forecast the cash flows that the business is likely to generate. Will it grow and be profitable?

Secondly, we have to understand the risks surrounding those cash flows. What could go wrong that might derail it?

Weighing up these factors gives us an estimate of the intrinsic value of the business. We can then compare this value to the current share price to work out when the investment becomes an attractive opportunity.

TCFD disclosures are particularly valuable when we’re evaluating the risks facing future cash flows. However, they’re also very useful when we’re making forecasts about cash flow. Let’s take a couple of examples.

Company A: Rising sea levels

Let’s take, for example, Company A, which has a building right next to the ocean, only a few metres above sea level.

We can estimate how much money will be needed to move the structure away from the shore, build a new shed, or construct a flood wall or embankment to protect it against king tide floods and rising sea levels.

Company B: Carbon emissions

Take Company B, which has a factory releasing greenhouse gas emissions. We can look at its emissions data to work out how much this business will be hit by changes in the price of carbon credits.

Emissions data is categorised into scopes. Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 includes all other indirect emissions that occur in a company’s value chain.

Management teams that spot these environmental risks and pivot or adapt early will be rewarded because they’re more sustainable companies, so they’ll get a greater share of the investor’s wallet.

So, for those of us in the investment business, taking environmental risks into account in our research process will ultimately lead to better shareholder returns.

This new law requiring public companies to make TCFD-compliant disclosures is a huge step for New Zealand and it sets an amazing precedent for many other countries.

Set some incentives

The next step would be for companies to introduce compensation and key performance indicators (KPIs) tied not only to financial targets, but to environmental targets, too.

Climate change will continue to be a big factor affecting a company’s operations. Intuitively, we should be measuring their management’s performance on how they deal with this issue.

In life, incentives are the ultimate driver of human behaviour. They will naturally lead to management decisions which consider more than merely their bottom line.

Not all organisations have the same capacity to move New Zealand towards a greener future as low-emitting tech companies have, but all of us can do a little bit better.

Collectively, that makes a large difference. All these steps will help accelerate New Zealand and the world towards a greener future.

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