By Hamlin Lovell, NordicInvestor
NordicInvestor interviewed Melanie Brooks, Portfolio Manager and Head of ESG at Fondsfinans Kapitalforvaltning in Oslo, who was previously Head of ESG Risk Monitoring at Norges Bank Investment Management (NBIM), the Norwegian Oil Fund. She has moved from the world’s largest shareholder to a boutique in order to have more hands-on involvement in picking stocks and even placing trades. At NBIM her ESG team supported portfolio managers but now she has both ESG and portfolio management responsibilities.
Fondsfinans runs actively managed equity and fixed income funds in the Nordics, and thematic equity strategies within healthcare and renewable energy globally. Given such a diversification the asset manager sees the need to tailor its ESG policies to companies, industries, asset classes, and countries. For instance, in terms of the evolving EU sustainable finance framework, nearly all of its equity funds – which pursue active ownership, ESG risk analysis and best in class approaches – will make disclosures under SFDR Article 8. The global renewable energy strategy that Brooks runs has a clear focus on companies enabling the clean energy transition and will report under SFDR’s Article9. However, some of Fondsfinans’s fixed income funds, which are exposed to often smaller and unlisted companies, including within energy and oil services, will make disclosures under SFDR Article 6. “While these funds have an active approach to ESG risk integration, we think it is hard to say that individual issuers with high exposure to fossil fuels for example can be seen as ”promoting” sustainability in line with EU definitions,” says Brooks. “Another challenge is the lack of relevant data being reported by smaller and unlisted issuers that make reporting in alignment with Article 8 nearly impossible for such investments right now,” she adds.
On the topic of regulation, Brooks, an American who has recently become a dual citizen of Norway, says “while in Europe we are all concerned with the EU regulation governing sustainability for companies and investors, in the US it is often state-level rules and targets that can be more relevant than federal regulation”.
E, S and G
Yet some common ESG investment policies do apply across countries and asset classes. For the G, good corporate governance, including consistent quality management and communication with capital markets are sought, though the styles of these will vary between and within markets. Climate risk is the key ‘E’ environmental metric, though the approach to it can vary between asset classes. “For equity investments one is inherently more long-term and looking at strategies to transition and grow in a low-carbon economy, whereas in fixed income investments, one question is whether yields are high enough to compensate for the climate transition risks,” says Brooks. Social analysis also varies between countries. “In the Nordic region, companies’ social performance in terms of board, management and employee diversity is often more advanced than in other countries, as are human capital investments, so the focus may shift to topics such as consumer rights and protection and data security. In resource extraction globally, issues around human rights, labour rights and forced labour can be relevant not only for miners but also other firms that use resources in their supply chain. For instance, I have recently been discussing with companies in my portfolio to ascertain if their supply chain includes a region that is associated with forced labour and what they’re doing to ensure sustainable supply chains more broadly,” says Brooks.
Supply chain analysis could lead to exclusions, which otherwise focus on fairly typical areas. “Having worked for NBIM for 5 years, we use NBIM’s published exclusion list as a starting point. We also exclude liquor producers and are cautious about investing in companies producing beer and wine, based on research showing that most revenues come from problem drinkers rather than healthy drinkers. We additionally avoid gambling based on a risk perspective”.
Internal and external ESG analysis for asset managers and companies
The ESG process also needs to be tailored to individual companies because external ESG ratings agencies, and some widely used ESG benchmarks, may have little or no coverage of smaller companies, especially in emerging markets. “The coverage and scoring methodology of ESG ratings and benchmarks can be biased to larger companies in developed markets that make more disclosures,” says Brooks. There could also be a bias to richly valued “growth” names in some benchmarks, but Brooks says “you can find value companies if you try”. It is important to combine in house analysis and external data. “We have access to external data on climate, water, diversity and other metrics from providers such as Morningstar, Sustainalytics, Bloomberg and Refinitiv, but this needs to be complemented with internal analysis, especially for smaller and unlisted companies,” says Brooks.
One variable in weighting ESG scores is companies’ internal ESG practices versus external ESG impact. “Some small entrepreneurial companies run by a few founders might not have enough staff to demonstrate diversity, but their products and services could have a hugely positive impact on the environment,” says Brooks. Another angle on internal versus external corporate ESG is splitting carbon footprints between companies’ own activities and their customers’ activities. “Some firms producing heavy equipment, such as wind turbine manufacturers, naturally have a hefty carbon footprint internally, but the end use of their products clearly reduces emissions,” says Brooks. Of course, these “scope 3” emissions cannot always be precisely measured, but this is one situation where Brooks deems that it is reasonable to make estimates based on the type of technology.
Decarbonisation targets and routes
While committed to climate-smart investing and encouraging portfolio companies to develop net-zero targets and strategies, Fondsfinans doesn’t currently emphasise net zero targets for its portfolios’ carbon emissions, for several reasons. “Net-zero for several industries depends on future technology that is not yet commercial. We would rather focus on what is credible today and evaluate and engage on management commitment and strategies, than tick boxes for emissions targets. Decarbonisation targets need to be tailored to sectors and regions and real-world impact matters more. It is easy to reduce a portfolio carbon footprint on paper by adjusting exposures based on calculations of current emissions, but more important to have impact by reducing it on the ground in the real economy,” explains Brooks.
And there is no one size fits all for long term decarbonisation targets. “The Science Based Targets Initiative (SBTI) is a great initiative, but it also has a long waiting list and has increased its fees, which may be prohibitive for smaller companies. We encourage companies to look to SBTI, CDP and others to ensure that their methodologies for setting emissions reduction targets are sound, even if they can’t get targets formally validated right away. You have to start somewhere, and we are talking to our portfolio companies about this,” says Brooks.
The renewables universe
At NBIM, Brooks monitored 9,000 companies but now focuses on a smaller universe for her renewables strategy: around 200 companies are on a watchlist with 70 followed more closely. ”Renewables is broadly defined across the whole value chain, from production to transmission, distribution, and storage. This includes OEMs for wind and solar production, renewable generation, utilities, inverters, chips, the grid and battery storage over the full life cycle. In general, we see that renewables can be broken down into short, medium and long term solutions. While we are forward-looking in terms of wanting to find companies and technologies that will help reach net-zero in 2050, we try to limit technology risk and execution risk by focusing primarily on more established companies and mature technologies to reduce emissions. There is an opening for smaller companies with more emerging or niche technologies, but these will get a smaller allocation in the portfolio due to elevated risk,” says Brooks.
As a result of these considerations, the portfolio could include companies ranging from Italian utility Enel building out renewables in developed and emerging markets; microinverter and solar battery maker Enphase; solar panel manufacturer First Solar in the US, and Finnish firm Kempower, which is building interesting DC chargers for EVs.
Short term
It will take time to transition from ICE to EV cars and trucks, and some parts of the transportation sector will be prohibitively difficult or costly to electrify, so biofuels are one example of a short-term solution. “Short term, biofuels could be a way to reduce emissions from existing transport infrastructure, even if it does not look as promising over 20 years and there are other risks to consider in relation to biodiversity and food security,” says Brooks.
Medium term
Up until around 2030, EVs, energy efficiency and building out of onshore wind and solar are expected by the International Energy Agency (IEA) and others be the key to reducing emissions with proven, affordable technologies. Brooks does not define nuclear nor gas as renewable, but does see a role for them in providing baseload power to balance out renewables that are currently more intermittent and weather dependent. Batteries should eventually accelerate renewable uptake by allowing for large scale and longer-term storage of renewable power (and distributed solutions could also help). “We are getting closer to large scale, commercially attractive battery storage solutions and see the same long term cost curve as for solar and land-based wind. We also expect to see cost parity between ICE and EV cars. However, near term there are bottlenecks due to the tremendous amount of raw materials needed to support widescale electrification and energy storage. Recycling of batteries could be a source of supply,” points out Brooks. Doing more with less and increasing the energy efficiency of buildings and industry are also low-hanging fruit that will help reduce emissions in the medium term.
Long Term
Brooks has board appointments in Norway including Applied Hydrogen, a start-up focused on developing equipment and services related to green hydrogen in the construction industry. She views hydrogen as a solution for heavy industry, such as construction equipment, trucks, offroad vehicles, trains or ships, where batteries would be too heavy or unable to provide adequate power for certain use cases, or where charging infrastructure is not accessible. Many construction sites still use diesel generators to produce electricity on site for example, so electric construction equipment would not necessarily mean lower emissions if the batteries could not be charged with clean electricity. Green hydrogen also feeds off the growth of renewable electricity generation, as it could also be a by-product of surplus hydroelectricity in Norway or from solar or wind in other markets.
However, Fondsfinans has very little exposure to hydrogen currently. “There are few listed pure-plays in the space, and these tend to be smaller and more volatile. Regulatory support – including EU packages and the proposed Build Back Better programme in the US – could accelerate the progress of hydrogen, but for now Fondsfinans has chosen to focus on on more mature renewable solutions for our global listed equity fund”.
Additionally, though the renewables strategy recommends a seven-year time horizon for investments, Fondsfinans is cautious on unproven companies that may take many years to become profitable. The firm can invest in companies with a market capitalization as low as NOK 1.5 billion (around EUR 200 million), but does insist on a track record of sales, revenues and growth. “We do not want to invest pre-revenue companies and do not need to. There are enough more mature companies that are already positioned or transitioning towards the renewables value chain”.
The early 2022 equity market declines have thrown up good opportunities for stock-picking. “Timing is difficult but important: we aim to invest when there is upside and good potential returns. Recently the market selloff has not distinguished between higher and lower quality companies, and this provides a good opportunity to buy shares in companies we believe in for the longer term,” argues Brooks.
Defining impact and gauging alignment with the EU Taxonomy
Some strategies that have a positive long-term impact could have more short-term volatility. However, Brooks is circumspect about defining her strategy as impact investing per se. “When buying equities on the secondary market, one should be careful about claiming impact because you’re not directly financing any new activities, rather the shares are changing hands from one investor to another. We also have the opportunity to participate in IPOs and capital raises which does directly provide companies with capital to fund their operations and investments,” she says.
Additionally, there is a debate over whether impact investing sacrifices financial returns for impact, and Fondsfinans is seeking the best risk– adjusted returns.
She is also proceeding cautiously on one framework for “impact investing”, alignment with the EU taxonomy: “we are gauging potential eligibility based on revenue breakdowns, while awaiting companies’ official reporting on their alignment of revenues and operating spending. We do not want to use estimated data if we can avoid it. We anticipate that a very high proportion of the renewable fund should be eligible, though we await clarity on some areas, such as how “acceptable harm” is distinguished from “significant harm” in order to meet the DNSH (Do No Significant Harm) criterion”.
EU Energy Security
In addition to the climate imperative spurring the transition to a low-carbon energy system, energy security is also an issue that regulators and investors have become acutely aware of in light of the tragic situation in Ukraine. ‘Europe’s new REPower EU plan aims to reduce imports of natural gas to Europe, increase the deployment of renewables and boost energy efficiency, among other things. This will create tailwinds for companies operating in the renewables universe,’ says Brooks..
