The Unexpected Portfolio – a holistic approach to investing for net zero

Many of today’s sustainability focused strategies exclude the companies that will ultimately contribute the most to future CO2 reductions

By any stretch of the imagination, Nippon Steel’s facilities at Wakayama on the western coast of Japan’s Kii Peninsula do not have the appearance of a low carbon-footprint operation.

The sprawling mass of grey buildings, snaking pipes and multiple smokestacks have for decades produced steel from scorching furnaces, a visible reminder of one of the world’s most CO2-emitting industries.

But earlier this year, Nippon Steel, the world’s third-largest steel producer, announced that it was investing heavily in hydrogen research and other cutting-edge technologies as part of an ambitious journey towards achieving net zero emissions by 2050.

“We will take on the challenge of adopting ultra-innovative technologies such as mass production of high-grade steel in electric furnaces, drastic reduction of CO2 emissions…and other developments in hydrogen reduction methods,” the company announced in March. “We will aim to achieve carbon neutrality by taking a multi-aspect approach.”

Many of today’s approaches to investing along sustainable lines and in a low-carbon economy might overlook or even exclude Nippon Steel from consideration on the basis of its historic and present carbon footprint – as well as the fact that it resides in a sector that is generally “unloved” by today’s increasingly carbon-conscious investors.

Yet these approaches often fail to recognise that the greatest positive impact on decarbonisation is destined to come from companies that are currently high emitters and that have the commercial need and financial resources to transition to a much lower level of emissions in the future.

As a result, strategies tend to avoid climate-relevant sectors, resulting in reduced portfolio diversification and increased concentration risk. They also fail to recognise that as the world moves towards, companies aligned to that transition gain new competitive advantages and opportunities to gain market share. In short, they risk missing out on the transition opportunity.

Today, the world currently emits 52bn tons of greenhouse gases every year. To limit global warming, these emissions need to be brought to zero, with CO2 emissions falling to net zero by 2050 or before if the world is to limit global warming to 1.5 °C by the end of the century.

Getting there by 2050 is not enough. To limit global warming as intended, we need to reduce our emissions by half approximately every decade. Reducing our emissions by 50% by 2030 is one of the most significant economic challenges of all time – and it will produce plenty of winners and losers along the way.

But accurately picking the winners from the losers requires a holistic and long-term view of companies. It also requires an understanding of the cost, availability and potential of various technological solutions. Only through access to such detailed roadmaps can we understand what the transition will look like, and which players are likely to come out on top.

Nippon Steel, which has estimated its future investment in hydrogen technology at ¥500bn for research and development, and between ¥4tn-¥5tn investment in facilities, is what we call an “ice cube” – a company that operates in a carbon-intensive sector but whose strategies and commitments may bring it into line with the climate-related objectives set out in the Paris Accord.

These types of companies contrast with ones that we call “burning logs” – companies with high emissions that are likely to continue to be high emitters, contribute disproportionately to global warming, and remain highly exposed to transitional risks. As the transition accelerates, these companies may lose their place to more agile competitors.

Nippon Steel is just one of many ice cubes. Another obvious one is Volkswagen, the German automobile group, which is transitioning quickly into the manufacture of electric vehicles. In the process, it is helping to transform an entire sector that for decades has contributed to global warming via the manufacture of petrol engines.

A less obvious example is LafargeHolcim. Indeed, the world’s biggest cement producer could easily fall into the “excluded” categories of many popular approaches to sustainable investing. The built environment accounts for an estimated 40 per cent of the UK’s total carbon footprint, and it is a similar story in Europe and beyond.

But the Swiss cement and building-aggregates producer has already begun its stated journey down the pathway towards net zero. It has begun exploring greener building materials, carbon-capture technology and fuels derived from waste. By 2030, it expects to inaugurate its first carbon-neutral cement plant. It has pledged to become a net zero economy, working with the Science Based Targets initiative to define what the roadmap to get there will look like. The company is not quite there yet, but is beginning to move in the right direction.

“I will not stop pushing the boundaries on our net-zero journey with rigorous science-based targets,” says Jan Jenisch, the company’s CEO. “We are accelerating circular and low-carbon solutions to lead the way in green construction.”

The corporate winners and losers in the transition to net zero will inevitably come from a wide variety of sectors. But the biggest contributors to future reductions in carbon emissions are transitioning companies that reside in today’s unloved sectors. Understanding the transition trajectory companies are on allows us to identify which players are likely to come out on top – and allows us to help them get there.