Explore the Thinking behind our investment approach

When it comes to the capital markets, the U.S. markets are the world’s largest and “among the deepest, most liquid and most efficient.”[1] Healthy, transparent markets are critical to ensure that capital flows to support innovation and job creation, which drive a robust economy and underpin individual wealth creation. However, the U.S. has been slow, diplomatically speaking, to create the conditions to ensure that the markets orient capital towards the most important environmental and social challenges of our time. In contrast, the E.U. is moving at a much faster speed. In a recent episode of TheIMPACT TV, Michelle Friedman, Executive Director (ESG/SRI strategist) of MSCI, refers to the E.U.’s Sustainable Finance Disclosure Regulation (SFDR) as the “most ambitious plan we’ve seen in terms of ESG regulation.”[2] SFDR is intended to shift capital towards sustainable opportunities, while mitigating greenwashing at the product and entity levels. According to SFDR, the volume of transparent sustainability data funds will increase, thereby influencing funds and fund families beyond the E.U.’s jurisdiction, while fund families will likely not want to create two levels of disclosure based on geography. We may even see multinationals broadly disclosing according to E.U. guidelines to avoid the onerousness of operating at multiple standards. In addition, financial advisors in the E.U. will be required to ask their clients about their specific sustainability interests as part of determining suitability for investments. While the SEC and other U.S. regulators are getting better educated on ESG, many advisors remain behind the curve on offering sustainable investing to their clients, despite growing client interest.[3] In fact, research institution Cerulli found that advisors “limit ESG investing to their high-net-worth clients…with more than $5 million in investable assets, leaving out the 56% of households with investable assets between $100,000 and $250,000 who said they would rather invest in companies that have a positive social or economic impact.”[3] In the E.U., on the other hand, “ESG really seems to be on track for becoming business as usual” according to Friedman.[2] The G7 Supports TCFD The Task Force on Climate-related Financial Disclosures (TCFD), which only released its recommendations in 2017, has fast gained support from financial services firms and governments. At last week’s G7 meetings in the U.K., finance ministers stated their support for mandatory climate disclosures, using the TCFD framework. This is another signal, ahead of COP26 in November, that climate risk is moving up the geopolitical agenda. Whether disclosure leads to far-reaching changes commensurate with the problem remains a big question, however a globally aligned understanding of the issues should support better international and domestic policy and drive more capital towards solutions and adaptation.

As we reported back in April, climate would be a significant theme in this year’s proxy season. Since then, Exxon now has three new board members nominated by activist hedge fund, Engine No.1 (initially, two board seats were announced but a third is anticipated). BlackRock, historically criticized for a lack of alignment between its outward ESG marketing messages and its proxy votes, supported three of the Engine No.1 nominees, and Vanguard voted for two. In fact, “many of Exxon’s top institutional investors voted in favor of Engine No. 1’s candidates, while retail shareholders tended to favor the company’s nominees.”[1] Proxy advisor, ISS, had recommended that shareholders elect three of the nominees stating that Engine No.1 “made a compelling case that additional board change is needed to provide shareholders with sufficient confidence in the sustainability of (Exxon’s) business.”[2] The proxy fight has cost Exxon and Engine No.1 $35 million and $30 million, respectively, making it one of the most expensive ever. While Exxon is a huge multinational corporation, Engine No.1 is a only six months old and has just $250 million in assets with a holding of just 0.02% in Exxon. Engine No.1’s May presentation regarding its campaign stated that “a lack of successful and transformative energy experience on the Board has left ExxonMobil unprepared and threatens continued long-term value destruction.”[3] It also accused Exxon of refusing to reassess its strategy in light of decarbonization pressures and instead avoiding the subject or dismissing its importance. The economic thesis underpinning the campaign is what helped Engine No.1 achieve this victory. The hedge fund highlighted Exxon’s financial underperformance and made a bet “on a confluence of events, including longstanding investor dissatisfaction with Exxon’s corporate governance and a growing appreciation on Wall Street for G.”[4] Clearly, this is a big development, but it remains to be seen what will unfold at Exxon as a result. However, as Charlie Penner of Engine No.1 stated, “If you can get Exxon to change, everybody else in the industry has to listen…There probably could have been easier targets…. But it’s about getting the most impact…”[5]

The month of May brought us another climate-related executive order, stating it is the administration’s policy “to advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk…including both physical and transition risks.”[1] This latest order specifically directs financial market regulators to assess climate risks, including how they impact the financial stability of the government and the financial system in the United States. Treasury Secretary Janet Yellen, who leads the Financial Stability Oversight Council (FSOC), will convene other agencies, including the SEC, to deliver a report by November. Public and private company disclosures could be impacted by any changes. Climate disclosures and related regulation have been increasing around the world and are seen as critical to improving capital allocation decisions. S&P recently reported that “data shows that the five largest U.S. public banks reduced their exposure to energy and utilities in 2020 compared to 2019. With this latest executive order putting increased emphasis on the financial risks of climate change, we expect this trend away from financing fossil fuels to continue.”[2] So far, so good. However, the New York Times reported that, counter to the pledges, orders, and other talk, this “administration has quietly taken actions this month that will guarantee the drilling and burning of oil and gas for decades to come.”[3] Politics, notably trying to secure support for the infrastructure bill, is unsurprisingly in the mix. A lawyer quoted in the article called the administration’s actions, “carbon bombs.” A low carbon transition is hardly an easy project. And, as we asked earlier this month, until a carbon price is in place, how effective can theses orders really be? ESG at the DOL Another part of the executive order explicitly asks the Department of Labor (DOL) to “suspend, revise, or rescind” the Trump administration rule that constrained ESG under ERISA. One of the options is the proposed bill, The Financial Factors in Selecting Retirement Plan Investment Act, which has been endorsed by Morningstar, US SIF, State Street Global Advisors, and the CFA Institute, among others. Jon Hale of Morningstar explains how the bill would amend ERISA in this recent article. Given the potential valuation impacts of increased climate-related disclosures, the opportunity for individuals to use ESG and climate-aware products in their retirement savings is a welcome development.

At the Earth Day summit, President Biden announced that, by 2030, the U.S. will cut greenhouse gas emissions by at least 50% from 2005 levels and will double climate-related financial aid to developing countries by 2024. Both proclamations bring the U.S. back onto the road towards meeting the ambitions of the Paris Agreement. However, lofty goals bring challenges and trade-offs, one being profound changes to the mix of energy sources in the U.S., and another being how we use land. Taking data from Princeton University’s Net-Zero America Project, a Bloomberg article stated that, “no matter how you slice it, the U.S. will need to rethink land use for an emissions-free future.”1 The current energy footprint of the U.S. is “about the size of Iowa and Missouri combined, covering roughly 4% of the contiguous U.S. states”.1 A low-carbon transition would require significantly more land to house solar and wind, even when considering offshore wind farms and rooftop solar. Additional land-use challenges will come from building the transmission infrastructure needed to connect renewable energy with end-users. The Net-Zero America Project has created pathways to illustrate what the transition to a carbon-free U.S. could look like from now to 2050. The pathway that uses the least amount of land increases dependence on nuclear energy and natural gas plants that use carbon capture technology. Neither of these options come without controversy. The same Bloomberg article notes that, “expanding nuclear power will present serious land-use challenges. While no one wants a power plant in their backyard, many people don’t want nuclear power on their planet.”1 Wind power, the pathway with the greatest additional land-use, would quadruple the current energy footprint, with the potential for wind farms to cover an additional 250 million acres. Land-use challenges aside, some stakeholders question whether the U.S. goals are realizable without a carbon price in place to provide a key market incentive. Last September, the Commodity Futures Trading Commission (CFTC) became the first U.S. regulator to call for a carbon price, describing it as the “single most important step to manage climate risk and drive the appropriate allocation of capital.2 More recently, the American Petroleum Institute professed its support for such a mechanism in its newly published Climate Action Framework. John Kerry, Special Presidential Envoy for Climate, stated in a briefing in India that, “President Biden believes that at some point in time we need to find out a way to have a price on carbon that’s effective. He hasn’t decided or made an announcement about it, but we all know that one of the most effective ways to reduce emissions is putting a price on carbon.”3 In the meantime, other jurisdictions are ramping up their carbon trading activities. The EU will expand its Emissions Trading Scheme and China will establish a national one for the first time. Global commodities traders and financial institutions are predicting carbon prices could rise to $100 per ton in the nearer term, a price that would be highly disruptive to multiple sectors and regions. As you would expect, new carbon-related investment instruments and strategies are coming to market as we are now “entering a period of expected future scarcity.”4 NET ZERO ASSET MANAGERS Climate commitments are proliferating across the financial services industry. The Net Zero Asset Managers Initiative, launched last December, has already attracted 87 signatories representing $37 trillion in assets under management. Managers signing up commit to “help deliver the goals of the Paris Agreement and ensure a just transition.”5 We are proud to work with several of the managers listed: Allianz Global Investors, Boston Common, Calvert, DWS, Sage, Vert Asset Management, and Wellington Management. Check out the full list and the commitments here.

This Earth Day we’re encouraged by the proliferating commitments from financial services firms, regulators, policy makers, and corporations, in support of protecting and valuing the climate and natural ecosystems. Although there is much to be done, including greenwashing to discern, an increasingly bright spotlight is shining on climate, which illuminates interrelated environmental and social issues. One of those issues is the management and protection of natural capital resources, which is the focus of this email and a key theme in our upcoming RIA Channel ESG Playbook iSummit on May 12th from 12:00 – 2:00 PM US ET CORPORATE NATURAL CAPITAL MANAGEMENT In March, BlackRock released Our Approach to Engagement on Natural Capital, noting the connectivity between natural capital and climate, with a particular focus on biodiversity, deforestation, and freshwater and oceans. The report stated that “heightened awareness of the economic and social impacts of unsustainable natural capital depletion could accelerate policy actions that either introduce or increase taxes on the externalities from which companies currently benefit. This has the potential to significantly impact the economic viability of some business models.”1 BlackRock underlines the need to appreciate critical social aspects. Beyond supporting food systems and livelihoods, biodiversity, for example, is “an integral part of religious, cultural, and national identities throughout society, and provide[s] sources of recreation, knowledge, and inspiration.”1 Companies should therefore see natural capital within this broader lens and focus on their impact on communities in addition to disclosing their reliance on natural capital. These topics are gaining more priority from a standards and frameworks perspective. The Taskforce on Nature-Related Financial Disclosures (TNFD), which emerged from discussions at the January 2019 World Economic Forum (WEF), aims to leverage the structure of the Taskforce on Climate-related Financial Disclosure (TCFD) and emulate its rapid path to industry acceptance. TNFD expects to deliver a reporting framework in 2023 which will guide “corporates and financial institutions to assess, manage, and report on their dependencies and impacts on nature, aiding in the appraisal of nature-related risk and the redirection of global financial flows away from nature-negative outcomes and towards nature-positive outcomes.” As with TCFD, “[i]t is expected that complying with the recommendations of the TNFD will initially be voluntary for financial institutions and corporates. Over time, mandatory disclosure requirements are expected.”2

New York University School of Law recently conducted an expert survey on the economics of climate change. Out of 738 PhD-level economists responding, 74% agreed that “immediate and drastic action is necessary.” Respondents estimated that “economic damages from climate change will reach $1.7 trillion per year by 2025, and roughly $30 trillion per year (5% of projected GDP) by 2075 if the current warming trend continues.”1 Mitigating and adapting to climate change requires multiple interventions across multiple sectors, which is why the $2 trillion infrastructure plan announced last week by President Biden is an interesting read. The White House release states that “domestic investment as a share of the economy has fallen by more than 40 percent since the 1960s” leaving the U.S. 13th in the world when it comes to the “overall quality of our infrastructure.”2 Even with rapid decarbonization, near-term physical climate risk will further challenge crumbling infrastructure. The White House notes that, in 2020, “the United States faced 22 extreme weather and climate-related disaster events with losses exceeding $1 billion each – a cumulative price tag of nearly $100 billion.”2 In addition to fixing and improving transportation systems, among many other measures, the plan seeks investment to increase the resilience of low-income communities likely to be impacted by physical climate risks, improve access to high-speed broadband, and upgrade and retrofit buildings, including schools, for energy efficiency and air quality, alongside various measures that seek to address “long-standing and persistent racial injustice.”2 The plan also calls for funding to “establish the United States as a leader in climate science, innovation, and R&D,” listing key priorities as “utility-scale energy storage, carbon capture and storage, hydrogen, advanced nuclear, rare earth element separations, floating offshore wind, biofuel/bioproducts, quantum computing, and electric vehicles, as well as strengthening U.S. technological leadership in these areas in global markets.” Funding for innovation is critical if we are to achieve the “immediate and drastic action” expert economists recommend.2