David Smith joins Nick Robinson on the latest episode of the Emerging Market Equities Podcast. Topics include measuring emissions, decarbonising Asia and abrdn’s framework for investing in companies leading the way towards net zero.

The Emerging Market Equities Podcast

Nick: Hello everybody, this is Nick Robinson from abrdn and you're listening to the Emerging Markets Equity podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. So, one of the important debates in sustainable investing is how to deal with companies that are significant emitters of carbon, but are on the pathway to reducing emissions. Some investing styles steer clear of these companies due to the poor headline emissions, whereas other investors see these as giving the greatest opportunity to influence management to reduce their footprint. So today, we're going to talk about climate change, the decarbonisation of companies, and the role that shareholders have in terms of both providing capital and also influencing those owned companies. abrdn has developed a framework for investing in these types of companies. So, we'll have a bit of a discussion in terms of how that works. So today, I'm delighted to be joined by my colleague, David Smith. David is a Senior Investment Director based in Singapore, and has a PhD in corporate governance. So, he's extremely well placed to talk about this, and he also runs our funds, which are aligned with the UN's Sustainable Development Goals. David, thanks for joining today. Welcome back. It's great to have you on. 

David: Thanks, Nick. Good to be here. Good to be back.

Nick: Brilliant. Well, let's start by framing the problem, decarbonising Asia or indeed for world how should we think about a country's need for energy, but also the need for growth and how do we balance those issues? 

David: Yeah, I think this is one of the most important questions as we think about decarbonisation globally and our quest for Paris aligned trajectories. If you think about Asia, the region that I'm in, you see a terrifically exciting region, very attractive economic growth, strong potential, growing populations, all the things that we as investors like, you see relatively low per capita carbon emissions, but on an aggregated basis on a country bases, you see relatively high gross carbon emissions. And so if you look at the top 10, carbon emitting countries or regions around the world, if you take the EU as a block, you see China, India, Indonesia, in the top 10, because gross emissions are a function of per capita individual emissions, and then also the number of people in the country. So, by sheer dint of the size, these countries are very high gross emitters. Now, if you think about what that means, as countries in Asia develop, continue to grow, you expect electricity consumption per capita to grow, you would expect energy consumption per capita to grow. And so you would potentially see very dramatic growth in gross country carbon emissions. And so the challenge is, how do you see Asia grow. How does Asia grow in a sustainable way that doesn't completely blow out carbon emissions on a gross basis. One of the things that you alluded to in your question was how does Asia achieve this in a way that decarbonises that sees power industry transport decarbonise sustainably but also in a way that doesn't impact energy security. So there's quite a difficult needle to thread, but an extremely important needle if the world is to meet decarbonisation targets. Sorry, that's a very long answer. But it's a really important question Nick.

Nick: Yeah, no, that's interesting. So thinking about gross emissions. Is it possible do you think for countries to actually reduce gross emissions despite generating all that economic growth? 

David: It's possible, of course, but it's not going to be easy if you think about where those emissions come from. And so you see countries have, excuse me, very ambitious decarbonisation plans, very ambitious net zero plans, if you think about what we've seen in Asia, countries committing to cutting their emissions. So, the ambition is certainly there. But in terms of the change that's required, it's certainly not going to be an easy task to achieve this in a way that, A meets the energy needs. B meets the social needs, and C does this in a way that doesn't impact energy security. So, it's possible but not easy. 

Nick: Okay, and which countries in Asia do you think are doing a good job on emissions? I mean, one thing that always strikes me as being quite interesting is the government's come out with these targets to go to net zero, but they tend to be several decades in the future when you're presumably the current governments are unlikely to still be in place. So it's quite a tricky target setting exercise. 

David: Yeah, it's a good question. So, you're seeing ambition across the region, as I mentioned, what you see in somewhere like China, for example, is extremely fast transition of the power sector in terms of reducing energy intensity of power consumption, through the increased penetration of renewables. And so China leads the way in terms of annual installations. The same is certainly happening in India, where you're seeing a lot of the gross capacity ads come from renewable electricity, renewable power sources, and so you're seeing positive change in the region. It's just that, on the other hand, economic growth and electricity consumption per capita, continue to increase. 

Nick: Right, and when you think about the role of the various parties that can potentially influence companies to reduce emissions, how do you think about the balance between governments and shareholders and the role of shareholders in this process? 

David: Yeah, this is the interesting trifecta that we've got is companies, governments to include government policy, but also regulators, I suppose, and also shareholders as providers of capital. And so as investors, what you like to see is ambitious government targets towards decarbonisation, sure, but also a steady, stable, predictable regulatory regime that puts incentives in place for companies to decarbonise, and I'm primarily thinking about power companies. But of course, this is true across the broader economy. Where those incentives are, or the regulatory regime is predictable and sustainable. What you don't want is regulators to chop and change their mind, because you're asking power companies to invest in a 20, 25, 30 year, power plants, solar plant for example, or wind plant wind. But if regulations and for example, an ROE regulated  ROE level is reset every 3, 4 or 5 years. And that's not very helpful for long term planning. So, you need governments and regulators to be constructive. But also on the shareholder side, I think this is where we get to the nub of the issue. As investors, we have a responsibility to the companies that we own to steward and engage in a responsible way and to encourage them to decarbonise. I think what we've seen over the last, maybe 5 years, but you could potentially argue over the last 25 years is a move by some parts of the financial industry to decarbonise portfolios. But that's not necessarily been the same as achieving real world decarbonisation. So it's very easy for us to sell a coal fired power plant or to sell a cement producer. And that gets the carbon intensity off of our books, but it doesn't necessarily change anything in the real world. And so it's our responsibility as stewards of capital and stewards of these companies, to engage with these companies and for encourage them to decarbonise. Now, there's a couple of components here, A this is how we achieve real world change. But B if you think about some of the pricing discriminations in Asia, certainly that we see, you're starting to see a big dichotomy in terms of pricing between high carbon and low carbon companies in the same sector. And that could be power that could be cement. And so you're starting to see the market discriminate in terms of valuations. And so as investors what is interesting is A the ability to achieve decarbonisation in the real world, but also B through that sustained engagement, and patient and constructive engagement to see returns as companies potentially rerate or rerated by the market as they continue that journey from high carbon to low carbon or what you could sort of more clearly put as brown to green. So, I think there's a really interesting opportunity there. I think the risk is, or the challenge is that this is hard work. It requires a lot of knowledge, technical knowledge in terms of the industries and companies that we're investing in. It requires patience and it requires a whole of organisation effort in order to steward these companies and I fear that in some cases for some parts of the industry that can be simply put under the too hard bucket, but I think that's where the opportunity is for investors like us. 

Nick: Okay, so that's interesting. So, this kind of brings us into your how you think about investing in those high emitter companies. You know, what's the risk that you in, if you find a company that is a higher emitter management tell you a good story in terms of how they're likely to reduce emissions going forwards, you invest effectively lower their cost of capital through that making that investment but then nothing happens. I mean, how do you guard against that as a risk? 

David: Yeah, you're right. There's, there's two, there's two big risks here that we are seeing and we'll see and continue to evolve over the next few years. On the one hand, it's companies that tell a nice story and show the market a nice story about decarbonisation. And that includes lots of nice charts, but charts with no numbers on. And the risk is that for investors, who are not scrutinising those claims, and who are not holding management's feet to the fire, you can end up investing in a company where that commitment may not really be there, or where actions may not follow through that commitment. And so you think you're investing in a company that will transition from brown to green, but actually that, the pace of that transition is nowhere near as fast as you would like it to be for whatever reason we can get into that. On the other hand, I think the risk is that we've seen allegations of greenwashing, I think the next risk in the industry, or certainly one of the risks in the industry, is what we might call transition washing. And that's where investors say they're engaging with a company and say they continue to own the company for this transition. But in reality, there's not the level of active and informed engagement that you might want there to be it potentially boils down to sort of one letter a year to the company, with the provider of capital, saying, yes, we continue to engage with the company as they transition. And so there's, there's two risks there. And so again, you've got this very big challenge about how do you decarbonise companies, as well as the country as well as your portfolio. But also, how do you do so in a disciplined way to make sure that you're doing what you say you're doing and that companies are really doing, what they say that they're doing, and that we can all evidence to our stakeholders that we are making progress. 

Nick: Right, so probably requires to have quite a good relationship with the company as well, is that an important factor and you're being local in terms of close to the companies we invest in? 

David: Yeah, I think that is important. I think, like all engagement, patience is important, tenacity is important, being constructive is important. And being on the ground and close to companies is super important. I think there's a few things here. It's important as investors to be close to the companies as possible to understand that local context to understand the dynamics locally to understand the regulations locally, to be able to meet management regularly, effectively to be there. On the other hand, I think what's also quite interesting, and certainly what I found beneficial as an analyst sitting in this region, is the ability to say, or to have that dialogue with a company and say, what are you doing about x. What are you doing about y. But then be able to say, well, have you thought about x, and have you thought about why. Because we own a company in India, or Australia or Japan or Singapore, where they've tried this, and it's proven to be quite successful. And so you can talk about what's happening elsewhere. So yes, being on the ground is important. But yes, also that ability to tap into a regional or even a global network of colleagues, as you engage with companies and say, you know, this has worked in this market maybe that's something we can think about. And maybe it's helpful, maybe it's not, but I think it's certainly better than sitting behind a desk, 10,000 miles away and pinging off an email once every six months. 

Nick: Right, and have you got a sense that, you know, to some management teams really get it now in terms of the ability to raise their stock price through lowering emissions? Or is that something that still have a bit patchy, depending on which companies you're talking to?

David: I think it's mixed. But I think you're starting to see a greater awareness, as I mentioned earlier, Asia’s probably at the beginning of pricing and valuation discrimination between brown and green, so you see more attractive, or should I say better valuations for green companies, lower carbon companies, whether that's companies involved in power generation, whether it's companies involved in cement or any other heavy industry. So, I think management teams are starting to recognise this, I think, on the other side of that coin. So there's a recognition that this is going to be jolly hard work. This is not something that you can achieve in the next sort of 1 to 2 years, in a sense that certainly lends itself to this region, given the dominance of families or other long term owners that own companies. I think what's important is that as shareholders, we are constructive and encouraging to say, yes, this is going to be hard work, yes, this is going to require significant CapEx. And we encourage you to undertake that CapEx knowing that there's a beneficial payoff, even if in the short term, maybe we don't get to double our dividend every year, as responsible shareholders, we should be there having that constructive discussion with management. 

Nick: Yeah, okay. The framework that you've developed for investing in these types of companies, how do you think about that in the context of the overall fund that you're running? I assume, we can't have too many of these companies in the fund, because you'd be quite nervous about the overall level of emissions of the fund. Is that fair? Or is it a bit more nuanced than that? 

David: Yeah, that's a good question. I mean, there's several reasons why you wouldn't want to have an over concentration in high carbon companies, whether it's sort of factor risk, for example, but I think what's important to your point around the framework is there on the first hand that there is a framework, there should be a structure that as investors, we say, we want to invest in this higher carbon company, or we want to stay invested in this higher carbon company, we want to be able to assure our clients that when we say that we're investing in a higher carbon company, we really are engaging, we understand transition risk, and we're engaging with the company to manage that transition. I mentioned earlier, this transition, washing risk, and I think that's a big focus of our clients. And so what we did was develop a framework whereby we could evidence how we choose these companies, how we run through a guide, that would determine whether this company is something that we would want to be eligible for this transition allocation that we've got. And so that includes asking, is this a company in a high carbon sector, is it a hard to innovate sector. Does the company have a net zero goal, is there adequate governance of climate change. Does the company recognise the level of CapEx that's required. And so on and so forth. And where you have a series of answers that would suggest that yes, there's a transition risk, Yes, valuations are attractive. Yes, there can be transitioned. But yes, maybe the company would benefit from a much more energised and energetic level of engagement, then that could be something that would be eligible for this allocation. And of course, there's a governance process around how we determine that or how we approve that in the allocation that we've got. So it's not just me unilaterally saying, yes, that's fine. I think the other side of that, is that after we've invested, we should have a very clear plan for our engagement, what do we want to achieve, what kind of milestones do we want to achieve as we progress towards the end state that we want to that we want it to be in. How are we going to engage as it bilaterally. Is it through some kind of collective engagement. Are there other levers that we can use to engage other methods that we can use to engage. And then how often do we revisit this. Are we making enough progress. Should we be doing something different. Do we need to escalate this. Or has the investment or decarbonisation case change sufficiently that this is something that we need to rethink quite seriously. And so there should be a fairly difficult or challenging process for companies to be eligible for this sleeve that I talked about. But there should also be that discipline, after we've invested to say, let's roll up our sleeves and engage. This is what we want to achieve. This is how we're going to engage this. These are the milestones. This is how we track it. So we can evidence to our clients that we really are working very hard on these on these transition companies that we've invested their capital in. 

Nick: Are clients in general coming around to this idea? I mean, it's quite a new part of sustainable investing. I suspect. You know, some of the portfolios I run I know that clients generally get quite nervous about these high headline omissions, and you're quite keen to avoid some of those companies completely. So, you are you seeing now in client conversations, but actually, this is something that more people are buying into? 

David: Yeah, I think we're certainly seeing the sophisticated clients look at this quite intensely now. In part that's because there's the growing recognition that simple divestment from hydrocarbon companies is not going to achieve real world decarbonisation that we want, you can decarbonise your portfolio if you want, but if the weather outside is 45 degrees, it's not done anyone any good. And so when you combine that with the fact that there's a very interesting valuation and returns angle, then you're certainly seeing some of the more sophisticated, some of the leading asset owners globally, really interested in transition, and how you can effect decarbonisation but also secure some of that alpha we hope for the fund. But again, with that comes this focus on structure. How can you evidence this. How can you assure us that you're that you're doing what you say you're doing?.

Nick: Great. How about we finish off with a real life example of an engagement that's brought about a change in company behaviour in terms of emissions and was it good for the company and was it good for the stock price? 

David: Yeah, I think one good example is a company we've been engaging with around decarbonisation strategy around the way the company can decarbonise. And I think that company has been on a tremendous journey over the last 5 and 10 years about setting a green strategy setting targets for net zero. And through that we've seen quite ambitious targets, we've seen quite decisive action as the company's built up its clean energy portfolio, and I think over time the market has rewarded that and so if you look at the share chart, then obviously that's been a very interesting company to own for us over the last 3 to five years. 

Nick: Okay, great. Well, I think that's probably a good place to draw the podcast or close. So thanks very much to David for joining today. 

David: Thanks Nick, been good to be here. 

Nick: Great, and thanks to everyone who took the time today to listen in. If you enjoyed it, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for the next episode, and tune in.
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