To Meet Net Zero, Prioritize ESG Laggards

On the heels of COP26, investors are not only thinking about the climate-related risks of companies within their portfolios, but they are also considering whether to make new investments or maintain existing investments in high-emitting companies or countries going forward. With the long-term goal of net zero in mind, it may be tempting for investors to focus on capitalizing ESG trailblazers over ESG laggards. But this approach misses out on untapped value and potential in the companies that have room to improve. To capture unrealized value and move toward net zero, investors should continue to invest and prioritize active engagement with ESG laggards on their response to climate change and management of greenhouse gas (GHG) emissions.

Engaging for Net Zero

While engagement has been perceived as primarily the domain of equity investors, fixed income investors can also drive meaningful engagements on ESG risks with bond issuers. Active engagement benefits both the issuer and the bondholder; investors can recognize the companies dedicated to improving ESG metrics and identify those with shortcomings, which may improve issuers’ GHG emissions – and, potentially, their financial performance – over time. (For fixed income investors new to engagement, the UN’s Principles of Responsible Investment offers guidance on ways to structure engagement strategies.)

With this perspective in mind, we engaged a U.S.-based oil and gas producer whose production process included injecting carbon dioxide into the earth. The company has used this expertise to develop direct air carbon-capture technology, which removes carbon dioxide from the atmosphere and produces oil that is either net zero or net negative carbon. By 2040, the company aims to be net zero and expects their carbon management business will overtake their traditional business.

Through this engagement, we learned best practices from an industry leader and will use this information with other producers to contextualize the risks facing the industry. As investors, it will be critical to monitor the progress of these plans, hold the company to account and continue to engage to ensure these plans are executed in the most open and transparent process possible.

Avoiding Punitive Measures

The world is already behind in raising the capital needed for a low-carbon economy. In 2009, developed countries pledged to mobilize $100 billion annually by 2020 to help developing nations adapt to climate change. While final figures are not yet available, the OECD reported that developed countries are expected to miss the mark in 2020, and the goal will likely not be reached until 2023.

To hit emission reduction targets, we must break other bottlenecks in the flow of capital to combat climate change. Denying debt or equity investment to a company or country before it has had the opportunity to set out its plans for the transition to net zero is both punitive and counterproductive. It may also be detrimental to reaching net zero over the long term. Instead, managers can meaningfully fund the transition for companies that demonstrate a realistic and credible commitment to net zero.

Walking away from companies or countries that are behind on managing ESG risk does not solve the problem. It potentially exacerbates it. When a responsible investor sells – or divests – from companies that are low-performing on ESG metrics, this provides an opportunity for an indiscriminate investor to buy the security in their place. Unlike an active investor, this new one may not be committed to actively engaging and influencing change within the company, which can stall the momentum to improve practices and mitigate ESG risks. It is more important than ever for responsible, active investors to stay engaged with countries and companies that perform low on ESG measures because it is not guaranteed that other investors will do the same.

When asset managers finance the transition to net zero, they must also be responsible stewards of their capital. Because not all investors will push for improvement and hold companies to high standards, it is critical for responsible businesses to stay engaged and encourage companies to continue to improve on the path to net zero.

Asset managers have an incredible opportunity to be a catalyst for change within the companies and countries in which they invest. When investors help companies and countries improve on ESG metrics, it is a win-win for both parties. Through active engagement, companies become better prepared and more resilient for the global transition to net zero while asset managers gain a better understanding of the strengths and opportunities within their investments. With these benefits, active ownership is good for the climate and good for business.

William Vaughan is a research analyst at Brandywine Global Investment Management, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Franklin Templeton and our Specialist Investment Managers have certain environmental, sustainability and governance goals (ESG); however, not all strategies are managed to “ESG” oriented objectives.

Past performance is no guarantee of future returns.

About Franklin Templeton

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About Brandywine Global

Brandywine Global Investment Management, LLC ("Brandywine Global") believes in the power of value investing. Acting with conviction and discipline, Brandywine Global looks beyond short-term, conventional thinking to rigorously pursue long-term value. Since 1986, the Firm has provided a range of differentiated fixed income, equity, and alternative solutions to clients worldwide. Brandywine Global, a specialist investment manager of Franklin Resources, Inc., manages $67 billion in assets under management as of December 31, 2021, with headquarters in Philadelphia and offices in Singapore and London. Visit www.brandywineglobal.com and the Firm’s industry-leading Around the Curve blog.