Transition investments: A pragmatic approach Polluters today, paragons tomorrow?

Investors who want to know that their assets are contributing to a cleaner, greener, fairer world often build sustainable investment portfolios of companies that have best-in-class social and environmental performance. However, there is another, more surprising way to achieve impact that is often overlooked: by investing in companies that have a heavy footprint today, but that are taking action to lower that footprint and increase their positive impact on people and the planet.

"Compared to traditional sustainable investments, transition investments take a more pragmatic approach towards sustainability. They recognise the need to improve the unsustainable parts of the economy we still need", says Thomas Hassl, Senior Portfolio Manager at LGT Private Banking.

This investment approach includes what is known as "hard-to-abate" companies - those in industries such as oil and gas, aviation, construction, shipping, chemicals, mining and cement and steel production. 

In these sectors, there is no easy fix on the road to decarbonisation. It requires significant capital expenditure on everything from the upgrading of manufacturing facilities to investments in technology and supply chain reorganisation.

Focus on supply chains, not emissions

For this reason, a transition portfolio may also include younger companies and innovative start-ups whose products, services and technologies can provide solutions for the transition of hard-to-abate sectors.

But also, because these transition portfolios support work-in-progress, they can even include companies that add to a portfolio's overall environmental footprint. For example, transition funds could include mining companies. While mining as an activity is quite carbon intensive, it also produces the copper, aluminium and other materials that are essential to the infrastructure needed for the transition to clean energy generation.

"There's no solar or wind power industry without aluminium or copper", explains Hassl. "So those companies can be in a transition portfolio. Yes, they do bump up the baseline emissions and water footprint of the portfolio - but as sophisticated transition investors, we have to look at the supply chain and the companies that are needed to make it happen. We at LGT know that without these companies, the transition is not possible."

Holding these assets also comes with the ability to nudge them in a better direction. "We have an important opportunity as investors to influence companies, for example, engaging with the mining sector to embrace more responsible standards", says Siobhan Archer, Global Stewardship Lead at UK-based LGT Wealth Management.

Similarly, younger companies that are developing innovative products, services or technologies that address social and environmental challenges may not meet the disclosure requirements of a traditional sustainability portfolio, but could be valuable additions to the transition investment mix.

"Of course, they should report on their transition plans and measure their transition. But they don't have - and should not spend - a large amount of money on writing shiny sustainability reports", says Hassl. "But if they have great products that really change the status quo with regard to sustainability, they can be a great addition to a transition portfolio."

In some cases, the companies in a transition portfolio have sustainability benefits that outweigh their operational impact. One example are companies providing paper and forestry products: While their production processes consume large volumes of water, these companies provide renewable materials such as lumber, bamboo, pulp and paper. Forests act natural carbon sinks - absorbing carbon dioxide from the atmosphere - and forestry materials are recyclable, making them part of the circular economy.

Focus on social issues on the rise

Nor is transition finance limited to environmental themes. LGT sees social issues as equally relevant to transition investments, which can include companies promoting the protection of human rights, societal wellbeing (increasing access to clean water, sustainable food and healthcare) and equality, job creation and improvements in living standards - all of which are captured by the UN's 17 Sustainable Development Goals. 

Including social issues in transition portfolios is a forward-looking strategy. "When we at LGT develop investment strategies, we want to futureproof them and make sure we have something that is valid in five years' time", says Malte Stiel, Senior Portfolio Manager for Fixed Income at LGT Private Banking. "The industry is moving, and social topics are becoming more important - so why not include them now?"

Archer agrees. "If you think about even just keeping one person out of labour exploitation in the mining sector, that's a huge opportunity we have as investors", she says. "If firms get their labour and human rights practices right today, it's going to have a really big impact in the coming years."

Avoiding the dreaded greenwashing risk

Of course, while companies are setting out ambitious plans, a key part of building a transition portfolio is verifying that the companies selected are actually doing what they say they are doing to improve their social impact and lower their environmental footprint.

Increasingly, this is something captured in their transition plans. And given the key role of these plans in investment due diligence, regulators are monitoring them closely and issuing guidance on what they should disclose.

For example, the IFRS Foundation, which is behind the International Sustainability Standards Board reporting standards, now hosts the Disclosure Framework and Implementation Guidance for transition plans that was developed by the UK's Transition Plan Taskforce.

Meanwhile, the European Commission's taxonomy data classification system lists the technologies and processes that can be considered sustainable (and transition), offering companies a practical tool to help guide their reporting. European companies must disclose what percentage of operational and capital expenditure goes towards these technologies and processes. 

This creates what the Commission describes as "an important market transparency tool that helps direct investments to activities most needed for the transition to net zero and environmental sustainability."

For Stiel, one of the most important of these indicators is capital expenditure. "A company can say as much as it wants to about how it is protecting the planet", he says. "But if a large share of its capex is going to offshore drilling, you might question its intention."

Importantly, by holding these assets rather than divesting from them, investors can help prevent companies from ending up in the hands of less accountable owners while also using engagement and voting to push them to improve their social and environmental footprint.

With robust diligence practices in place, a transition investment strategy offers another big opportunity: to build a diversified portfolio that is less vulnerable to swings in the policy agenda - something that is increasingly relevant. "From a portfolio perspective, you can get an all-weather portfolio", says Stiel. 

While sustainable investments are already best-in-class, transition finance offers investors a resilient, future-proofed portfolio that can also deliver benefit to wider society by helping companies move faster on their journey towards social and environmental sustainability.