Defining our approach to achieving net zero

For institutional investors only. Newton Investment Management Ltd. (NIM), together with Newton Investment Management North America LLC (NIMNA) form the Newton Investment Management Group (Newton or Newton Investment Management). Please read the important disclosure at the end of the document.

As responsible investors and long-term advocates of the Paris Climate Agreement, we want to ensure that the transition plans of the entities whose securities we invest in on behalf of our clients are not just scientifically sound, but that they can be capitalized, and that there are strong leadership teams in place to deliver on long-term plans.

With this in mind, we have aligned ourselves with the Science Based Targets initiative approach, which involves a commitment to aim for an interim target of 50% of the financed emissions from the investments we make on behalf of our clients to be covered by credible transition plans by 2030, and 100% to be covered by 2040. , This will be complemented by a suite of other measures around absolute and intensity-based emissions, alongside engagement and voting data. As we seek to invest and engage with companies that we believe are demonstrating a genuine commitment to real-world decarbonization, we believe it makes sense to reject the idea of a linear reduction target, as we anticipate that the path to net zero will be uneven and anything but linear.

There will inevitably be a few ‘bumps in the road'. The conflict in Ukraine has shown starkly how near-term fossil-fuel consumption is likely to rise as countries scramble to wean themselves off Russian oil and gas, and the drive for energy self-sufficiency among many Western nations is likely to cause near-term spikes in the extraction of fossil fuels, which may temporarily reward some of the heaviest carbon emitters.

We are very conscious of the need to balance energy security and affordable energy pricing with exploration in low-cost, low-emission energy sources, while keeping an eye firmly on the broader systemic issue of climate change. The phrase that the stone age didn’t end because of a lack of stones is very relevant. For us, the key is to enable substitution from fossil-fuel related products through sensible government policy that creates the right economic conditions for a transition in markets.

There has been an emphasis on achieving an annual emissions reduction of about 7% per annum for the next decade if we are to stay within 1.5 degrees of warming. Our view is that such a linear approach runs the risk of oversimplifying the issue while not effectively addressing the urgent problem at the core. Indeed, we may have clients asking for such an approach, but we believe such targets could be artificially attained with relatively little effort and negligible meaningful progress towards net-zero emissions. For example, by increasing exposure to energy companies seeking increased exposure to the clean energy sector, one might see an approximate average increase in carbon intensity of 9% on a weighted MSCI basis, while simply divesting from emerging markets could produce a 5% reduction in carbon intensity, but, as we discussed earlier, emerging markets are where the most urgent need and biggest funding gap to achieving a successful energy transition lies.

We see other complications with the linear approach, which stem from the way in which emissions are classified. For example, the lack of consistent Scope 3 disclosures makes it difficult to implement a 7% reduction meaningfully, and the reality is that it remains highly unlikely that global carbon emissions will drop over the next several years, which for us, makes the 7% reduction issue a non-starter. We believe the more important question is how one is achieving an actual physical carbon reduction within a portfolio of financed emissions; decarbonization needs to take place in the real economy, rather than via a more superficial portfolio decarbonization that can easily be obtained by investing more heavily into capital-light business models rather than engaging to help difficult sectors with their transition.

That is not to say that reduction targets are a pointless tool. We may still rely on some carbon- intensity measures to provide a supporting framework of data for our portfolio assessments, but it is crucial to understand the context and realities of carbon-intensity data and how it can change.

As active investors, our approach is centered on engagement with the heavy emitters within our portfolios to help change their practices. For most asset managers, the heavy emitters tend to be focused among a small number of securities, but we must commit to working with them even if they may not be able to pass the interim emission-target plans.

Our focus must also be on investing in affordable and scalable substitutions for oil, rather than simply forcing down the supply of oil, which risks raising prices further and harming near-term climate transition peaks. Because climate change is a systemic risk, it is also crucial to understand that asset managers alone cannot solve the issue. We depend on the right regulation and technology being put in place, and asset managers becoming better aligned. Industry bodies and trade associations must be onside too, and we must involve ourselves with advocacy efforts – not just engage with our investments alone.

We must be brave; first movers may fear that competitors will not follow suit, but companies have to play their part in lobbying governments for the policies required to achieve our targets, and where industry is unwilling, government regulation must step in. From an investment perspective, we know the current environment is one of significant uncertainty for net-zero efforts, with economies still recovering from pandemic lockdowns, the continuing Russia/Ukraine conflict, and capital discipline by heavy emitters providing a good short-to-medium term environment for carbon-intensive securities, albeit with a long-term overhang from potential regulation.

Our advocacy efforts must call for government and industry regulation with genuine ‘teeth’, as voluntary efforts alone are unlikely to be enough to create the level playing field to deal with the complexities of issues such as carbon taxes, border taxes or offsetting green premiums. For us, this is the crucial mechanism by which net zero will be achieved; we believe that voluntary action from consumers and asset owners will struggle to realize the desired outcomes on their own.

At an asset-manager level, we still get a sense that the thorny issues are being broadly dealt with within responsible investment and environmental, social and governance (ESG) team silos, but it needs a more holistic approach across companies, harnessing the risk function and the critical role that investment teams need to play. To create that internal ecosystem to deliver on our net-zero pledges, it requires a standardized and multi-disciplinary approach with ESG teams, analysts, portfolio managers, and senior management all pulling together.

We are facing some very stark realities. Fossil-fuel substitution with cleaner counterparts needs to happen more quickly. Energy security and affordability must be balanced with climate considerations. Crucially, government regulation must be strengthened to correct the market failure to price emissions, which will create the right market considerations to incentivize the transition. These are imperatives.

In the near term, we believe that the Russia/Ukraine conflict will continue to create headwinds on the path to net-zero. We view it as a short-term ‘speed bump’ to the energy transition in that we will see a near-term increased reliance on coal and gas, but over the longer term we see it as an accelerant of the energy transition as a number of countries seek to bring forward their clean-energy transition plans.

While there is a huge amount of jargon used by asset managers, broader business and governments seeking to quantify how to achieve net zero, at a fundamental level climate change represents a series of risks and opportunities for all businesses that must be managed. Burying heads in the sand and using the past as an indicator of the future could not only cause serious damage to our planet, but also result in permanent destruction of capital and the missing out on the opportunities as new industries emerge.

We know there are a concentrated number of stocks that produce most of our financed emissions. We will continue to work closely with them even if they do not achieve initial target-emission reductions. We must also act as advocates to influence the wider system, which includes government and trade bodies, to ensure that the right regulatory framework is put in place.

If we are to succeed in our aim of becoming a truly effective net-zero organization, we will need to harness our active engagement approach and a truly company-wide buy-in to ensure that all our financed emissions have credible transition plans. By setting interim targets towards our end goal, we will be accountable to our clients, via transparent and timely reporting, to mark our progress along the way.

^{1While Newton’s final target of having 100% of its financed emissions covered by credible transition plans by 2040 necessarily implies that all of its global assets under management (AUM) will be committed to net zero emissions by that point, currently 67% of its AUM (as distinct from financed emissions) are subject to the initiative.}

^{2‘Financed emissions’, global assets under management’ or ‘AUM’ refers to the combined assets under management of Newton Investment Management Ltd and Newton Investment Management North America LLC.}

^{3Data derived from stress tests on the weighted average carbon intensity (Scope 1+2 emissions/sales) of the MSCI ACWI index. MSCI ACWI, Newton, March 29, 2022.}