Since 2002 BNP Paribas Asset Management (BNPP AM) has run various ESG equity strategies. The new Environmental Absolute Return Thematic Equity (EARTH) UCITS fund launched in July 2020 is not an ESG fund per se, though the ‘E’ [environmental] element of ESG guides its top down thematic thinking and bottom up stock selection. “This is a returns first environmental solutions fund, focused on existential threats to our environment, but also looking for business opportunities, cash flows, growing technologies and margin expansion,” explains co-portfolio manager, Edward Lees.
Our primary focus is backing interesting new companies on solutions, not making big speculative bets on the decline of fossil fuels.
Edward Lees, Co-Portfolio Manager, BNP Paribas EARTH
Lees and co-portfolio manager, Ulrik Fugmann, believe that new technologies including batteries and fuel cell applications are at inflection points both in terms of scientific breakthroughs and commercial viability, while flourishing technologies such as renewable wind energy offer a multi-decade trajectory of double-digit growth that is hard to find in other industries.
Why not simply invest on a long only basis? The pair do run a long only fund with a somewhat narrower mandate that still looks at more than 1,000 companies globally, focused on energy transition, but they have chosen a high conviction, substantially market neutral approach for environmental solutions. The strategy will hold 25-45 names with latitude to range between 20% net long or short, and gross exposure capped at 200%. There are several reasons why they favour a long/short approach.
“There will be big divergences between the disruptors and the disrupted, which may lie in less green – or even brown sectors,” says Lees. EARTH could short companies losing out from disruption that may be forced to make write downs, and could ultimately end up owning stranded assets. EARTH has the freedom to short stocks that are excluded from the long universe for many BNPP AM mandates.
This would not necessarily result in the most obvious short book trades however. The managers expect fossil fuels to see price pressure and eventually get phased out, but they are not necessarily inclined to short thermal coal or oilsands companies in July 2020, as although they expect the long-term downward trend to continue, energy prices could be subject to temporary short-term recoveries. “This trade has been around for a long time and to a large degree has played out. Our primary focus is backing interesting new companies on solutions, not making big speculative bets on the decline of fossil fuels. We would rather find a company pivoting into new growth areas, and pair it against a short in one that is not changing its business model,” says Lees.
“An exclusive saints versus sinners approach would not only introduce a huge amount of sector and factor risk, but also overlooks another important trade type: owning companies that are transitioning their business model,” says Fugmann. Though the fund does produce a quarterly report including footprints for carbon emissions, waste and water and positive impact thereof, the belief in transition explains why they retain some flexibility on individual long holdings’ greenhouse gas/carbon footprint/implied temperature rise metrics, with no requirement for any individual position to be aligned with the Paris Agreement target of a well below two degree world (although there are constraints on a portfolio basis). “We do not want to impose artificial labels on the investment process,” says Lees. “Naturally, many companies greening the atmosphere, such as wind, solar, hydrogen and battery companies have palpably low carbon footprints, though there are also good opportunities in the mid-range of carbon emissions. We will get large marginal changes from some companies that have reasonably high carbon footprints, but which are reducing them in the future, such as cement or steel companies using hydrogen as an energy source”. Greenhouse gases, carbon and climate are anyway only part of EARTH’s environmental metrics; the circular economy of recycling is another one, which can point the portfolio towards firms such as steel companies using recycled scrap.
Pairing such firms against sector peers that are greening their business models more slowly – or not at all – can create a “green stub”: isolating the green change in a business model, while mitigating sector and factor risk. Hedge funds traditionally constructed “stubs” by using holding companies or parent companies trading at discounts to their constituents or subsidiaries, but the same concept applies here between unaffiliated firms. Lees envisages those with more environmentally aware business models could see their valuations expand, while the laggards will suffer multiple compression. In these pair trades, longs are likely to derive more of their revenues, capital spending or EBITDA from environmental solutions than shorts.
Where single name counterparts cannot be found for a pairs trade, the optimal hedge basket can be carefully constructed to hedge out market, sector, style or other factor risk using indices or ETFs.
EARTH can also construct pair trades within green industries. Green growth sectors can sometimes run into overcapacity, as happened with solar power generation a few years ago. “China brought onstream a huge supply of low-cost photovoltaic capacity, which led to a collapse in its price. A long/short approach allows for picking winners and shorting losers within growth sectors. We can winnow the herd of hangers-on taking productive capital away from the champions,” says Lees. Similarly, within a sub-sector such as wind power generation, dispersion creates potential for pitting winners against losers. Some firms make more efficient turbines, and could have stronger order books and more robust business models due to more recurring revenues from servicing.
Another reason why Lees and Fugmann opt for a long/short approach is that it builds on their prior investing careers. “We worked together at Goldman Sachs, in the early 2000s, including at the GSPS (Goldman Sachs Principal Strategies) internal hedge fund, which did a lot in energy and natural resources. We also invested in private equity and venture capital. Natural resources, including green and brown sectors, formed the basis for our North Shore Partners strategy that was brought into Duet in 2015,” says Lees.
Lees originally worked in investment banking for Morgan Stanley and also had a spell working for a biotech long/short strategy, Clear River Capital, which had a long bias ahead of the 2011 market correction. EARTH in comparison will be fairly market neutral. Lees and Fugmann partnered with BNPP AM to roll out the strategy they had been developing since setting up a firm called Sustainable Solutions in 2017, after they left Duet. EARTH has a broad base of capital from three sources: a minority share of internal proprietary capital, affiliated discretionary client capital, and external clients.
EARTH reflects BNPP AM’s steadfast commitment to ESG. “BNPP AM is one of the most credible SRI investors in Europe, with a 25-person sustainability team. BNPP AM is engaged on the regulatory front as part of the steering committee on the EU taxonomy,” says Fugmann. BNPP AM’s long standing ESG commitment began with establishing an ESG team in 2002; moved on with being a founder signatory of the UN PRI in 2006, and the firm is now involved with more than 40 initiatives, including PRI, IIGC, TCFD and TEG. The managers are part of the ongoing development of ESG at BNPP AM, having sat on the committee for the latest overhaul of BNPP AM’s own ESG scoring system, though as mentioned earlier, they are pinpointing the ‘E, and do not necessarily require the highest overall ESG scores for their portfolio companies.
BNPP AM has well organized engagement and proxy voting routines. Lees and Fugmann talk directly to companies as they have long-standing corporate relationships, and will actively engage with both long and short portfolio companies when necessary, but voting is coordinated through the Sustainability Centre.
EARTH can also draw upon BNPP AM’s strong pedigree in quantitative development, regional equity teams across the globe, and the internal macro group.
The strategy will hold 25-45 names with latitude to range between 20% net long or short, and gross exposure capped at 200%.
The first strategy that Lees and Fugmann started managing at BNPP AM in September 2019 is a long only energy transition fund, which was up 61.37% YTD (as at the end of August 2020) and has outperformed its reference benchmark by 72.38% since September 2019. This has some degree of overlap with EARTH’s long book, since energy transition is also among EARTH’s themes. “But EARTH could have different holdings in this sleeve for reasons including time horizons, volatility tolerance and hedging. The liquidity criteria for the two funds are on balance similar as they are both daily UCITS: while EARTH’s five-day notice period for daily dealing might provide more flexibility on the liquidity side, it is also likely to be trading more actively to control volatility,” explains Lees.
Beyond energy transition, EARTH addresses a range of other sub-themes, including: the circular economy, plastic, oceans, water, alternative protein and sustainable forestry. “The ecosystem needs to consider trees, oceans, rivers and land as well as carbon,” points out Lees.
EARTH’s big picture guiding stars are addressing population growth by two billion growing to nine billion by 2035 and associated urbanisation; the need to reduce carbon emissions from over 33 trillion gigatonnes in 2018 to below 10 trillion by 2050, and the growing resource intensity of energy, food and water, which may rise by 35-50% by 2035.
EARTH’s various aims can, to some extent, be mapped onto one or more of eight of the 17 UN Sustainable Development Goals (numbers 2, 6, 7, 9, 11, 12, 13, 15). “However, digging deeper into the 17 SDGs reveals that they have 169 more precisely defined goals, targets and indicators, and we are of the opinion that most of these can only be attained through public policy. For each of the eight relevant SDGs, we estimate that only two or three of the targets and indicators can realistically be targeted through investment in public equity markets, based on a granular analysis of companies’ green or potentially green revenues. This adds up to around 20 or so of the 169 criteria,” Lees points out. “We do not lead with the SDGs, rather addressing some aspects of the SDGs is a by product of making good decisions towards our objectives,” he adds.
EARTH’s investment universe can also be estimated as 1,700 public companies spanning four broad sectors – energy, materials, agriculture and industrials, but again traditional industry breakdowns are not so helpful, because EARTH is focused on 24 specific sub-sectors. For instance, within energy, EARTH looks at renewable and transitional energy generation, equipment, production and distribution including for wind and solar energy, biofuels, fuel cells and batteries, with the tech sector increasingly involved in our space. “Our objectives of environmental solutions including decarbonization, digitization, decentralization and detoxification, cross over the classic sector classification. We are finding potential companies in green buildings, plastic, waste disposal, recycling, farming, sustainable forestry, water conservation and looking at contamination of land, air and water,” says Lees. He keeps an open mind about where to find these sorts of firms, so it is more informative to highlight a selection of themes that are potentially in the portfolio.
Within energy and renewable energy, Lees expects that, “battery technology, fuel cells and hydrogen will eventually advance to allow for dramatically increased penetration of cost-effective storage of renewable energy, addressing the intermittency of solar, wind and hydro power. For the time being, other fuels such as nuclear or natural gas are also needed to provide the guaranteed baseload generation capacity. Therefore, EARTH can invest in utilities that are using some natural gas or limited existing nuclear generation capacity, but it cannot invest in new nuclear capacity”.
Lees is excited about hydrogen fuel cell applications in transport, power and heating. Historically, “grey hydrogen” had the drawback of creating carbon but now there is potential to make hydrogen with low or no carbon footprint. “Hydrogen has been around for decades, but the potential for increasingly cost-effective carbon-free hydrogen is new. One solution here is “blue hydrogen”, using carbon capture. “Green hydrogen” generated from renewable energy via an electroliser holds out potential for a complete cycle of greenness when the electricity is generated from renewable sources. This is initially practical for backup power supplies, trucks and warehouse forklifts, but could soon be used for boats and potentially even planes eventually,” says Lees. “This is being accelerated by European policy,” he adds. Hydrogen straddles both energy and mobility, where EARTH has also looked at scope for methanol powered engines.
EARTH sees a long runway of growth for various electric vehicle manufacturers – and related ecosystems – to revolutionise transport, though the managers are disciplined about valuations of some firms in the space.
“We see potential for biofuels to play a growing role, but are cognizant of their heavy water use in some situations. We are aware of the controversy around whether biofuels increase food prices, but view this as a second order effect that should not outweigh the investment case,” says Lees.
“Veganism is not the main thrust of the fund, but we view meat and fish through the lens of their environmental impact. Meat is a health burden and a drain on grain and water resources. We are interested in plant-based proteins, algae or insect-based products but are wary of valuations ascribed to some firms in the area. In fish farming, we would seek responsible approaches including floating offshore farms that can bring disease down,” says Lees.
EARTH is concerned about the health risks of GMO farming and advocates organic farming for detoxification benefits. Fugmann argues that, “responsible organic farming can be more efficient and produce higher yields on a sustainable basis without impairing soil quality or using fertilisers that cause problems for river and ocean health. This can also involve more efficient irrigation and water use, through smart watering drones”. This is one example of the exciting scope for agri-tech and modern greenhouse precision agriculture to develop higher produce yields using less land, while eliminating the need for pesticides by creating controlled environments. This could eventually revolutionise how we use land, reduce airborne food travel, create smaller supply chains, and improve our health significantly.
Lees acknowledges that, “the strategy is likely to have some degree of factor tilt towards growth given the underlying investment themes that are still nascent and developing quickly. A few holdings can be pre-profit or even pre-revenue, but the great majority will already have revenues and profits. At the same time, we are finding some compelling value stocks, particularly in Europe, and particularly amongst those transitioning to newer business models”. Some utilities in Europe trade on single digit PE multiples.
Active risk management also helps to rein in some of the glamorous growth stock exposures. Several holdings in the long only fund are up by triple digit percentages for the first half of 2020, but the managers have been top slicing the positions, partly to keep them within target weights, but also to stay within the UCITS diversification criteria.
An exclusive saints versus sinners approach would not only introduce a huge amount of sector and factor risk, but also overlooks another important trade type: owning companies that are transitioning their business model
Ulrik Fugmann, Co-Portfolio Manager, BNP Paribas EARTH
EARTH can forage globally, in all cap sizes in the Americas, Europe and Asia, subject to its liquidity needs, which generally set a minimum market cap at USD 1 billion, although sometimes slightly below, and mean that emerging market exposure is likely to be in the larger countries rather than frontier markets. For instance, “in Asia, we have identified firms in China that are active across multiple verticals, including autos, battery powered bicycles, solar panels, rechargeable batteries and smart grids. These can be leveraged to stated-backed infrastructure plans for grid optimization,” says Lees.
The managers had anticipated a bias towards Europe, but given much of the technology is being developed by US companies their portfolio is weighted towards North America, followed by Europe and then followed by developed Asia.
“The EU is clearly at the forefront of policy action and well ahead of the US Federal government. However, US politicians are taking action at the state and city level, with California being a standout. We expect that a Biden Presidency could be transformational in bringing the US back into the Paris Agreement, amongst other things,” says Fugmann. “Yet whatever the outcome of the US elections, market forces are driving environmental solutions including the adoption of renewables in both Democratic and Republican states. Solar can be cheapest in the South and West, while wind is a very efficient way to generate power in the mid-West. Politically, solar and wind are also important because they now employ far more people than does the coal industry,” says Lees. Globally, the managers are constructive on governments enhancing the growth story for companies providing environmental solutions, with a very recent example being China’s commitment to carbon neutrality by 2060.