Carbon exposure

Portfolio manager Joe Mares accurately anticipated that decarbonization would move into mainstream consciousness as carbon prices have more than tripled from EUR 20 to 75 and the California price has almost tripled from USD 10 to 30 since the fund started. Some investors have profited from owning carbon emission rights in funds, futures or ETFs as a long only beta play, though it is very volatile, and vulnerable to capricious politics. Some equity long/short funds claim to be carbon neutral – or even negative – based on buying emission rights or offsets at the fund level, and/or shorting higher emitters and subtracting this from their longs. In contrast, Trium ESG Emissions Improvers Fund aims to equalize long and short book carbon footprints, and has only traded a slither of emissions, between 1 and 3% of NAV, as a balancing item. Performance has not been sensitive to the tripling of EU carbon prices in 2021, nor their subsequent halving.

Decarbonization competitive edge

Rather than wagering on carbon prices, Mares views equities through proprietary prisms of emissions analytics: “We are looking for decarbonized economic profit where companies can decarbonize more cheaply than their competitors”. The team monitors marginal abatement costs and associated capital costs amongst a range of sustainability metrics. Mares does not view companies buying offsets as a source of competitive advantage, though there is no aversion to them, and Trium buys offsets at firm level to offset carbon from its flights, electricity and heating.

Short alpha based on E, S and G

Single stock alpha shorts are clearly not the emissions inverse of the long book: “Shorting hugely cash generative coal companies would have been a disaster,” says Mares, who is sincerely committed to short alpha, which exceeded long alpha in 2023.

Some shorts are high emitters, but the strategy can short “green” companies with structural or governance issues, and Mares has a good nose for ethically questionable behaviour: “We look at the entirety of corporate culture. We build a mosaic, which might start with governance or treating workers or local communities badly. Any one of these things is worth a close look and we get very interested when we see multiple ESG issues in many areas, while financials can be another red flag”. Mares has occasionally had shorts that saw a 90% plus share price drop and attracted the attention of activist short sellers, though he does not publicise shorts.

Expanded team of high carbon sector specialists

The strategy only invests in high emitting sectors: energy, resources, materials, utilities, industrials and transport, which account for 90% of European equity market emissions. These are a great canvas for alpha generation since sector dispersion – between top and bottom performers – can be as high as 50% in a year, though the fund seeks a 6-8% spread between longs and shorts.

The team has expanded, adding five sector specialist analysts. Co-portfolio manager and senior analyst, Harry Thomas, covers industrials. Sam Thompson covers chemicals and clean technology, Sargis Asatryan covers basic materials, Matilde Bertoldi covers batteries, solar and auto/EV sectors, and Kate Prakhova covers utilities and renewables. The emissions team, and other Trium managers running macro, merger arbitrage, convertible arbitrage and other strategies, meet every week or two to share ideas. Trium ESG Emissions Improvers Fund has grown assets from USD 25m to USD 500m in June 2024 and is one of three funds managing more than half a billion dollars at Trium, now home to over USD 2 billion.

Growing investment universe

Whereas the total number of publicly listed companies in the US and Europe has been shrinking for years, the fund universe of firms in the six sectors with market caps between USD 1 and 30 billion, has been growing from IPOs and “green” spinouts, including units with energy transition business models.

Mares, who started his career in sell side equity research before buy side roles at GLG, Moore Capital Management and Société Generale, runs a more focused book than some equity market neutral strategies. As of 30 April 2024, the split was: 41 core long positions, 28 core short positions, 30 opportunistic trades – 20 long and 10 short – and 20 index/hedge positions. Some of these positions are baskets/indices, partly to mitigate the high volatility of shorting some single names during a “dash for trash” or “risk on” period. The industries invested in make up about 30% of the S&P 500, and therefore the short book partly uses sector hedges to match the factor exposures and avoid having misaligned short exposure to sectors such as healthcare, technology, financials and consumer, which are not currently traded.

Granular analysis of EU Green Deal and US regulations

It is easy to extrapolate grand and superficially impressive predictions and generalizations from EU or US regulations, but Mares takes a bottom-up approach: “It varies sector by sector and project by project. For some projects like wind farms there are local state issues, but for others federal support overwhelms that. Some areas of Europe have very cheap electricity prices while others have higher and variable prices. Hydrogen steel needs green hydrogen from green electricity. This can work well in some regions with cheap electricity like the north of Sweden but not in other countries. We have also found a fertiliser company that can make green fertiliser from hydrogen, contributing to decarbonization of agriculture. We can identify winners and losers from both the EU Green Deal and a potential Trump presidency”.

Bottom-up analysis for energy transition metals

Mares is somewhat constructive on the outlook for green metals, but commodity price forecasts are only a small part of the jigsaw that needs to include costs, political risks, expropriation risks, valuation and reinvestment of capital. “Over my career I have seen some gold miners go bust after the gold price went up ten times. In any case, there will be efficiency improvements that economize on use of green metals in areas such as electric vehicles,” points out Mares.

Energy transition and stranded assets

Mares is generally not impressed by oil to gas energy transition stories, since geological factors have driven this trend for 25 years before ESG became a thing, and natural gas prices are much lower than oil prices in BTU terms. Similarly, the “stranded assets” narrative that foresees fossil fuels becoming figuratively stranded due to obsolescence caused by electrification is not a good enough reason to short a stock. Near term, Mares looks at “stranded assets” in a much more literal and physical sense: assets that are geographically remote from pipelines, LNG terminals or other infrastructure may just be too expensive to transport to end markets. He is not taking a view on the oil price but expects some high fixed cost assets could be vulnerable: “Petrol stations and some processing assets could eventually become stranded, as well as businesses relying on residual value of ICE cars”.

Selected renewables now in value territory

The actively traded strategy turns over about three times a year and is also conscious of style and factor exposures, in contrast to some thematic clean tech or energy transition funds that can have heavy exposure to “long duration growth” and “unprofitable tech” factors that performed spectacularly in 2020 but disappointed since then. Renewable and clean tech share prices in wind, solar and batteries that commanded 12x EBITDA valuations have derated to perhaps 6-7x, as their capacity and growth runway has gone up, and some are now on palatable valuations: “Even though interest rates are up, and PPAs are up, we are starting to find opportunities. Two years ago we had no exposure to renewables, but now we do,” says Mares.

Why prioritize carbon?

Carbon is the main focus because there is better data, and it is more scalable than other related sustainability objectives. “Naturally decarbonization dovetails with other green and sustainability themes: water, waste and biodiversity are linked to emissions through two-way feedback loops, but these are harder to quantify through data and invest in. Water scarcity is exacerbated through climate change and has been under-invested in both developed and emerging markets. Waste is very important for feedstocks and recycling as part of the circular economy but is still a fairly small percentage of the portfolio. Biodiversity is very hard to invest in because it is hard to find companies that fix it, and the data is not great. Decarbonization is more scalable because more money needs to be spent on it and there are more companies exposed to this theme,” says Mares.

Improving carbon reporting via quiet engagement

To compare decarbonization efficiency, companies need to be reporting high quality data or be amenable to reasonably accurate estimates. Since 2019 the fund’s long book has gone from 90% to 100% reporting Scope 1 and 2 emissions – roughly 90% of the data is available on Bloomberg, with the rest coming from a combination of annual reports and MSCI estimates – while the proportion of firms reporting Scope 3 has stayed around 79%. These metrics are much higher than in the fund’s overall investment universe, where only 62% are reporting Scope 1 and 2, and 47% reporting Scope 3.

“We urge companies to join the CDP so it is easier to get comparable breakdowns. Data disclosure can be much improved especially from smaller companies and developing markets,” says Mares. Though Mares has been quietly engaging with companies to encourage them to adopt CDP and/or SBTI reporting, he does not want to take full credit for these decisions: “It is a relatively complicated process that involves governments, workers and redesigning processes. We prefer to give credit to the company management and employees rather than fund managers”.

In any case, he notes there remains much room for improvement on Scope 3 reporting: “Companies can vary widely on methodology, so we have to carry out credibility checks all the time. We fill gaps by estimating data from the bottom up, using data on emissions, because very few companies have totally unique industrial processes. We do not use the MSCI Sustainalytics methodology based on peer groups”.

Expanding universe

Bottom-up engagement with companies can contribute towards better disclosure while governments can compel it. “Anywhere with credible carbon markets can allow firms to decarbonize at the margin, but some of them are quite narrow. The US RGGI scheme only covers electricity for instance,” says Mares. Expansions of existing carbon markets to cover more sectors, e.g. the EU ETS adding shipping and airlines, and new carbon markets in China, South Korea, Brazil, India and Japan, all have long term potential to expand the tradable universe for the strategy, by sector and geography.