Scoping the Path to Net Zero

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Welcome to On Purpose.

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I'm your host, Travis Allen, senior investment strategist and national director of Purpose Driven Strategies at Bernstein. Today, I'm pleased to be joined by David Tsoupros. He's a senior research analyst on the concentrated growth team at AB. He's been at AB since 2013, is a CFA charter holder, and he has a certificate in the fundamentals of sustainable accounting from SASB—the Sustainable Accounting Standards Board. David recently published a blog on net zero commitments from corporations and the importance of corporations having a climate action plan.

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This is something that obviously a lot of people are talking about today as we see an increasing number of commitments hit the press from corporations. So today, David will give us some insights into what these commitments actually mean and why they should be important to responsible investors. David, welcome. Thank you for joining us. Thanks, Travis. I'm excited to be having this conversation with you. Well, it's clearly something that has been in the news a lot. And I think it's really important to start with some definitions. What is net zero? Sure.

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So net zero or you could think about it as carbon neutral is a balance between the amount of greenhouse gases produced with the amount removed from the atmosphere. Now for your frequent podcast listeners,

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you've had a prior speaker talk about greenhouse gases as a bathtub, filling up a bathtub. So in a net zero case, we produce greenhouse gases, which fills up the bathtub. Net zero is also thinking about the drain dynamic of actually reducing the water or in this case, the carbon from the atmosphere—that we need to do both both reduce emissions and find a way to offset unavoidable emissions.

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So, David, as someone who evaluates public equities and the idea that corporations now have these climate action plans, as you integrate ESG research in your portfolio, decisions, like what impact is that having? Well, let's lump climate action into the broader context of ESG or said better, responsible investing. In a sentence, responsible investing helps us as analysts fill out the entire investment mosaic.

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It's a bunch of tiles in that mosaic that helps us both improve client returns by managing risk and identifying opportunities. So that's broad-brush ESG responsible investing.

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Now climate action and climate plans. Let's get specific into our process. As an analyst on the AB Concentrated Growth Team, we have a long-term investment horizon. As part of our process, we model revenue and earnings many years out into the future. Our investment decisions are driven by the amount of conviction we have in those out-year estimates. So we have to think about a future, years in advance. We are transitioning to a low carbon future.

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There's no doubt about that. That drives in net zero, and we'll talk about net zero is an example of that, evidence of that. So a company that has a climate action plan is showing that they're actively mitigating the risks that come with that transition. So it reduces the variability that we can have in our forecast models and it allows us to have greater conviction in our investment.

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Now, let me just maybe go into more about the idea of integration. I think integration of ESG is table stakes for every investor out there. Just think about responsible investing. Would you not want to invest responsibly? Right. We think we do more than just integrate. We are encouraging our companies toward positive change. So that's really interesting. So tell me more about how you do that. Sure. So our ESG strategy is centered around the idea of engagement, which you've talked to your guests about in the past.

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We talk to our companies and encourage them to behave in ways that will benefit all stakeholders and eventually benefit long-term shareholder value. Now we run a concentrated portfolio in the US. We invest in roughly 20 companies and we hold our positions for a very long time.

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We think we have a really unique seat at the table sitting across from company management. They're familiar with us and as active owners of a significant size, even for the largest of large caps, we have access and credibility to push for positive change.

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So you wrote a recent blog about net zero and companies being more forthcoming with climate action plans. And in that blog, you actually mentioned FedEx as an example. And I have to say I was surprised. Why are so many companies, even companies with obvious challenges in reducing their greenhouse gas emissions like FedEx coming forward now?

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Like what's driving this change in corporate behavior, you think? I'd like to think that they're accepting their responsibility in their role, that everyone at every company plays in the environment. But as an analyst, I could be a cynic, too. So let me take the cynical side. There's a real business imperative. And we used FedEx. We have no ownership interest in FedEx. We use FedEx because we thought that was a great example. The business case is very obvious, right? They manage aircraft fleet and trucks that emit a lot of carbon.

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But for them to be more efficient, to reduce carbon fits right alongside real costs in their business.

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And their 2019 report, FedEx said they saved roughly 550 million dollars in fiscal year 2019 because of a more efficient aircraft fleet. That's dollars. Now that 550 million dollars sits right alongside the 2.4 million metric tons of carbon emissions that they've avoided.

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Obvious example there. Sometimes it's not that obvious. Competitive advantage is another reason why a company would want to have a net zero plan. Again, using FedEx as an example, there's a handful of logistic providers. If FedEx is the one that could say that they're net zero, maybe someone using a logistics provider changes their decision based on that. Not only that, you actually have a very large online retailer that is also heavily involved in logistics.

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They're actively promoting their net zero goal. So the competition is also pushing companies towards that net zero goal. Let me expand upon this further, because you have a lot of companies out there that don't have large carbon footprints where they're still declaring carbon net zero as a goal.

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They're realizing that climate change is disrupting business. One of the biggest impacts from climate change is extreme weather events. For example, we have an investment ownership in a financial services firm with a significant presence in Texas. They don't want to have to deal with what they went through this past February with energy shutdowns because of extreme weather events. Everyone's being affected in different ways, some more obvious than others.

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But it doesn't really stop. I'd like to say also there's pressure from stakeholders, including shareholders, to do it. And certainly we're using our role to push for that change towards a net zero world.

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I was glad to hear you mention the stakeholders, because I think that's one of the things that's been driving a lot of our responsible investors that we've worked with over the years is that they want engagement, right? They want actual change, not necessarily just looking for sort of best in class ESG companies. So thank you for that explanation.

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But there are a lot of ways for companies to get to net zero, right? They could buy carbon offsets. They could make some of the operational changes that you hinted at as you talked about FedEx. So maybe talk about the pros and cons of those two main approaches, buying carbon offsets, making operational changes to reduce greenhouse gas emissions, and perhaps some companies will do a combination of the two. But how do you size up those two approaches? There's lots of pros and cons between the two. We can't rely on carbon offsets.

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It might be a fallback approach to think that we could buy our way to net zero and that's just not going to work. You really need a behavioral change to look at your footprint and see ways that you can change it. I'll use a great example. Pre-COVID,  when I was doing a lot more traveling, I decided to look into offsetting my own travel footprint. So airlines, right? One particular airline offers the ability to offset your flight—click through it and they move you to a donation to the Nature Conservancy.

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There's pros and cons right there. The pro there is they're actually tying a dollar amount to your footprint. That's something that we're not naturally doing. And I think that's something that's necessary to do.

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That flight from New York to L.A., round-trip, it's about three quarters of a metric ton in carbon. If I donate $12 in that case, that would offset my footprint. So attaching a cost was a great pro. The con there is that I'm donating to the Nature Conservancy and I really have no idea. It might be a feel-good thing for me, but is it really offsetting carbon emissions? So again, pros and cons in that one example.

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Now fast forward, we just took our first family vacation trip and were looking to do the same thing. So it's been a while since I went to that website, that same website, that same company. They've evolved their approach, which is phenomenal. Now you can offset your flight and you have four different very specific projects that they have around reforestation, afforestation with that same amount of money tied to them. So they've gotten more sophisticated. That sophistication is really what we need.

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Reliability in carbon offsets is a little bit more risky. And I would say driving real operational change and driving real behavioral change is more appropriate. So, again, using that example of me, I might want to step back and say, did I need to take that flight to LA for that company visit? Instead of taking three flights a year for conferences, can I get 90 percent of the value of what I'm getting from that out of one flight and maybe doing two virtually?

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Hopefully that example helps understand we've got to do both.

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There are some trips that you have to take and you could use a carbon offset for that. But you really have to think about and change and modify your behavior, which is sometimes not a comfortable thing to do, but we have to do it. That particular example also resonates with me as someone who was also a frequent business traveler before COVID. It's one of the few silver linings that we have from COVID that we'll get to revisit—how much time we spent on airplanes and perhaps lower our own individual carbon footprint by using Zoom.

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Right. For those times that you don't have to travel, it's actually a good way to bring together the carbon offsets, but also the change in our own individual behavior in the same way that companies may end up using both carbon offsets and changing their operations to be more efficient and to produce less greenhouse gas emissions.

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We hear a lot of responsible investors and we've had responsible investors on this podcast talked about the importance of measurement. And oftentimes they talk about it in terms of greenhouse gas emissions, in terms of scope one, scope two, scope three emissions. And so maybe first you can just tell us what those three things are, but also tell us how accurately at this point we can really measure greenhouse emissions generated by companies. A lot to unpack there.

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So scope one emissions are direct emissions. Using FedEx as an example, the emissions that their owned air fleet has are their scope one emissions, so direct emissions. Scope two are indirect emissions. The biggest scope two emission is use of electricity.

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So not the airlines that FedEx plane, but the electricity that they need to power their distribution facilities. That would be scope two emission and then going further down the line, scope free emission is in the supply chain. Actually using FedEx for your supply chain or your logistics would be your own scope three emission.

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Talking about scope one, scope two, they are a little bit more straightforward. Scope three is a little bit more indirect and you could kind of see how someone's scope three emissions will be someone else's scope one or scope two emissions. So it gets a little convoluted.

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Which goes back to your question around measurement. Now, measurement for responsible investors is absolutely key. It's a way for us to track progress, to standardize across not just the individual company, but across industries, to compare and contrast companies. From an operating perspective, measurement is also important. They say what gets measured, gets matched. But measurement is a means to an end. Right? Measurement isn't the be all and end all.

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You can measure your carbon emissions, but if you're not making change, it doesn't really matter. It's kind of like going on a diet and counting of calories. But if you don't actually adjust what you're eating, you're not really on a diet, right? Measuring is important. But we can't lose sight of the forest for the trees and know that measurement is for an end goal of eventual improvement. Now, of all the ESG areas, carbon emission is probably the most standardized when it comes to measurement, which is a great thing.

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The majority of companies have coalesced around reporting to CDP, the carbon disclosure project, they use CDP now, and using GHG protocol as standards. That said, it's not nearly as standardized as traditional financial accounting where there are solid, agreed upon standards. There's regulatory agencies around it and there are regular third party audits.

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So we're somewhere in between. Companies seems to be doing a really good job of measuring scope one and reporting on scope one, scope two. Then as you get into scope three and beyond, it's a little bit more fuzzy. But again, it's all about being in the process of positive change. Some of that positive change is understanding your carbon emissions beyond scope one and scope two, going further down at the scope three.

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Now, you mentioned scope three and beyond, and so you hear more and more people talking about measuring scope four.

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So maybe you can tell us what is scope four and what does it add to the picture. And looking at companies' performance from a greenhouse gas emissions standpoint. I love geeking out about this stuff. I think this is a topic that more people need to geek out about. So, happy to talk about scope four. From the perspective of being a growth investor, so it adds something additional to the picture. It's a way to account for growth. So let's think about it. If you're a car company, you can reduce your carbon footprint by not selling more cars.

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But obviously, from a business perspective, that's not the route you want to go.

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So if you can manufacture a car that uses less carbon emissions in the process or get some better MPG, which is a smoke three emission, scope four allows for that company to tell a story about real improvements that you're making to that individual car's footprint. So you might be selling more cars, which net increases your footprint, but on a per car basis, scope four gets at that growth component.

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A lot of our companies are growth companies, so their revenues are increasing, which we like to see from a business perspective. It's the emissions per revenue that's something that's worth looking at. Regardless, we're still pushing for absolute reduction in emissions, but it's scope four kind of gets them to that normalization for sales dynamic. So as an analyst, it's useful to look at. But I want to be using scope four to offset your other emissions. It's just a great way to analyze the company.

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So, David, you mentioned a little bit earlier about measuring greenhouse gas emissions that are attributable to your supply chain as a company. Are companies doing enough today to address greenhouse gas emissions in their supply chains? And what do you think companies can do to improve their performance in that area? The short answer to that question is no. Actually, I don't think companies are doing enough in their supply chains about anything. Look at what's going on in this world.

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You can look at semiconductors, what's happening in that industry, go from semiconductors to chicken wings and look at what's behind you. Feel free to Google that, listeners.

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You'll see that there are supply chain dynamics that are causing disruptions in those markets. As it pertains to emissions, actually, I think a reassessment of a company's supply chain, which I think many companies are undergoing right now, taking that reassessment now with a more holistic view, including the carbon footprint of your supply chain, could be a good thing. Like I said before, scope three fits into that supply chain emissions.

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There's a Venn diagram between companies. And if all companies can take responsibility for their scope three or supply chain emissions, it puts additional pressure at every point where carbon is being emitted.

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So we have everyone working towards that same goal. Bringing it back home to the FedEx example, FedEx is a part of many companies' supply chains. The fact that FedEx thought it was worth enough of their time to set a net zero goal probably shows that their clients are looking at that dynamic. Does that make sense? Yeah, it does. And I think that especially I like the FedEx example because they touched so many really large companies.

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And so if we can get the really large companies with broad, vast supply chain networks to actually step forward and lead, the other companies that are part of their supply chain, will sort of have to follow. Yeah, that's a great point on size. You know, the large companies have the resources and the ability to really assess this. And if they could push it on maybe the smaller companies that line the supply chain, and push for excellency, we'd all be in a better place.

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So, David, let's circle back to where we started. One of the criticisms of these net zero announcements is that they don't address the immediate need for us to start tackling climate change. And since many of the time frames are 15, 20 years in the future,

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how do you think about the near-term versus long-term benefits of these public commitments? Yeah, I think it's OK to have some skepticism about a goal that's set 20, 30, 40 years in the future. It's certainly beyond the tenure of management teams that are setting the goals today. You might say that pushes off the responsibility. But we'd much rather have a company make a public commitment today about 2030, 2040, 2050, than not make any commitment at all.

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A good net zero goal contains a plan to action. And that plan is something that we as analysts can check on a regular basis to make sure that they're progressing on a broader plan, understanding that to get to net zero will require some technology in the future that will help with the offset part of the dynamic. If we know that that company is developing that muscle memory today,

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I'm talking about muscle memory, it's a phrase I got from one of the companies we spoke to—developing that muscle memory. So going back to the airline example, right. They started with a donation in Nature Conservancy. They had the muscle memory to say, OK, let's up our offset and they've got more sophisticated.

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So starting today is a great place to start with the acknowledgement that investors will be pushing them forward along that path. That will be way down in the future. David, we'll stop it there. But thank you so much for joining us and sharing so much of the research you've been doing and your blog and the writing you've been doing around net zero and how companies are accounting for the greenhouse gas emissions and what research analysts and other investors can do to continue to encourage them to move in that direction.

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Great. Travis, thanks for having me.

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This has been On Purpose. Thanks for joining us. And remember, we all have values we hold dear. Now you can insure your investments reflect them. You can reach me on LinkedIn. If you've enjoyed the podcast, please rate us on Apple Podcasts, Spotify, or your podcast service of choice, and be sure to subscribe. Thank you again. Bernstein: Making money meaningful for individuals, families, and foundations for over 50 years. Visit us at Bernstein.com.