Catalyst with Shayle Kann - A theory of change for climate investing [partner content]

Episode Date: March 8, 2023

Last year’s surge in oil prices brought record windfall profits for oil majors, and a boon for investors. But historic trends don’t favor fossil fuels. From 2010 to 2020, the oil & gas sector underperformed the broader S&P 500 index. The sector gained 6% over that period, while the benchmark S&P index grew 180%. Some called it a "lost decade" for fossil fuel investors. “If anything, oil's been a drag,” says Zach Stein, the co-founder and CEO of Carbon Collective, a company building climate-focused portfolios for investors and employer 401(k) plans. The recent surge for the oil and gas sector shows how fundamental fossil fuels are for today's economy. But looking forward, oil is facing the most significant competition it has ever seen, thanks to electrification and clean energy.  That view of the long-term threat to fossil fuels drove Zach to co-found Carbon Collective – with a mission to build funds around industries that will deliver strong returns in a climate-constrained world. In this episode, produced with Carbon Collective, Zach Stein talks with Stephen Lacey about trends in sustainable investing – how to define the category, identify good investments, and separate it from the confusing world of ESG. If you want to invest sustainably – at work or individually – you can learn more at carboncollective.co. There, you can see how the portfolios are built and read more about the company's theory of change.

This is a branded podcast from PostScript Studios. When oil demand dropped sharply at the start of the pandemic, many believed it was the start of a structural decline for the industry. Shell's CEO speculated the demand might never return to pre-COVID levels. Then the global economy bounced back. Russia's war caused supply shortages and oil consumption in 2022 outpaced production, bringing high prices, windfall profits for oil majors and a boon for investors. At the same time, ESG funds took a big hit. And so, yes, oil had a really good 2022. It was the only sector that was positive, and it was very positive.

It was up 62%, whereas the S&P 500 was down 19%. This seems to be one of those examples where you would say, oh, yeah, of course, this is why. Even if you don't like it, it's a necessary evil for investment performance. The problem when we zoom out is historically that's not been true. From 2010 to 2020, the oil and gas sector underperformed the broader S&P 500 index. The sector gained 6% over that period, while the benchmark S&P index grew 180%. Some called it a lost decade for fossil fuel investors.

So if anything, oil has been a drag. That's Zek Stein. He's the co-founder and CEO of Carbon Collective, a company-building climate-focused portfolios for investors and employer 401K plans. The recent surge for the oil and gas sector shows how fundamental fossil fuels are for today's economy. But looking forward, oil is facing the most significant competition he has ever seen, thanks to electrification and clean energy. 49% of global oil that is used today is on road transportation. So about half of oil's customers are cars and trucks.

Most of that is light-duty vehicles. This is the type of car that's sitting in your driveway or the truck. An electric car is just fundamentally a better technology. It does everything you like in a car better. That is why we're seeing an exponential adoption of them. And oil is going to have no way to make up that market share. So for someone like me, why would I want to have a long position on oil over a 30-year period for an industry that is having literally half its market share be disrupted and without any hope of replacing it?

That view of the long-term threat to fossil fuels drove Zan. to co-found carbon collective, with a mission to build funds around industries that will deliver strong returns in a climate-constrained world. I am, you know, if I'm going to retire at 65, I'm 32 years away from touching my retirement. That's a much longer time horizon. And especially for institutional investors and pension funds and things like that, these are much longer time horizons. So for that kind of investor, which is a majority of the assets that are under management in the market, that is a really different question to ask. So what questions should investors be asking to avoid the short-term allure of fossil fuels?

In this episode, produced with Carbon Collective, Zach Stein talks with Stephen Lacey about trends in sustainable investing, how to define the category, identify good investments, and separate it from the confusing world of ESG. Can you give me an example of what a greenwashed fund would look like that claims to be for sustainable investors but is actually not? Absolutely. So ESG, just as we broadly know, is an analytics tool that is used to look at a bunch of other types of risk than kind of a classic set of tools like credit risk.

So you look at environmental risks, social risk, and governance risks. And these will all kind of get rolled up into like aggregates and averages, and then those will get averaged together. So you end up losing a lot of key details in that point. And so BlackRock, for example, has hundreds of ESG funds. a lot of them invest you in fossil fuels, an industry which fundamentally cannot exist in a world where we have solved climate change. What is the reason they can do that? So it's a really good question, and there's a few pieces of that. One is that ESG as a framework is not just looking at environmental metrics.

And so you could have a social metrics of a fossil fuel company, could have a very diverse worker population, or board, or, be very well governed and kind of the G piece of it. And so that could come in and outweigh some of the clear environmental pieces of it. There's also just frankly a lot of fossil fuel misinformation and money that goes into it of saying that these are necessary transition partners. We hear this all the time of you should be investing in these companies to either help them transition faster or because we're not going to be able to solve climate change without them. And that just continues to again and again be patently wrong. At the beginning of this week, BP, which is probably the most notable as going not as British

Petroleum, but beyond Petroleum, they came out and said, yeah, we're actually just going to focus more on fossil fuels, given what happened in 2022. So that is where kind of things lay at with ESG and why it can feel so muddled, because you're kind of trying to do everything at once in an opaque process. Now, the bulk of our audience are people who are probably doing. the work to think about how to deploy their dollars in climate conscious ways. But I think there's probably still a lot of confusion about how to evaluate different kinds of funds, what questions to ask. So if you're approaching this market and thinking about how to better invest your money,

what are the questions that you need to be asking in the first place and start that evaluation process? I'll share how our lens to doing it, and then maybe we can zoom out a little bit of what ways that you could do it as well. So our lens is really simple. Does this align with what science tells us needs to happen to solve climate change, which is we need to be investing $5 to $9 trillion more per year into climate solutions and stop investing a new fossil fuel expansion. We have plenty of fossil fuels. The supply shortages are just, we're not as good as we need to be at moving them around. And to be clear, we cannot get rid of fossil fuels overnight. I think your audience would know that very well. We are still fully addicted to them. But the path is coming.

for that. So that is how we build our portfolios, where we very simply do not hold the industries who cannot exist in a post-carbon world, things like oil and petrochemicals. We give their share to the companies that are building solutions to climate change. So we overweight this. We cover over 40 different ones. And then we broadly hold the vast remainder of the market, because these are the companies whose core businesses can exist in a post-carbon world. So they're the ones we should be using our shares and our voices to pressure them to adopt things like 100% zero carbon electricity and 100% electrified fleets. Because we're not saying it's different than saying ExxonMobil become a solar company.

It's saying Coca-Cola, you can keep selling this beverage with a secret recipe. Let's just make sure it's powered differently and delivered differently. And that's actually better for business in this environment. And that's only going to get more so. So that's our lens of how we look at it. In general, if you work, say, with a financial advisor, I would push them to justify why are they using these ESG ratings? Why are they using the funds that they are? And how does that align with either a theory of change on an impact level or a theory of change or just a theory of why you'll make more money?

So that range of corporates that you're talking about with are those corporates that have sustainability goals, place or corporates that potentially could implement sustainability goals, what does that range of companies look like? We approach it really broadly. And so it is the second one of companies who their core business can exist at a post-carbon world, whether they have a sustainable goal, sustainability goal in place or not. That to us is how we clearly define what is an engageable universe. A lot of what ESG does is it focuses on how a company does what it does.

does, our goal is to build portfolios that makes sense for a long-term goal like retirement. So our portfolios, they are historically tracking the S&P 500 in the U.S. aggregate bond index. So it makes sense for that type of long-term goal. But where you have that investable universe, if everything makes sense in it, including a lot of companies you might not be that excited about. But again, that company like Coca-Cola, there's no reason that they can't exist or even utilities. When we look at, like, what is it going to take to decarbonize?

there is no way we are going to be able to do it without the participation of utilities. They are big carbon emitters today. So how do you want to hold them and engage with them? That's the type of questions that we hold. That's a difficult question because most of the utilities are somewhere on the path of transformation. Some are really resistant but recognize that change needs to happen. Some are far forward. But the reality is that many of them still have vast portfolios of fossil generation.

So how do you actually like slice and dice that and evaluate it? So we try to get to make it as simple as possible. So when it comes to utilities, the approach has to be economic. There is probably the recent report you probably saw that 209 out of the 210 coal plants that are operating currently in the U.S. would be cheaper to shut them down and just invest in the capital cost of building renewable energy to replace them. That's the fortunate position.

that we are in now. We are not saying make this change because it is the morally correctly to do while it is. We are saying it is the financially smart thing to do. And how do we build that type of path and path forward as shareholders that we're pushing for these business outcomes? That's what we need to do. And so we try to draw those lines as broadly as possible for that collection. How we draw what is a climate solutions company? You need to be generating at least 50% of your revenue from identity. climate solutions. We are not the experts in what is a climate solution. It is our job to look at the leading plans for solving climate change. So things like Project Drawdown or the IEA or rewiring America, what has to happen for us to reach a world of real drawdown. So we go through and identify and collect what is every single publicly traded company that is building any part of the revenue,

is building and operating within one of those solutions. And then we make the cutoff at you have to do at least 50% from that to be defined as a climate solutions company. What do you think are helpful terms to use to define this space? I mean, I find sustainable investing or climate conscious investing really helpful because we're talking about a very narrow type of investing focused on climate outcomes. When you start to broaden to ESG, it gets very fuzzy, and then suddenly your portfolio is waited for something that is potentially not helpful to the climate as you've identified. And so the wider you brought in the net, maybe the less helpful it is, what kind of terminology

do you like to use? And do you like the term ESG? We do not identify as an ESG company. And I think I'll answer your question by maybe taking a step back and giving some definitions of how we see these terms. So ESG was originally invented by institutional investors who wanted to be able to diversify across new classes of risk. So in the world of investing, diversification is your best friend. The more you can do that, the more you can be balanced as there's bumps in the road. So previously, you couldn't say diversify across water risk or these other elements of environmental, or carbon risk should carbon legislation come and happen. So it just makes sense as a theory of if you're trying to deliver

alpha, which means outperforming the market, that the more you can diversify across these risks, that's going to be really beneficial. What happened, though, is ESG had an innovation, and the innovation was quantifying these new types of risk for the first time. And that's where you had these other use cases of sustainable investing, values-aligned investing, impact investing, get globed onto it. And we believe that we're actually now seeing the unbundling of saying, ooh, this was actually never invented for that. So let's peel that off and give something that is actually and was invented for that purpose. So what is sustainable investing to us? Sustainable investing is a way of investing that accounts for a secular trend. Secular in the world of finance

just means something that is outside of kind of like the normal dollars and cents you'd see on a balance sheet. The secular trend we focus on is climate change. And how do you build portfolios that account for it? It makes sense from a climate risk and reward perspective. And then the second piece of that is impact investing. Impact investing, it tries to answer the question of, I'm going to make a change with my money. Often that is going to involve like a bunch of clicks on a computer or like signing with a new financial advisor. What is the tangible difference in the world that happened from that action? That is the goal of impact investing.

To answer that question clearly. And then things like values aligned investing is where you can do a kind of all-locked cart strategy of saying, what are the things I care about? How can I build kind of a customized thing that's like just right for me? So it's less of a collective action. It is going to be something that's going to be kind of custom fit to you. And it's going to have a bit less of a theory of change. It'd be a lot harder to tell that impact story. So at Carbon Collective, our goals we want to put together, sustainable investing and impact investing with this clear goal around climate Let's dig in a little bit deeper to the risks and rewards. So on the reward side, how have

sustainable funds done relative to common indices and fossil fuels? And what are the potential short-term risks in a sustainable fund? When we can, we zoom out over this like 10-year period. We have seen that doing a sustainable investing fund, which we could simply, like a very simple one, as like a fossil fuel-free portfolio, would have outperformed. A recent report came out that looked at the Colorado State Pension Fund, which was at around $12 billion in 2012 and has grown to over $20 billion over the course of the decade. If they had divested from fossil fuels in 2012, they would have had $2.7 billion more dollars in that fund. It would have been about an additional $4,100 per pensioner.

before that. So that's a pretty significant difference. We can flip that and then look at things like solutions. So this would be like a renewable energy fund or our climate solutions fund. They had a really hot 2020. It's the Biden election and the Georgia runoff set them in the kind of promise of build back better, set them into the stratosphere. And then we saw over the course of kind of 2021 and in 2022 the lack of legislation passing, kind of they gave back a lot of those games. And then even with the passage of the IRA, we didn't see that type of big bump come back. So again, I think if you're doing this type of investing, it's always important to think, what is your financial goal with it? If you are looking to turn a quick buck over the next year, that's going to be a really different question to ask than say, what's in my IRA and how am I thinking about this for the long term?

and know that there's going to be months, there's going to be years where sustainable investing underperforms and where sustainable investing overperforms. Anytime you deviate from the market, you're going to have deviating results. So do you believe in kind of the broad secular trends we're looking at, like the transition to EVs, like the decline in oil, that that will come from it? The fact that renewable energy is the cheapest form of electricity in a most in a growing part of the world, the prices of batteries coming down and the impact of that virtual power plants and things like that rolling out. So those are those type of trends where you would want to be

looking at because investing fundamentally is trying to predict the future. And so what do you believe is going to happen? Just a couple of days before we are having this conversation, a financial analysis was released looking at this anti-ESG bill in Indiana. And so there's this GOP push across the country to pull public pensions out of ESG investing. And in Indiana, they found that over the next decade, the fund could lose over $7 billion. I know we're not talking about ESG broadly here. We're talking about sustainable investing, but still, this is wrapped up in this bigger political debate around ESG investing. What do you make of the dust-up and the political reactions to this ESG framework? The political right, as we know, has really latched on to ESG

as the current boogeyman in the same way that a critical race theory was before. It's going to be really interesting to see how that plays out. Is this going to be a fad that will fade in kind of the ways you don't hear about it, or is it going to be some ongoing trend? The problem here, and this is a problem to ESG and why it was so vulnerable to this is it was not well-defined. ESG, and this is when I talked to institutional investors

and pension fund managers and things like that, they are saying, this is a way for us to account for other types of risk in our portfolio. It is in our fiduciary duty not to ignore these types of risks for our pensioners, the things that would be elevated

by environmental, social, or governance with that. And that makes a ton of sense. But it has been seen, and this is again, I think, to that theory of because of the innovation of ESG, of quantifying for the first time, you had these other use cases, sustainable investing, impact investing, values aligned to investing, get latched onto it. It's that kind of broad understanding that ESG means all of that, that is now giving a really good attack lens for folks to say, don't impose your values on us. Whereas instead of being able to say, I am doing my job, trying to chart the best path I can to having this fund be the highest it could possibly be in 10 years from now. That is the job of those. And that's where it's kind of ESG really

struggles because there's no figurehead representing it. You know, everyone's kind of got their own secret sauce in it. And so that's what I think we're seeing play out today. What is your theory of change in the sector. We see a lot of contradictory trends, some really positive and some negative. So over the last decade, we've seen trillions and trillions of dollars from institutional investors pulled out of fossil fuels because of the divestment movement. That movement has been really successful. But at the same time, we see, you know, oil and gas majors making record profits and actually saying, we're going to invest less in renewable energy and put our money into new fossil fuel projects. Meanwhile, investors have more options than ever before, but with those

options comes a lot more confusion. So what is your theory of change in sorting through all those contradictory trends? Yeah. So a lot of the theory of change that has historically been in kind of climate-focused or sustainable investing is we have to hold our nose and own oil companies so we can use or have that seat at the table to pressure them to change. We think that engagement and pressure is incredibly important, but that focusing on supply makes no sense at all. Right now, ExxonMobil is like a business with a line out the door and around the block. It really doesn't make sense to go to the guy behind the counter and say, like, you should really consider changing business models. Instead, we should go to the people in the line and say, hey, you can

actually get a lot better deal across the street, and it's also better for the planet. That's what we should be doing. And so that's what leads to our strategy of the pressure the rest, of the rest of those businesses who could adopt 100% renewable energy, who could fully electrify their fleets. Those are the ones we should be spending all of our engagement energy on. And so we're actually really excited. We're going to be launching our first engagement strategy this year. So your funds, your fees and going to carbon collective are going to help fund direct pressure of these companies to take clear decarbonization steps. We're in the process of building out what that strategy is right now,

but I'll give you an example of the type of thing that we would be really excited about, which is big box stores. We hold all of them. They could exist in a post-carbon world. They have really big roofs. Let's pressure them to adopt 100% solar coverage across those roofs, ideally with battery backups. That makes sense for business.

in a time of fluctuating electricity prices and more outages due to climate change. And again, it's also much better for the planet. That's a really tangible goal to be pushing for. And it's the type of things that we should be pushing for. We think we often can get a little bit too mired in being like, well, you have to really measure your scope through emissions super well. When we know the final report is going to have a lot of the same actions, like switch over to 100% renewable energy, electrify your entire fleet.

So let's just start with the actions we know have to happen, and then we can get into the details further later. So that's how we view this space in terms of engagement. There's also, I think, again, on the narrative level, that is where people like you and I, and I think the listeners of this podcast, we need to have a clearer thesis and strategy and narrative around why this is going to make more money in the long term. It is impossible to quantify method of impact. But the more that that can become ubiquitous, the more we flip from sustainable investing being something that bleeding heart green people like you and me do because we feel better about it to say like, yeah, we do that.

But we also think we're going to make more money in the long term. That is what needs to happen. Sachstein, co-founder and CEO of Carbon Collective. Thanks so much. Thanks for helping us sort through this. Thanks for having me. If you want to invest sustainably at work or individually, you can learn more at Carbon Collective.co.co. There you can see how the portfolios are built, read more about the

company's theory of change, and even talk with Zach's co-founder, James Regalinski.