Matthew Tillett and Mike Shrives, fund managers of the Premier Miton UK Value Opportunities Fund, take a look at the impact ESG has had on the investment landscape over the past decade, particularly focussing on three industries that are not normally considered beneficiaries of ESG.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
ESG – for contrarians
The Environmental, Social and Governance (ESG) movement has had a major impact on the investment landscape over the past decade. As ESG risk and return factors have gained more prominence, it has altered the way major asset owners think about asset allocation. It has also had profound real world impacts by effecting supply and demand dynamics across many industries.
From an investment standpoint, most commentary has tended to focus on the former. We often hear how asset owners are incorporating ESG considerations into their decision making, for example by divesting from tobacco companies. Such decisions are typically couched in a mix of ethical (“its bad for health”) and financial rationale (“it’s a declining industry”). This is an entirely understandable and defensible position, which we take no issue with.
However, as contrarian investors, our interest is more focussed on identifying the areas where ESG may be creating investment opportunities that are not already widely understood. And to do this requires understanding how ESG may be altering the actual fundamentals of an industry or company in ways that could lead to surprising financial outcomes. Today we are finding many such opportunities, often in unexpected places. Below are three examples across very different industries. Interestingly, all are in traditional “old economy” capital intensive industries, which are not normally considered to be beneficiaries of ESG.
Commercial real estate – obsolescence risk or rental growth opportunity?
As one of the major sources of emissions, the property sector – both residential and commercial – is being upended by ESG driven shifts. The office sub sector is particularly impacted, and thus far the effect has mostly been negative. With stricter emissions standards set to come into force in the coming years, owners of some office assets face the risk of either obsolescence or large capital expenditure bills. This problem is particularly acute amongst older tired assets where the expenditure required to improve the energy efficiency rating is very high relative to the capital value.
What is less well understood is what is happening at the other end of this market. For many companies, the office building will be one of their biggest sources of emissions. As the pressure builds on all companies to reduce their emissions, demand for energy efficient office buildings is on the rise. Moreover, the price elasticity of this demand may be reducing as factors other than the rent play a greater role in tenants’ decision making. Emissions reduction is a key part of this, but other factors are also at work, such as providing a healthy and attractive work environment for workers.
There is much doom and gloom towards the office sector currently, as evidenced by the appalling share price performance of the sector over the past three years. This is in part due the above ESG issues, but it also stems from long standing concerns around working from home and the high vacancy that exists in a number of major US cities.
But look at the prime London office market and the picture looks much better. According to Savills, Grade A (the highest energy efficiency standards) office rents in central London have seen an acceleration in growth over the past year, whilst the rest of the office stock has seen declines. Moreover, a growing proportion of office lettings are Grade A, suggesting that tenants are increasingly focussed on this type of building. We believe this could be a major long term value driver for specialist real estate companies that focus on this area of the market, yet one wouldn’t know this from the very depressed valuations that they currently trade on.
3. Avg central London 4. Market: leasing of all central London office units
Source: GPE half year 2023 results – presentation. GPE, Savills. https://www.gpe.co.uk/investors/reports-and-presentations/presentations
Low cost airlines – environmental liabilities or markets share opportunity?
Although air travel is not a major contributor to global CO2 emissions, it is a growth industry by virtue of the fact that most of the world’s population has never been on a plane. As more and more people take to the air, CO2 emissions from air travel will rise, unless the industry can find ways to decarbonise its environmental footprint. This is one of the key reasons why environmental regulations towards the industry are on the rise. The rules and regulations vary by region, but the trend towards higher environmental costs seems likely to continue for the foreseeable future.
The airline industry has always been financially challenging, even at the best of times. High capital intensity, high fixed costs, heavy exposure to volatile fuel pricing and a commoditised undifferentiated product has made it difficult for most operators to generate a healthy and sustainable level of profitability. Against this backdrop, those that have succeeded are the highly efficient, low cost carriers. By competing effectively on price, they have been able to slowly increase their market shares at the expense of weaker competitors.
We believe the trend towards greater environmental costs may serve to accelerate this trend. The reason is simple. Highly profitable airlines that are growing have the financial capacity to upgrade and improve their aircraft fleets, and it is the newer aircraft models that are the most efficient from an environmental perspective. For example, in Europe where Ryanair and Wizz Air already have a major cost advantage over the legacy carriers, both companies made very large aircraft orders during the pandemic, whilst their competitors were retrenching. These new planes should underpin their growth for the rest of the 2020s, and in the process further increase their cost advantage versus the competition.
Source: Redburn Atlantic, Cirium
Natural resources – climate destroyer or climate saviour?
The real world pressures and conflicts of ESG are particularly apparent in the natural resources industries. We discussed this phenomenon at length in a previous insight note, “The ESG paradox and the case for natural resources”. In it, we described “the ESG paradox” as “the inherent contradictions that exist between, on the one hand, the understandable and necessary drive to achieve net zero, and on the other hand, the unfortunate reality that much of the investment required to make this happen involves huge quantities of natural resources (including fossil fuels). And because such investments are inherently dirty and polluting in nature, often in emerging markets with associated issues around corruption and poor labour practices they face high and rising investment obstacles due to poor perceived ESG metrics.”
This combination of a resilient demand backdrop combined with a constrained supply side bodes well for existing assets that are well placed on the cost curve, with long asset lives, where the capital has already been invested. Such assets may be able to earn supernormal profitability for a sustained period of time. Yet despite this, valuations across both the energy and mining sectors remain surprisingly low, especially for established assets where profitability and cash flow generation is already very strong.
Matthew Tillett and Mike Shrives
Fund Manager, Premier Miton UK Value Opportunities Fund
