PGIM: Why today's narrow approach to decarbonisation is flawed

Dive deeper into solutions

clock • 5 min read
Neil Brown (pictured), is co-portfolio manager of the PGIM Jennison Carbon Solutions Equity fund

Neil Brown (pictured), is co-portfolio manager of the PGIM Jennison Carbon Solutions Equity fund

There is a broad consensus that climate change is one of the biggest risks facing humanity and that we need to transition to a low-carbon economy, without triggering a big drop in standards of living.

Technological advancements, shifting consumer preferences and regulations are leading countries and companies across the world to reduce carbon emissions and embrace more sustainable practices.

Even with limited further action or change, current policies suggest the decarbonisation economy will be massive: a $2.5trn opportunity by conservative estimates.

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This focus on decarbonisation is transforming industries, creating a broad and growing opportunity set that is underappreciated by many investors.

As the power and transportation sectors are among the top polluters, respectively accounting for 32% and 17% of global emissions, electric vehicles and renewable energy have been popular areas of decarbonisation discourse.

But with 50% of emissions coming from other areas, the debate is too narrowly focused - investors and policymakers are looking only at the tip of the solutions iceberg.

We need to look at a far broader set of solutions sitting below the waterline.

Scope 4 consideration is crucial

Investors tend to focus on operational emissions generated by a company, for example, power plant pollution or automobile exhaust.

However, they are overlooking progress being made on an important related trend - avoiding carbon emissions in the first place.

In our view, a narrow focus on operational emissions impedes the decarbonisation effort and vastly underestimates the universe of investment opportunities.

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While most investors would intuitively agree with the tremendous benefits of avoiding emissions, most traditional decarbonisation/carbon/energy transition strategies do not account for this aspect because it is harder to calculate.

In other words, how can you measure emissions that using a specific technology, product or service helped to avoid?

But because it is hard does not mean we should not try. Still, current strategies in the decarbonisation space do not try at all, limiting the universe of potential investment opportunities.

Focusing on Scope 1 and 2 emissions is an easier approach because the data is often disclosed directly by companies and the numbers are widely agreed upon based on standardised measurement methodologies.

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Scope 3 emissions involve some estimation, and Scope 4 requires investors to estimate a counterfactual and think critically about companies laying claim to the same emissions avoided.

For example, a consulting company helping clients avoid massive future emissions may itself contribute to operational emissions as it grows.

This growth would disqualify the consultant as an investment candidate in many traditional strategies, even if its own rising emissions are dwarfed by the future emissions that it helps its clients avoid.

In our view, this is a significant flaw in the current common approach and a missed opportunity.

A mistake to exclude oil and gas entirely

As for traditional oil and gas companies, while it would be much easier to exclude these groups in decarbonisation strategies because they are only considered as part of the problem, we need to think more deeply about achieving society's goal of a low-carbon economy while maintaining - or even improving upon - today's standard of living.

We would all be thrilled to reduce our dependence on fossil fuels to zero overnight.

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However, given the enormous global energy base, the transition to renewables and other low-carbon energy sources will take significant time and fossil fuels likely will have a long sunset.

While most oil and energy companies cannot and should not be considered in decarbonisation approaches, the ones adapting the most progressively may make valuable contributions to the global efforts to reduce carbon emissions in the coming years.

This is because coal remains cheap and abundant but is also the dirtiest and most carbon-intensive source of energy.

Gas, and LNG, are a much less carbon-intensive source of power.

When gas is used to displace dirty coal power, it is a powerful decarbonisation fuel, both economic and easily scalable, until such time as coal has ceased to be a significant part of the global energy mix.

Also, some progressive companies in the oil and gas sector are investing significantly in renewables.

In fact, the most progressive companies in the sector sometimes invest more in renewables projects than all the large ‘pure' renewables companies combined.

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In addition, these companies also offer deep and broad engineering capabilities to quickly and affordably complete these complex projects, many of them offshore.

Because the immense decarbonisation challenge requires both speedy and affordable solutions, excluding these companies sets the world up for failure.

A singular focus on solar, wind, batteries and electric vehicles ignores the complexity of this challenge.

Oil and gas companies are often overlooked in the decarbonisation investment narrative, but the most progressive ones are pivotal players.

Fully capitalising on the opportunity

The role of progressive energy companies in decarbonisation efforts provides just one example of overlooked or minimised solutions providers.

Similar opportunities exist with designers of heating, ventilation and air conditioning systems - as well as manufacturers that make buildings more energy efficient, power engineers that upgrade the electrical grid to accommodate intermittent renewable electricity sources and underwater cable installers that connect offshore wind farms to a larger grid.

Global efforts to reduce carbon emissions will require massive spending and fundamentally alter global supply chains and industries.

We cannot stress strongly enough that the decarbonisation economy encompasses so much more than electric vehicles and renewable energy. It spans sectors, geographies and economies.

To fully capitalise on the opportunity, decarbonisation approaches need to take a much broader view.

Neil Brown, co-portfolio manager of the PGIM Jennison Carbon Solutions Equity fund

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