Net Zero beyond target setting

AMBITION

Well-framed emissions reduction targets can galvanise a business and help attract the resources needed to make progress. To respect the Paris Agreement, targets should be designed both to spur action over the near term and to compound results over the long term, ultimately lowering a company’s carbon footprint.

But the plan will need to address some thorny questions. After all, the ideological desire to decarbonise for a better world will often conflict with directors’ perceived duties, the business’s strategy or the near-term imperative to generate return on invested capital. So does the company want to be a first mover, a fast follower or the last incumbent standing? Does it want to respect shareholders’ primacy over stakeholders? Does it want to move ahead of or in line with society? Does it restrict its attention to its own emissions or choose to take responsibility for the entire ecosystem?

CREDIBILITY

Whatever the outcome of this soul-searching, targets and goals are just the start. Pledges only have power if they are supported by a coherent strategy and an appropriate capital allocation plan. In many cases, significant investments are needed to re-engineer existing businesses and build new ones, so financial flexibility and balance sheet strength are critical. The company will also need to communicate clearly – with both shareholders and the market more broadly – to gain support from capital providers.

VALUE CREATION

Listed companies need to convince the stock market that capital will be deployed responsibly into projects that are aligned with corporate capabilities. Otherwise, investors – facing the threat of flagging valuations – may force a retreat from Net Zero goals, as we have seen in recent months.

In short, a transition strategy must create value if it is to be successful. By analysing strategies on this basis, we can identify risks and opportunities to advance the Net Zero transition, whilst potentially delivering financial returns for our clients.

So how does our approach work in practice? Let’s look at two recent examples: BP and Ryanair.

BP NEEDS TO CONVINCE THE MARKET

The divergence between US and European oil and gas company valuations has remained stubbornly wide. We believe some of this spread is due to differences in perception of companies’ transition plans.

BP’s shares remain at a discount to the likes of Chevron and Exxon, after underperforming broader industry peers for several years. The reasons for the valuation gap and underperformance are complex and multi-faceted, and we don’t want to over-simplify. Nor do we assume that the stock market is the best arbiter – or even aware – of the quality of transition plans.

However, even with the recent change of CEO and earlier adjustments to its transition strategy, BP has held onto a Scope 3 downstream target, whilst American peers such as Exxon have decided against setting one. In addition, BP has plans to stabilise oil and gas production and allocate substantial capital to non-oil and gas businesses such as bioenergy, hydrogen, wind and EV charge points. We think the stock market is worried that BP will destroy economic value by winding down its oil activities too quickly and allocating capital to projects that sit too far from its competitive strengths. In short, the market wants reassurance that these investments will pay off.

We view BP through our three-part framework and have been engaging with the company to get a clearer understanding of both the credibility of its transition strategy and the scope for value creation. Our engagement is now focused on improving the granularity of financial disclosures to help give both us and, importantly, the market comfort on this potential for value creation, and thereby the targets’ credibility.

If BP can change the perception that its transition strategy will depress economic profit, its pursuit of new energy prospects may be rewarded with a rising share price. We believe this opportunity makes for an interesting investment case, especially since our models indicate the shares are not pricing in any economic value creation in the future.

Our recent engagements with BP have addressed this key question: how can the company sharpen disclosure to convince the market and shareholders that its transition growth engine investments are on track to generate positive economic profit over the long term? We focus on segment hurdle rates and how they compare with cost of capital. We want to understand how management considers cost of capital in its investment decisions, how project risk affects hurdle rates and how buffers are used when setting hurdle rates above cost of capital. In essence, we are trying to determine the level of capital allocation discipline exercised with respect to over- or under-investment across all the company’s segments.

Over time, we would also like more granular financial disclosure beyond current reporting segment breakdowns, so that we can see how rapidly capital is being reallocated and track the trajectory of return on incremental invested capital. In our view, high-resolution disclosure is one requirement for the market to accept investment in clean energy projects. If a company can’t generate a return above the project hurdle rate (the cost of capital plus a margin for risk) that the market deems appropriate, then the share price is likely to suffer, signalling the market’s preference for that capital to be returned to shareholders via dividends or buybacks. But tension arises when the company is using a different hurdle rate to the one implied by the market.

In principle, we would support the return of capital to shareholders if BP couldn’t meet the cost of capital in its transition engines. But, to make this judgement, we need to evaluate return on capital (both current and prospective) robustly over a reasonable time horizon across a range of plausible scenarios. The level of returns is important, of course. But, even if today’s returns seem unattractive, being a first mover in the energy transition space could pay off in spades if climate policy or customer demand shifts faster than expected.

Not every company can be – or, indeed, wants to be – the green leader or try its hand at developing solar or wind capabilities. And it certainly shouldn’t deploy capital without a clear strategy. We seek to identify companies’ competitive strengths by parsing corporate disclosures, conducting quantitative peer benchmarking and engaging with management. This analysis helps us determine what type of climate contribution companies should make, and conversely what activities companies should leave to better-placed operators.

RYANAIR: FROM THE GROUND TO THE SKY

Since we started analysing Ryanair through our transition risk framework in late 2022, our view has been that the aviation industry’s transition imperatives will reinforce Ryanair’s fundamental advantages over its peers. Our continuing engagement with the company has only strengthened this view.

On our dashboard of key financial metrics, Ryanair stands out for its operational strength, financial flexibility and robust balance sheet. These qualities are only partly reflected in the share price premium over European peers. Whilst several key abatement levers are dependent on suppliers and regulators, Ryanair has direct control over some important ones which could lead to a competitive advantage. The company’s lower carbon intensity can be attributed to its business model, load factor and fleet characteristics. The more people on a given plane and the more fuel efficient the aircraft, the lower the company’s carbon intensity.

The adoption of sustainable aviation fuel (SAF) is another critical element that will nudge Ryanair closer to the path to Net Zero. Given SAF’s importance as an abatement lever, our engagements with Ryanair have centred on the company’s efforts to secure sufficient supply, through memorandums of understanding (MOUs), to meet EU requirements and, more significantly, its own demanding 2030 goals. As we wrote in last quarter’s report, we are encouraged to see agreements already in place to cover 75% of its 2030 target for SAF to make up 12.5% of all fuel used to fly its planes. As the fleet is upgraded and SAF is delivered, we have also been encouraged to see the company lower its carbon intensity target for 2031, with a new interim target set for 2026.

As EU emissions regulation tightens, we intend to follow the company’s progress through our ‘SAF tracker’. Crucially, to support our thesis on Ryanair’s competitive advantage, we are looking for decarbonisation to be accompanied by strong financial performance, both in absolute terms and relative to peers. To that end, we will continue to follow many key performance indicators for SAF, such as its percentage of fuel consumed, cost premium, lifecycle greenhouse gas intensity and availability across locations. These will be monitored alongside key financial performance metrics.

Through the lens of our transition risk framework, we see Ryanair as both willing and able to take a leadership role in the decarbonisation of aviation. We believe active collaboration across the value chain is needed for the industry to develop the intellectual property required for cost-effective emissions reduction. Airlines will have to work with airframers and suppliers, fuel producers and academic institutions. And these actors will need to work with policymakers to shape the regulatory landscape in a way that supports fuel-switching efforts.

We look to Ryanair to continue providing a positive impulse to this endeavour across the ecosystem. Its robust balance sheet and resilient operating model give it the firepower to invest in abatement levers such as fuel efficiency and SAF, whilst its strong customer base should underpin upstream investment into developing and scaling solutions. As one of the few passenger airlines that has demonstrated the ability to generate positive economic profit, Ryanair’s approach to transition risk could become another key pillar of its competitive advantage.

The ecosystem approach

We know from disclosures and engagement with Ryanair that the company is pursuing MOUs with established SAF producers to meet its 2030 targets. It is looking to make agreements with fuel companies with the financial strength to make the necessary investments and the ability to deliver SAF at scale, all without having to worry about running out of cash. Ryanair has struck deals with the likes of OMV, ENI and Shell, though not yet with BP, as far as we know. However, BP is active in the space through Air BP and evidently has the capabilities to contribute to the decarbonisation of aviation, having supplied SAF to operators such as Virgin Atlantic and DHL and agreed to supply SAF to Munich Airport.

By engaging with companies right across the value chain, we can use insights from different companies to cross-pollinate our knowledge and drive ecosystem engagement. For example, one element of our engagement with BP will focus on innovation and the adoption of SAF. Is the company generating new knowledge that can bring down SAF’s green premium? How is the company scaling up its activities and ensuring it can service the broadest range of customers?

By engaging on big-picture issues like capital allocation, we are addressing risks and opportunities that are potentially material to BP’s market valuation. We are thus addressing its ambition, credibility and value creation. But we believe that engagement should also grapple with micro-initiatives – direct, focused actions which are not presently financially material for the implementing company, but could be significant for the ecosystem, especially if replicated by peers. SAF platforms housed within sprawling integrated oil and gas companies fit squarely into this category. We plan to identify more opportunities like this in the future where we see alignment with our portfolio companies and with our commitment to the Net Zero Asset Managers initiative.