How does ESG Integration and carbon risk analysis influence a portfolio?

By Andrew Headley

At Veritas, we are proud of our sustainability approach.

A recent Sustainalytics report showed that our portfolios have a low carbon footprint. The carbon intensity of the strategy is 88% less than the Sustainalytics Rating Global Developed Benchmark and the carbon risk rating is low (55% lower carbon risk than the benchmark). This should not be surprising to clients and illustrates the effectiveness of the sustainability approach that we follow at Veritas.

Among the criteria we seek, one is the sustainability of growth in demand for a product or service over the long term (10 years +). A wide range of products fall into scope – products related to lifestyle diseases, use of Cloud, online payment systems, some branded consumer products etc. But one that is less clear is Oil.

Demand may or may not increase in the short term but trying to accurately predict what happens over the next 10 years is difficult especially with the focus on renewable energy sources. It is likely demand will fall. As such there are no oil (or coal) companies on our Universe List. We have not avoided investing in them because of their carbon output or a low ESG rating but because they do not qualify under our definition of sustainable/quality businesses. So, whilst we do not bluntly screen out companies, our Universe List of good quality sustainable companies from which we select, possesses no coal/oil companies or, indeed those capital-intensive companies that tend to generate a lot of carbon (steel, mining, utilities etc). This is illustrated by the report showing no holding with a ‘high risk’ carbon rating. 

So why do we have some higher carbon producers in the portfolio?

Below we detail how two of the higher carbon producers (medium risk) in the portfolio are aligned with a transition to a lower carbon world. Canadian Pacific Railway and Safran are two companies directly or indirectly involved in transportation and thus carbon generation from fuel burn.

Canadian Pacific Railway

Canadian Pacific Railway (CP) is a Class 1 freight railway that runs across Canada and into North America. The company transports everything from food crops, cars, imported finished goods and some oil and metallurgical coal (approximately 9%). Because it transports oil and coal, it has been classified as a Fossil Fuel company by Sustainalytics and seen as ‘medium risk’. So, is CP an environmentally unfriendly business and is the company not adequately positioning itself for a lower carbon world?

The transportation sector accounts for the second most greenhouse gas emissions in both Canada (28%) and the United States (29%). Railways move approximately 70% of all freight on a tonne-kilometre basis in Canada but only account for 3.3% of the greenhouse gas emissions from the transportation sector. Railways are on average 4 times more fuel-efficient than truck and CP offers shippers an opportunity to move their products with less greenhouse gas emissions. These goods have to be moved somehow and CP is educating customers (and exploiting an opportunity) that transporting their goods by rail will help lower their carbon footprint. One could argue this is an example of a carbon lowering solution.

Despite the energy efficiency, locomotive fuel consumption at CP is the second largest operational cost. Subsequently, fuel conservation is a driving factor in financial performance and directly related to CP’s compensation plan. The company has set multi-year locomotive fuel intensity targets that reflects 96% of CP’s Scope 1 greenhouse gas emissions. This target is one of CP’s key performance indicators linked to management compensation. The company is clearly aligned with shareholders. CP discloses its carbon output and it is independently verified so any reduction in emissions will be independently measured. The company continues to invest in a modernisation program which includes technology upgrades, fuel efficient engines, enhanced cooling systems and efficiency improvements like a new covered hopper car for carrying 44% more grain but is shorter and lighter than the previous version.

It is important that management assess climate change risk and the Board have therefore set up a Risk and Sustainability Committee. The Chair of the Committee reports to the Board on climate related risk such as flooding, extreme precipitation events, droughts, fires etc that would impact the company’s ability to operate and serve its customers.

CP’s business is based on transporting a wide variety of commodities from suppliers to the market place. Much of this is grain (both whole grains and processed products) and CP’s grain network is unique among railways in North America as it is strategically positioned in the heart of grain-producing regions of Western Canada and the North plains of the US. This business is centred in the Canadian Prairies with grain shipped primarily west to the Port of Vancouver, and east to the Port of Thunder Bay for global export. Climate change will increase the volatility of certain commodity markets like reducing the yields of agricultural crops that CP transports. Changing weather patterns and climate conditions are influencing changes in where certain crops are now being produced beyond traditional growing regions (e.g. corn increasingly grown in more northern areas). These changes result in shifting demand for logistics services and infrastructure to new regions of CP’s rail network. CP will need to adapt network resources to meet this demand. In short, when one looks at many of the criteria laid out by the TCFD in terms of climate change management (strategy, measurement, incentives etc), CP management are better positioned than one may glean from an overall risk rating. The report does elude to this with the high management score that the company received.


Safran makes aero-engines including the popular LEAP engine which powers the A320neo and Boeing 737 Max. These planes are popular on shorter haul flights and have seen increased demand especially from Asia. Prior to the COVID-19 pandemic, there was a 10-year waiting list for the LEAP engine. Safran is at the forefront in addressing the environmental challenges relating to air transportation. As the production of an aircraft accounts for a few percent of its emissions over its life cycle, the key is the reduction of CO2 emissions from the engine - Safran’s product. One of the reasons for the demand for the LEAP engine, is that it is 20% more energy efficient than the previous model. Currently there is no viable substitute to burning fuel to power these planes but Safran has consistently worked on producing more efficient engines. Whilst reduced unnecessary flying is environmentally beneficial and should be encouraged (more Teams, Zoom etc), the reality is that only 20% of flights relate to business, 80% of individuals on the planet have never stepped a foot inside a plane and the number of Chinese applying for passports is growing exponentially each year. Indeed, most of the incremental demand for travel is derived from emerging markets with the increase in disposable income.

Once we are past COVID-19 it is likely air traffic will revert to its 4% p.a. growth rate. There is pent up demand for travel. In 2008, the Air Transport Action group (ATAG) set an ambitious objective of reducing CO2 emissions by 50% in 2050 in relation to 2005. Applying the 4% growth rate assumption from 2005 to 2050 means there needs to be a 90% improvement in average emissions per passenger / kilometre. Realistically, there will need to be several drivers to reach this goal including renewing the global fleet with new generation aircraft, replace the existing jet engine, improving air traffic operations and management and finally introducing disruptive technologies. Safran's technology roadmap specifies contributing to a disruptive aircraft towards 2030-35 that would reduce fuel consumption by 30-40% (including the substitution from existing jet fuel to sustainable fuels), and to move towards ‘zero-emissions’ in flight by 2050.
Approximately 75% of research and technology spending is on technologies aiming directly or indirectly at reducing the environmental footprint of air transportation.

The diagram below demonstrates a realistic transition to a decarbonisation progression path. The next 10-15 years may see electrification playing a role in shorter haul travel with alternative fuels (biofuels and green synthetic fuels) the most likely improvement in that time frame for longer haul travel. There needs to be shared vision by stakeholders beyond the industry to make it happen. Not investing in a company that a) benefits from an enduring growth driver b) has extremely high barriers to entry and c) will be part of any solution to reducing carbon and focussed on doing so, is an opportunity missed.

What does all of this mean?

We wish to help clients gain a better understanding of the portfolio’s position with regards to the transition towards a low-carbon economy. It should be stated at the outset, that no report is perfect and should be seen in terms of the direction of travel i.e. are the companies within the portfolio improving their position over time, and as a base from which to explain to clients any outliers and whether those companies are adjusting to a lower carbon economy.

It should be noted that the Sustainalytics report is not used within the investment process but as an independent report card (using their assumptions) as to the carbon position within the portfolio i.e. what is the outcome of the investment process. This is important, because the Veritas investment process is predicated on sustainability in the widest sense. The more enduring and sustainable a business is, the more likely it is to be aligned with shareholders not only in value creation but to the risks and opportunities posed by environmental and social factors. We would argue this is true ESG integration, rather than treating ESG as a separate compartmentalised consideration.

It should also be noted that the limitation of any carbon report is the non-disclosure by companies of their carbon output and/or policies they have to address transition. Some companies, for example, have never completed a CDP questionnaire. Where the data is missing, assumptions have to be made and this can lead to different opinions as to whether a company is ‘high risk’ or ‘low risk’. This is one of the reasons we support the Transition Pathway Initiative (TPI) in its efforts to encourage disclosure and provide a free online tool which investors can use to assess their portfolios. We also introduced a policy to encourage companies that currently do not disclose their carbon output to do so going forward. This will surely help improve the starting point to any assessment related to carbon analysis.

This month, Nedgroup Investments celebrates the 10-year anniversary of our Best of Breed™ partnership with Veritas Asset Management. Over this time, Veritas have performed superbly for our clients as well as winning a number of key industry awards along the way. This is testament to our reputation for researching and selecting high quality managers from around the world and partnering with them for the long-term.