Imagine this world without concrete—no high-rise buildings, bridges, dams, football stadiums or highways. Concrete is the most widely used substance in the world besides water—literally essential to all life on earth. And yet cement, the main ingredient in concrete, is one of the most unsustainable industries there is, responsible for emitting 2.8 billion tons of carbon per year, about half of the emissions of the entire US.

Our civilization is quite literally built on industries like cement, aluminum, chemicals and steel; while they are unsustainable, we can’t just dispense with them overnight. These industries are also considered “difficult to abate”—that is, it’s tough for them to decarbonize. And typically, they have do so at their own cost. 

However, there are significant actions that these industries can take. The cement industry, for example, is currently looking at the possibilities of substituting clinker, the key ingredient in cement and the production of which accounts for about half of the industry’s emissions, with a material called slag.

That is why Adam Gustafsson, a quantitative researcher at UBS Asset Management’s Quantitative Evidence and Data Science (QED) division, believes that these companies do have a place in green investment portfolios; and not only that, failing to include them could inadvertently disincentivize companies from transitioning to greener technologies.

Gustafsson and QED have developed a decarbonization framework for valuing the green transition of heavy industry—understanding how corporates could achieve strong financial performance in the future while shifting to more sustainable ways of going about their business.

Gustafsson says investment professionals must create returns for their customers. They also play the role of activists, engaging with corporates to encourage them in their green transitions. To perform both those roles, however, investment professionals need to be armed with empirical data; to value future green transitions, they need forward-looking data.

Gustafsson joined QED in early 2020 from Credit Suisse, where he was a quantitative analyst. The first topic he wanted to tackle at QED was a more meaningful investment approach to decarbonization in emission-intensive industries.

“It deserves a systematic framework, a robust way of quantifying the value of these transitions. Importantly, a facts-based foundation allows for a more constructive discussion with companies,” he says.

Looking forward

Many low-carbon portfolios are based on an analysis of what has happened in the past; with this model, Gustafsson wanted to create something that could value the costs and benefits of actions taken in the future.

“We are stuck in a world where investors are chasing a portfolio carbon footprint lower than the benchmark. They base it on data available today, which is one to two years old. We are backward-looking, evaluating companies based on their historical emissions. But obviously, green transitions are ahead of us, so we need to have a forward-looking view,” he says.

In the early stages of planning the model, Gustafsson decided he wanted to base it on ordinary financial analysis, as that is the “language” investment professionals speak. Also, if he was going to design it to be forward-looking, using financial analysis would make sense: Analysts commonly value companies based on future cash flows.

“In this case, you want to understand how both the cost of carbon and also investments in green technology will affect your future cash flows. That is what we are trying to do here, to move away from a backward-looking carbon perspective to what I think is a more constructive, forward-looking view on the value of these transitions,” Gustafsson says.

QED ended up basing the model on a widely used valuation methodology called discounted cash flow (DCF). Using DCF, an analyst forecasts a company’s future cash flows and then arrives at a present value of the company; QED’s model plugs expenditure and pricing components into a normal DCF calculation to make it suitable for predicting the potential outcomes of decarbonization efforts.

QED always wants to produce models that will scale, Gustafsson says; in this case, its team employs QED’s valuation engine to automate the DCF analysis.

“[The underlying engine] provides consistency and allows us to run systematic research across any universe, any region, any sector. It is all in Python code, which is our preferred language in QED. What we are doing here is setting up a valuation service, where you can plug in your key value drivers and receive a valuation back. We can test different fundamental investment theses on the fly. When the valuation engine is in place, adding the different green transition elements is straightforward,” he says.

Using Gustafsson’s framework, QED can add three line items to the financial statements of companies and perform a DCF calculation. The three line items are “cost of emissions,” “green capital expenditure” (capex), and “green operational expenditure” (opex). Green capex is the upfront investment and green opex is the ongoing cost of any investments already made into green transitions. These two elements realize the cost of emission abatements—the actions a company makes to reduce its carbon footprint.

The “cost of emissions” component is calculated using the price of carbon allowances in the Emissions Trading Scheme (ETS) for European companies, the most mature scheme of its kind, Gustafsson says.

The ETS is a major part of the EU’s attempts to reach 55% net reduction in greenhouse gas emissions by 2030, and full climate neutrality by 2050. The scheme caps the total amount of greenhouse gases that can be emitted by companies’ plants or factories or airplanes; if companies stay beneath that cap, they receive allowances, which they can trade with others. Trading these allowances has become what the EU says is the world’s largest carbon market, and the allowance price has become a benchmark for the cost of carbon emissions.

The price of ETS allowances has soared this year; one allowance is currently trading at around €50 ($59).

Currently, heavy industry gets a free pass under the ETS: 63 sectors, including cement and steel, get allowances that effectively cover all their emissions even if they exceed the cap. The EU fears that if it is too strict with essential industries, they will move their operations to other jurisdictions. However, the European Commission is planning to extend the scheme to cover these sectors soon, meaning that green laggards could be left without enough allowances to cover their emissions.

Using the QED framework, an analyst could calculate how the cost of a company’s transition to green technology is offset by its being able to resell its emissions allowances for a profit at future prices of the ETS.  

Return of the Macc

The model doesn’t just measure the cost of abatements; it’s very important to its aims that it prices in the benefits of green transitions, whether those benefits come from the resale of ETS allowances, or moving to a new and more sustainable technology.

In the model, these benefits are measured using the marginal abatement cost curve (Macc), an approach developed by a McKinsey consultant, Per-Anders Enkvist, about 20 years ago. Maccs are sets of “levers”—green actions that a company can take that have associated abatement potential and costs.

“The concept of abatement curves is widely understood, but within the investment community, not applied in a meaningful way,” Gustafsson says. “We’re plugging the Macc straight into the financial valuation model. It allows us to approximate emissions abatements achieved by corporate investments in green technology, and understand how these actions impact firm values.”

Enkvist left McKinsey in 2015 and founded a consultancy called Material Economics; QED worked with Material Economics to develop an updated set of sector-relevant levers specifically for the Maccs in this framework. For a building company, for example, a highly material “lever” would be the move from clinker to slag in cement production. And in the model, that would have an associated abatement potential of up to 15% compared to business as usual. The model also takes into account that this lever is one of the cheaper abatement possibilities available to the cement industry. 

QED lays out its framework in a paper available from UBS AM. The researchers say their own applications of the model suggest that abatement limits downside risk and in many cases even captures an upside potential.

The model is intended for investment professionals at UBS AM to use, but Gustafsson was adamant during its development that it not be proprietary.

“We don’t want to keep it to ourselves; it’s too important. I believe this is a constructive direction for the wider investment industry. I hope that our peers also start to think in a forward-looking way about green transition. We have a greater impact when acting together,” he says. “If we as investors don’t recognize the value of emissions reductions, we may indirectly hold back companies from taking action.”

The methodology is also meant for management teams of corporates themselves, he adds. “We want to show them that investing in green technologies is in their shareholders’ interest, allowing them to be more ambitious,” he says.

Gustafsson says the world needs renewable energy and companies that are 100% focused on climate solutions. But humans can’t completely divest from industries like cement. “There’s a lot of talk about building more out of timber, for example, but I don’t see any large-scale infrastructure being built with timber any time soon—there simply is no commercial substitute for concrete, and it seems like everyone agrees that we won’t get away from these basic materials,” he says.

“But they are a massive climate problem that must be solved. I hope that this framework can promote a more educated discussion on how we get it done,” he says.