09 January 2020

Green means protectionism

When the most pro-trade area ever is increasingly turning bearish on globalisation and looking towards a degree of protectionism, one can rightly wonder whether the process kick-started by Trump’s election (November 2016) that aimed at turning the world towards the practice of bilateral bargaining is soon complete. While the reasons fundamentally differ across the pond (one wants to save old industries, the other wishes to protect its green transition), both face criticism.

Europe is speeding up in the green race

The EU is unleashing several initiatives with the combined aim of adopting what it never truly had, a consistent industrial strategy, while remaining the world leader on climate issues and green standards. This comes when some EU leaders are calling for a more ambitious, powerful, and dynamic union.

Among the most notable action: the launch of a new European Green Deal, with €100bn to be invested to foster the Energy Transition and the creation of a €3.2bn battery fund to promote the research and development of clean energy storage. Parallel to these investments, the EU is also improving its legislative framework, aligning it with the development of a sustainable economy to be better protected against state-backed foreign competition (anybody said China?).

The recent agreement on a new taxonomy, which would define green activities at the EU level, and the potential implementation of a carbon tax at its border (a tariff applied on imports that would amount to the difference between the EU carbon price and that in the exporting country) are both powerful tools to encourage and protect stewardship companies inside the common market.

The last point is the most controversial of the whole EU green arsenal. The need for an EU carbon tax applied at the borders on all exports, is a proposition long championed by France. It comes from a natural understanding that as European companies are urged to go cleaner, cheaper and dirtier imported products could win additional market shares in the Common Area. Technically, the tax is hard to implement because of the complexity of tracking supply chains to assess the carbon intensity of products (different countries of production imply different carbon prices).

The EU and its exporting industry (read Germany) can legitimately fear some retaliation tariffs, leaving alone the separate issue of WTO compatibility. Nonetheless, the proposed steps reveal a change of mind-set of the EU’s top executive powers and can be retained in the short term, first concerning only the most energy-intensive industries: Steel, Glass and Cement. It is worth reminding that the first European tariffs introduced on China also targeted Steel.

The EU is in a situation where it wants take a lead on climate issues but is finding it hard to formulate local satisfactory solutions to a global problem. It is all about implementing virtuous policies, without killing its own companies through excessive regulations and/or cheaper imports. Ms Vestager, EU Commission Vice-President, linked the fight against Global Warming with tech innovation, where the EU is lagging far behind China and the US, therefore justifying the adoption of an industrial strategy. While the sacrosanct ‘free competition’ paradigm is still alive at the EU Commission, it looks as if the EU may be less ingenuous this time. The EU has come to realise that with green policies it could offer a structural answer to a whole bunch of its long-lasting issues.

ESG exhaustiveness for big companies: a far reaching goal

Global companies are squeezed by conflicting agendas: at a state level, where they are increasingly wielded or targeted as a geopolitical tool, and at a citizen level as a way to promote more social justice. As scepticism toward globalisation builds, companies which have unduly benefited have some explaining to do. Expect less tolerance on a number of corporate practices (think food), while a stronger social and environmental regulation is coming fast.

Current ESG data will never encompass all the risks facing global companies, which tightly engage with a vast number of suppliers, being subject to various jurisdictions and legislations. That means ESG risks are also likely to be bigger for these companies because of their complicated and world-reaching operations. For the moment, most reports do not begin to describe accurately the reality of all their relations and customers locations. This will backfire, inevitably.

For global companies, some ESG risk will remain out of the control of their top management. Even though some companies with purchasing power are already forcing their suppliers to align faster. Driven by their customer-changing habits/renewed perceptions and the fear of being associated with scandals springing from nowhere (who said forced labour in Xinjiang?), large corporates are pushing their suppliers hard for them to align to end-customers’ expectations of a better world. End-customers' simplistic vision of the world (for example, demands of no chemicals in fast fashion) imposes itself ultimately.

Making sure that a company’s contracts and operations in remote areas are consistent with Europe’s ESG investing standards is a Herculean task which has no end as peeling one layer of issues merely reveals worse ones below. In such a context, EU companies with large local operations are likely to find it easier to embrace these new standards. Transparency on all business relationships is consistent with ESG investing which consumers are asking for but this goes against the efficiency stemming from multilateral business relations. Leaning more towards ESG results in raising costs and prices, which is consistent with the fact that externalities shall no longer be free.

ESG criteria likely to favour domestically-oriented companies?

From an EU investor perspective, ESG investing could well mean going more domestic: to better guarantee a given company continued operations and business relationships. This will be particularly strong in Europe, whose “green and social” framework will be the world’s most demanding so one can therefore legitimately expect that companies operating in the common market will be the most advanced on ESG issues all along their value-chains.

Some politicians and economists are also defending the idea that a sustainable economy means a paradigm shift, where clean, local, and inclusive activities are all key in this new economic model. Requiring corporates to rethink their business model, if not to relocate/reshore.

The bet would thus be that the ESG push turns Europe into some sort of a widened Switzerland, where businesses are more protected for taking a long-term view in a collaborative way. As EU companies eventually become the world’s best and quickest in aligning to a low carbon, inclusive, economy, those that survive the effort may command a valuation premium just like the Swiss eventually. In the meantime, corporates with already large local operations are likely to be less penalised and comply to these standards at lower costs. It is quite a paradoxical statement that highlights how deeply the ESG exercise will affect corporates: an increase in cost maybe welcomed…

Whether protectionism is an essential component of any green policy or just an excuse for the EU to make a stronger push in the global race hardly matters. Two things look certain: the EU will impose higher green standards and will protect its companies. The protectionist Pandora's box has indeed been opened. Eventually the Fight for Climate also means a resurgence in geopolitical tensions. In this context, the localisation of companies’ operations is poised to gain importance, and ESG standards will increasingly insist on it.

Which stocks may enjoy the protectionist joyride?

In AlphaValue's coverage, 462 large European companies report almost 55% of their staff as being located in Europe (Scandinavia, the UK and Switzerland also included) and 50 companies have more than 95% of their sales in the European Community (Telecom and Utilities over-represented here).

We looked at two opposing equally-weighted baskets of 10 stocks each from our coverage. The first one is highly exposed to Europe and the second is open to the world. To judge their presence in the EU region, we have considered the percentage of their staff located in Europe and the geography of their revenues (consumers are key in driving sustainable changes, and even more so in social and environment minded Europe). Matching their (equally weighted) performances obviously embarks all market information way beyond the relatively Euro-centric profile of those companies.

While a degree of resilience over five years seem to be showing up for the European-centric group, these lists are too small not to be under the impact of individual performances. They are primarily aimed as reminders.

Europe-centric operations and sales (10 out 20 stocks)