Can we be sure that we are removing the same amount of carbon dioxide from the atmosphere as we have emitted as a business? That was the simple question we looked to answer as we approached our business carbon neutrality this year with the same rigour as our stock analysis.

In the process of measuring emissions, researching offset projects, and then purchasing offsets, we were surprised at what we found. Not only is carbon offsetting a largely unregulated industry, but most carbon offsets don't even remove carbon dioxide from the atmosphere! Read on to find out how Firetrail enhanced our carbon emissions offsetting process for FY21. By doing our homework, and focusing on what matters, we strived to ensure Firetrail genuinely is a carbon neutral business.

Step one -  measure the emissions

Firetrail expanded the scope of our emissions estimation process this year to include assessments on:

• Electricity usage
• Staff commutes and taxis
• Waste/water/paper/gas usage Flights and hotel stays
• Supply chain costs, including cleaning, software, and catering, and
• Working from home emissions when government restrictions were enforced, such as lighting, computer usage and heating

We worked in collaboration with Pinnacle, who have engaged in offsetting their business emissions for the last few years and achieved Climate Active Carbon Neutral certification for their FY20 emissions. Pinnacle also released their inaugural Corporate Sustainability Report in FY21, including details on their carbon inventory assessment, which can be found here. Firetrail's calculated carbon emissions for FY21 were 134 tonnes of carbon dioxide equivalent. A breakdown of the contribution to total emissions is provided below.

There are a couple of anomalies to highlight in the emissions for the past year. The Covid pandemic continued to impact daily life. This meant that business travel was virtually non-existent for the Firetrail team. We expect business travel to increase as border restrictions (both domestic and international) are eased, and as such expect that this portion of our carbon emissions will increases substantially in the future. We also avoided major lockdowns for the majority of the team in the July 2020-June 2021 period. However, we expect working from home emissions will be a feature of the FY22 carbon emissions due to the extended lockdowns at the beginning of the period. We admit our measurement process is not perfect, and estimation methods are evolving and improving over time as we get access to better data. Where relevant, we erred on the conservative side through this process. Firetrail will look to enhance our approach as we continue in our offsetting efforts in the year ahead.

A tonne of carbon is not a tonne of carbon

Once we calculated our total business emissions, we began the search for an appropriate way to offset them. The atmosphere cannot tell the difference between a tonne of carbon dioxide removed from the atmosphere and a tonne of carbon dioxide emitted into the atmosphere. It doesn't care how, or where this is done. It's all one planet and its all the same. But when it comes to offsetting, this isn't the case! What really matters to us is ensuring that if we are offsetting our emissions, that we are genuinely removing carbon dioxide from the atmosphere.

Source: Bloomberg

Carbon offset markets are evolving rapidly. Despite this evolution, less than 5% of carbon offsets are actually removing carbon dioxide from the atmosphere. These methods are Afforestation and Reforestation, and Carbon removal technologies (the far-right columns in the graph above). Most offsets still are firmly in the 'prevention' bucket, i.e. they are potentially stopping carbon from entering the atmosphere. The big question here is whether most of these projects would have gone ahead anyway.

The efficacy of the two biggest sources of offsets is questionable:

1. Renewable energy projects. The logic here is by building a solar farm or wind farm, you would displace energy that previously came from a fossil fuel source and should earn credits for it. There is no due diligence however on whether this occurs. Secondly the projects would have likely gone ahead anyway given the lower cost of renewables development. Fortunately - most voluntary carbon credit schemes are now starting to disallow these forms of credits.
2. Avoided deforestation. Best described as "Unless you pay me, I will chop that forest down". It's very hard (if not impossible) to prove whether the trees would have stayed anyway. In many cases the land is protected by covenants or planning restrictions also. And even if the trees do stay - it's just status quo for the atmosphere!

Of the two options which genuinely offset carbon emissions:

1. Carbon removal technologies are very expensive. For the fee of 960 Euros (AUD ~$1,500), Climeworks will suck 1 tonne of CO2 out of the atmosphere. Read more here.
2. Forest planting is a far lower cost option. As a tree grows, about half its mass is carbon, formed by breathing carbon dioxide in from the atmosphere. In Australia, the cost is ~$20 for this - depending on land prices.

To ensure that offsets pass the pub test, offset projects should be a) a project that is not the status quo and b) truly reduces carbon in the atmosphere.

Investing in the Flanders Carbon Project

Our science based, fundamental approach led Firetrail to purchase offset units from a Queensland native vegetation regeneration project called 'The Flanders Carbon Project'. The project is subject to independent audit as well as review by the Clean Energy Regulator. Once we purchased these Australian carbon credit units ("ACCUs"), we cancelled them in the Australian National Registry of Emissions Units, so that no one else can buy them. Doing this and avoiding any double counting means the offsetting is real. At $33 per tonne, the cost of doing this was more than double the cost of other carbon offsets we investigated.

The Flanders Carbon Project is situated in the southwest Darling Downs region of Queensland. Vegetation is growing and removing carbon dioxide from the atmosphere on land which was previously intensively overgrazed. The Flanders Project is spread over 32,000 hectares, and in FY21 140,976 tonnes of CO2 will be removed from the atmosphere. From an Australian national emissions perspective, the reforestation of Queensland is also critical. During the 2000s the rate of land clearing (destroying plants) was adding almost 100 million tonnes per annum to Australia's emissions. This process is now reversing through projects such as the Flanders project and reforestation - this can be seen in the dark green line below. Excluding this Australia's emissions reductions are minimal (ex-Covid impacts).

Source: Australian National Greenhouse Gas Inventory

Conclusion

Firetrail are dedicated to playing our part in creating a positive future environment for all our stakeholders and continue to make significant progress in our approach to responsible investing and sustainability. Our journey to carbon neutrality was an eye-opening experience this year, as we enhanced our methodology on not only emissions measurement, but choice in offsets. Carbon markets are certainly evolving, and our advice would be to do your due diligence when embarking on your carbon offsetting endeavour! We are very happy to share more on what we have learnt thus far and hope to keep developing our knowledge through engagement with our clients, portfolio companies and peers.

Disclaimer

This article is prepared by Firetrail Investments Pty Limited ('Firetrail') ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 ('the Fund'). This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person's objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 ('PFSL') is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited ('Pinnacle') ABN 22 100 325 184. The Product Disclosure Statement ('PDS') and the Target Market Determination ('TMD') of the Fund is available at www.firetrail.com. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.

Whilst Firetrail, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of Firetrail and its investment activities; its use is restricted accordingly. All such information should be maintained in a strictly confidential manner.

Any opinions and forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future.

Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Firetrail. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Firetrail.

Funds operated by this manager: 

Premium Asia Fund, Premium Asia Income Fund, Premium China Fund

It's been a busy, record-breaking year for the Australian share market. Not only did the S&P/ASX 200 close out its best financial year in two decades, but initial public offerings (IPOs) and mergers and acquisition (M&A) activity also reached new highs.

So, where might opportunities lie in this avalanche of prospectuses and scheme deeds?

On the way out

M&A activity in 2021 has eclipsed the 2007 record, with corporate acquirers driven by cheap interest rates, low leverage at many listed companies, and an imperative to grow earnings. Meanwhile, private equity firms are sitting on a mountain of cash and super funds have entered the fray in a bigger way, seeking a home for accumulating retirement savings.

A $23.6 billion bid for Sydney Airport (SYD) was announced recently and, if complete, will represent one of Australia's biggest ever buyouts. A $2.8 billion takeover bid was also proposed for fund administrator Link (LNK) - a rehash of last year's offer for the business. In another replay, Blackstone is back bidding for Crown (CWN). 

Premiums have also been higher than usual this year, averaging roughly 30%. Class Super (CL1) was bid for by HUB24 (HUB), with a staggering 72% premium. The Mainstream Group (MAI) takeover saga, which we chronicled in our June Monthly Report, finished with Apex Group paying $2.80 per share - 153% higher than where the business was trading before the initial bid. The $14 million for our remaining Mainstream shares landed in the Forager Australian Shares Fund's bank account at the end of October. 

A more recent example is Seven West Media (SWM), which made a bid for Prime (PRT) in October and handed Prime shareholders a 74% payday. By spending $72 million to fully own Prime, Seven West has paid just under three times earnings before interest, tax, depreciation and amortisation. Coupled with news that the company gained access to flexible new lending arrangements, its share price was more than 67% higher at the November peak.

Breaking in

While there were several businesses leaving the market this year, there were also plenty of new listings. Australia's IPO market has been back in full swing - rebounding from last year's COVID slump and overtaking the 2017 record to raise about $3 billion in the first six months alone. And so it should; macroeconomic conditions are favourable, equity valuations are healthy, and investors are opening their wallets in search of the next success story.

Small-cap IPOs have been landing on fund managers' desks quicker than they can be chucked in the bin. Many of these small, and largely unproven, businesses have been dressed up for sale and offered at hefty prices. There have been plenty of well-timed exits from private equity sellers. 

We haven't found a lot to participate in so far, but we are sifting through the rubble. The post-IPO blues can send good businesses far below their listing prices as the market's attention wanes and the reality of listed life sets in.

For example, the Forager Australian Shares Fund invested in online beauty retailer Adore Beauty (ABY) after its well-timed October 2020 IPO, but at a discount of about one-third to its IPO price. The Fund also invested in fintech lender Plenti (PLT), purchased a quarter below its IPO price. These are unlikely to be the last blown-up IPOs offering opportunities to patient investors.

Written By Alex Shevelev

Written By Michael Collins, Investment Specialist

The radical world of play-to-earn. How can a game that doesn't exist be worth $US10 billion?

In recent months I have been down yet another crypto rabbit hole, trying to understand the 'play-to-earn' space which, on the surface, can seem bizarre but is actually a revolution in capital formation and Web 3.0 adoption.

Crypto-native businesses are starting to use their coin, not just as a means to raise capital, but as an incentive mechanism to create community, build engagement, and provide feedback to products in development. They effectively distribute 'rewards' to early adopters of the products. This has been most successful in the gaming space where users earn rewards for playing a game.

'Play-to-earn' highlights how Web 3.0 companies are utilising behavioral and financial economics to spur on Web 3.0 adoption of products and, in turn, create 'traction' and 'network effects'. What many traditional investors are missing is that these 'rewards' resemble something close to equity, and significant value is being captured by early adopters.

A 'Pokemon remake'

One example that has caught my eye recently is Illuvium. Their website describes Illuvium as:

"a collectible NFT [non-fungible token] RPG [role-playing] game and auto-battler rolled into one. There is an open-world RPG experience in the overworld, where you mine, harvest, capture, and fight Illuvials."

In simpler words, Illuvium is a remake of the incredibly popular 'Pokemon', only with much better graphics and NFTs that enable you to actually own parts of the game, including the creatures.

Illuvium's aim is to be the first 'Triple A' rated game on Ethereum. The founders also want the game to run autonomously with holders of ILV (Illuvium's token) governing the project via voting and a council. Ambitious, yes, impossible, no.

Typically, in early-stage investments, liquidity is non-existent. Illuvium, however, (amongst many other crypto projects) are incentivizing users to provide liquidity on decentralized exchanges. Users are paid in more ILV for taking on the risk of providing this liquidity. Thus, solving the illiquidity problem up front.

The next step for Illuvium is then to incentivize the buying of their native currency ILV. But with no game available (remember this is a start-up) and little funding ($US5m pre-seed) that's a huge challenge.

A US$10 billion market cap despite no game

Again, the exact mechanics here are somewhat irrelevant, but Illuvium has introduced an in-game currency 'sILV' that users can earn by 'staking' the real currency ILV. 'sILV' gives users the ability to progress through the game quicker. The value to players is they can accelerate their journey in the game (potentially finding the rarest creatures worth a lot of value both in the game and on secondary markets too). This creates demand for ILV on the exchanges.

But this has an interesting indirect affect. Illuvium have only released a small percentage of their tokens. That means a minor increase in demand significantly increases the price of the token that unlocks a huge amount of value on their balance sheet. To appreciate this, the current fully diluted market cap of Illuvium is over US$10 billion. Not bad for a game that doesn't exist yet.

It really is a revolutionary way of capital formation and spurring on Web 3.0 adoption. The incentives that people are earning are now worth much more as ILV increases in price, and Illuvium can then start to attract real talent in the form of developers and marketers to advance the project.

The users at this stage are really just testers that, in turn, de-risks the ambitious vision that they initially had. It also creates a feedback loop that attracts even more investors and users competing for the now more valuable 'play-to-earn" rewards.

As a practical example, Illuvium recently released a 'Cinematic game-play trailer' which cost around $US2m.

Raising $5m and telling traditional equity investors that you were going to use 40% of funds to release a trailer would be tough (impossible almost). But in Web 3.0, the company formation process is changing, which is enabling these projects to do much more with much less and set their sights on much more ambitious targets.

Filecoin, a cloud storage decentralized network has a similarly ambitious vision - to change the way we store and move data across the globe. With a US$250m raise, Filecoin has 'build-to-earn' incentives that total over US$70 billion, which could turn into the trillions as the network develops. The numbers are extraordinary but so too is the capital expenditure required to build out the infrastructure for our data obsessed economy (see Figure 1).

Figure 1: Filecoin Capital Expenditure Incentives

Early adopters capture the value

To many traditional investors this can be difficult to grasp. A game that doesn't exists worth US$10 Billion?? A Cloud network in its infancy having trillions on its balance sheet??

Chris Dixon, a well-known internet entrepreneur summarized the network effect in Figure 2 and how token incentives are solving the Bootstrapping problem. In return, much of the value is caught by early adopters of the product.

Figure 2: Network Effect

This is why we are seeing such a rapid adoption of Web 3.0. Web 3.0 users and investors are being blurred, value is being pushed to those providing the value to these companies. For Illuvium, it is those that are most excited about the game. For Filecoin, it is those building the infrastructure. Even Bitcoin is rewarding those providing security to the network.

Figure 3 gives some insight to impact this is having for Web 3.0 adoption. Many of the Mega-Caps today (such as Google, Amazon, Microsoft) were formed at the start of the internet, roughly 10-15 years before these digital assets. The growth arc of digital assets is much steeper.

Figure 3: Mega Caps v Digital Assets - Total Market Capitalisation

We are at the very start of a hugely transformative period. Web 3.0 is going to come at an incredibly fast speed, and as an investor you need to understand why, which means understanding the incentives involved.

Many projects will fail, and that's ok. Not every business in Web 2.0 is successful either, but the ones that get the formula right will drive an immense amount of value, and that will mostly fall to their earliest adopters.

My concern is that so few traditional investors will have the ability to access these opportunities because their intermediaries are not set up for this disruptive change.