Efforts to transition to a low carbon economy have been a prominent feature of political and financial decision-making over the past year. These trends look set to gain further impetus with climate change issues becoming even more prominent in global geopolitical agendas. Investors are currently focused on the prospective influence of the incoming Biden administration in the US and the desire by many governments to put ‘the green economy’ at the heart of economic stimulus efforts in response to the Covid-19 pandemic.
The importance of climate change issues has also been reflected in efforts by investors to further incorporate ESG focuses into their decision-making and portfolio construction processes. Significant emphasis has been placed on a move away from fossil fuels, with a number of prominent institutional asset owners committing to action over the past year.
Such efforts are, of course, laudable in their aims. However, it is important investors do not focus on individual metrics such as emissions or fossil fuels in isolation, but instead take a more detailed assessment of how their portfolio is constructed in order to balance their ESG commitments with their long-term return objectives.
Divestment and reduction
To date, efforts to address the theme of an energy transition away from fossil fuels have primarily focused on two distinct strategies: fossil fuel divestment and the reduction of a portfolio’s carbon footprint relative to its benchmark.
Although understandable, it is increasingly evident that these approaches have significant limitations and can restrict investors from maintaining certain exposures. Perhaps surprisingly, these approaches can in fact reduce exposure to renewable energy and low-carbon technologies, ultimately reducing investment in the solutions that will facilitate the energy transition.
As an example, in the MSCI World Index, carbon emissions are highly concentrated with approximately 5% of companies responsible for 50% of the weighted average carbon intensity of the index. This would suggest it is possible to substantially reduce the carbon footprint of a portfolio by reducing exposure to a relatively small number of securities.
The reality, however, is more complex. High carbon emitters tend to be concentrated in three sectors: utilities, materials and energy. Similarly, while distribution across countries is more proportionate to market size, the US, Canada, Japan, Australia and the UK are the largest emitters on a regional basis in the developed markets universe.
As such, any approach based on a simple exclusion or carbon footprint reduction can leave investors taking large sector, industry and country bets relative to the benchmark, while limiting exposure to areas of the market that could be highly influential in facilitating the transition to cleaner sources of energy.
Investors also have to consider how they assess securities based on fossil fuel considerations. Metrics and measurement have always presented a challenge in the context of ESG due to the availability of data and, importantly, how relevant such assessments are to specific industries, companies or regions.
For example, an investment bank reducing its fuel consumption and resulting carbon footprint by 50% will not necessarily experience an increase in share price. By contrast, an announcement by an airline or utility company that it is able to deliver a similar reduction, potentially via the application of new technologies, would likely have a much more meaningful financial impact.
What does this mean in practice? How can and how should investors assess securities to ensure they are both meeting decarbonisation objectives and benefitting from opportunities associated with the energy transition?
First, by assessing a range of other metrics, for example how companies score in the production of green energy, investors can be much more confident they are not inadvertently excluding firms that are investing in renewable technologies and are capable of long-term improvements.
Second, and more critically, investors must consider how materially relevant specific issues and the resulting measurements are to individual sectors and companies. In other words, rather than overweight a company simply because it has a low carbon footprint or no fossil fuels, investors must identify the critical sustainability issues for that industry. This will help ensure investors not only tilt away from those companies with current sizeable carbon footprints but can also benefit over the long-term from exposure to those companies that will contribute to, and benefit from, the energy transition.
In such a fast-moving and complex area, more nuanced approaches are clearly required. Those willing to go beyond simple metrics and exclusions will therefore be better positioned to benefit over the long-term from future developments.