Climate change negotiations in Paris: What is at stake?

Delegates from around the world are now attending the 2015 United Nations Climate Change Conference in Paris, known as COP21. Motivated by the belief that carbon-based pollutants and greenhouse gas might have a catastrophic impact on our global climate, the conference will seek a binding agreement to reduce global greenhouse gas emissions.

Hope for a broad global agreement has been renewed, as the globe's largest emitters, the U.S. and China, recently affirmed their commitment to bilateral cooperation on climate change.

Regardless of whether a global agreement is reached at the conference, we should expect that varying approaches to greenhouse gas reduction will continue to emerge. These policies can affect equity investments and, as such, should be carefully considered by investors.

Currently, policy responses can be grouped into two broad categories, regulation based and market based.

Some countries favor an approach based on regulated, hard limits to emissions. For example, in the U.S., following recent regulation of coal-fired power plants, many utility companies foresee earlier-than-expected retirement of such plants, and have written down the value of their assets accordingly. Similarly, in 2011, the U.S. updated its Corporate Average Fuel Economy standards to require tighter fuel emission standards for automobiles through 2025, and this is materially shifting the industry.

An example of a market-based scheme is the cap-and-trade system, in which companies are allotted carbon credits, a certain quota of emissions. Companies can buy these credits if they need credit for more emissions, or they can sell them if they generate less. This creates a “price” for carbon emissions and, ideally, motivates companies to invest in cleaner technologies. In Europe, emissions are managed by carbon pricing, which is dynamically set by a market-based mechanism.

Whether COP21 leads to a global agreement, the convening of international leaders to address this issue marks the potential for increased emissions management focus. Regional approaches to greenhouse gas management likely will differ, as will timelines for implementation. But the bottom line is that we expect to see further regulation — whether legislative or market-based — and that could have significant implications for asset owners.

We believe there are three primary channels through which COP21 — and climate change regulation more broadly — might affect investment outcomes and processes.

• Portfolio performance: We would expect regulations that directly restrict or encourage changes in the business operations of some types of firms to affect their stock returns. There is limited regulation on carbon emissions on major commodity producers today, and this risk might not be fully reflected in current stock prices. For example, an agreement to lower emissions may inhibit some energy companies' ability to extract resources, effectively devaluing company reserves. An investor might elect to actively manage this “stranded asset” risk or, alternatively, to increase exposure to industries that may benefit from changing policies, such as alternative transportation and renewable energy.
• Relationships with stakeholders: We anticipate that an increasing number of plan beneficiaries will call for or consider more carbon awareness from their funds. In Europe and Australia, in particular, we have seen significant interest in portfolios that have lower carbon profiles. In the U.S., beneficiaries have been relatively muted in calling for climate change awareness, but several prominent U.S. college endowments are now facing pressure to divest their exposure to carbon assets. Notably, the U.S. Department of Labor recently updated guidelines to confirm that they do not discourage ERISA plans from investing in responsible investment strategies; this update might catalyze investor interest in these strategies in 2016.
• New reporting regulations: Emblematic of the growing importance of carbon exposure measurement, the 2014 U.N. Principles for Responsible Investing Montreal Pledge calls on signatories to measure the carbon footprint of their portfolios. The ultimate objective is to establish targets for carbon and reduction, but the first step is actual measurement. Since then, some countries also have mandated the disclosure of portfolio characteristics on environmental, social and governance issues. For example, France adopted mandatory disclosure in 2015.

A commonly promoted tool to account for climate change risk in a portfolio involves the exclusion of key sectors, such as energy and utilities. This divestment approach is a fairly blunt tool, as it introduces unintended consequences: benchmark-relative tracking error, alpha detraction given the small universe, and more.

More nuanced approaches do away with the myth that responsible investing is “values investing.” The industry has come a long way since the mere exclusion of “sin stocks.” Today, investing on the thesis of climate change is typically motivated by the belief that new regulations or market mechanisms will structurally change the economics of energy, the profitability of emitting businesses and ultimately the returns of our investments.

To manage the carbon exposure in one's portfolio today, investors should consider the following:

• Review portfolio carbon exposure. Carbon exposure must be accurately measured in order to be effectively managed. Just as it is customary to assess a portfolio's tilt toward value vs. growth, or small cap vs. large cap, an investor might seek to understand a portfolio's sources of carbon exposure and deviations vs. a benchmark.
• Tilt portfolios toward lower emissions targets. With the improved availability of carbon emissions data from corporations themselves, an investment manager can set a portfolio-level maximum carbon limit. This approach doesn't go so far as divestment, as it allows broad sector representation, but it allows an investor to preferentially select low emitters over high ones. .

These are still early days, and the results of COP21 remain to be seen. Regardless of the outcome, climate change management represents both opportunities and risk for investors' portfolios. Some industries and companies will benefit from policy initiatives, while others might see their markets erode or become subject to government intervention. In either case, it is an issue that is growing in scope and importance, and as such demands an active response from asset owners.

Asha Mehta is a portfolio manager with Acadian Asset Management LLC, Boston.