An innovative investment strategy could alleviate investor fears
Not all investors accept that climate change is taking place or that it might affect their portfolios. Some investors acknowledge that carbon-intensive assets are likely to suffer permanent value destruction, but have not acted because they think the risks are too remote. These risks might seem even more remote today amid President-elect Donald Trump's commitment to the exploitation of fossil fuels to foster economic growth and his suggestion the U.S. will withdraw from the 2015 Paris Agreement, the legally binding global climate pact.
Mr. Trump's position is potentially problematic for investors who integrate environmental, social and governance considerations into their decision-making processes; their great fear, however committed they are to responsible investing, is underperformance vs. broad market indexes. Asset managers divesting from stocks with high carbon footprints run the risk of underperforming their benchmark for as long as climate mitigation policies are postponed and market expectations about their introduction remain low. These asset managers, as well as those who follow low-carbon strategies, could be wiped out long before serious limits on carbon emissions are introduced.
If the U.S.' new economic path leads to a pullback in environmental regulation and a shift in capital to high-carbon industries, underperformance of green and low-carbon funds may become more likely, at least in the short to medium term.
What's the solution?
Until now, investors would either have to run the risk of underperformance by investing in green and low-carbon funds or try to outperform their benchmark by investing in an index of clean-energy stocks. However, clean-energy stocks tend to be volatile and represent a very different strategy from low-carbon investing.
An alternative to both these options is now available. A new investment strategy — proposed by Mats Andersson, Patrick Bolton and Frederic Samama and published in the CFA Institute Financial Analysts Journal of May/June 2016 — aims to track broad stock indexes while also removing much of the carbon footprint of the index.
The authors show that in the past, achieving a near-100% reduction in the MSCI Europe's carbon footprint would have come at the price of a tracking error of more than 350 basis points. The owners of the world's nearly $11 trillion held in traditional index investments are highly unlikely to be willing or able to stomach such a large deviation from the index.
According to the proposed new decarbonized strategy, tracking error could be virtually eliminated and, at the same time, the carbon footprint of the decarbonized index could be reduced to about 50% of the carbon footprint of the benchmark.
A 'free option' on carbon
The authors explain this decarbonized index is essentially a “free option” on carbon. That is, if actions are taken to mitigate climate change, the low-carbon strategy is designed to outperform; but if no action is taken, the strategy would be expected to provide the same returns as the benchmark. And when carbon emissions are repriced meaningfully — because of a change in environmental regulation, corporate behavior or investor sentiment — the decarbonized index should significantly outperform the benchmark.
This potential hedge against carbon risk could be important for many long-term investors, particularly passive investors. Any future underperformance of passive investments vs. decarbonized strategies could severely affect long-term investment outcomes and, consequently, the lifestyles and retirement prospects of millions of pension fund members and other end-clients.
How the decarbonized index is constructed
The decarbonized index with low tracking error is created by constructing a portfolio with considerably fewer stocks than the benchmark, but with similar aggregate risk exposure.
The application of the “green filter” seems sophisticated: the divestment of high-carbon-footprint stocks takes into account not just today's carbon footprint, but expected future carbon reductions resulting from current investments in energy efficiency. Similarly, the filter penalizes oil and gas companies that invest heavily in exploration with the goal of increasing their proven reserves, thereby raising the risk of stranded assets.
The authors explain the decarbonized strategy should outperform over the long term because financial markets seem to underprice carbon risk and this underpricing looks systematic: only in 2014 did a discussion about stranded assets make it into a report from a leading oil company for the first time. And, to date, only a few specialized financial analysts reference carbon-pricing risk in their reports to investors.
At some point, financial markets will probably begin to reprice this risk.
Transparency and diversification
Another claimed benefit of the decarbonized strategy is the transparency it offers. Institutional investors are increasingly tasked not only with meeting performance targets, but also with investing in a way that has beneficial societal impact. Clearly communicating which constituent stocks are in the decarbonized index should help these institutional investors to demonstrate they are adopting a proactive approach and that they also are encouraging companies to care about their carbon footprint.
For sovereign wealth funds of oil-and-gas-exporting countries, the decarbonized strategy could also help meet one of their central aims of diversifying from high-carbon assets.
What's the catch?
Investors should keep in mind there are limitations to this research.
An obvious potential flaw in the decarbonized strategy is the possibility that financial markets currently overprice carbon risk. The authors estimate this is unlikely, as the current level of carbon risk awareness remains low.
A more valid concern is whether companies' carbon footprints are correctly measured and, therefore, whether filtering for the index is meaningful. The authors argue that decarbonization methodologies have existed for many years and will only develop over time, thereby reducing the risk of faulty measurement and filtering.
There is also the fear that investment returns might suffer in the short term. The authors recognize this is always possible but, so far, their evidence suggests decarbonized indexes have matched or even outperformed the benchmark. In other words, investors holding a decarbonized index have been able to reduce their carbon footprint without sacrificing financial returns.
This study could potentially have a meaningful, positive effect on investor portfolios and climate change investing as a whole. Research addressing climate risk is to be welcomed and we would expect more such studies in the future, whatever the geopolitical situation.
Barbara S. Petitt is managing editor, CFA Institute Financial Analysts Journal