By Aled Jones
The risks posed by climate change have become familiar to us all, but investors in particular face the climate challenge with many more questions than answers. In light of the recent Paris climate talks, where a new global agreement to manage carbon emissions and tackle climate change was reached, I’m anticipating that the issue will rise up the agenda for investors in the coming years.
A lot of attention is now focused on “portfolio decarbonisation” either via low carbon indices or divestment of fossil fuel (FF) holdings. This is not surprising given the increase in public and media scrutiny. But responding to the investment implications of climate change calls for clearly thinking through one’s beliefs and objectives regarding responsible investing, or RI, and the ESG (environmental, social, and governance) issues that attach to it.
Investors concerned about their exposure to “carbon risk” – for example through their Energy and Utility equity holdings – must ask themselves what they are trying to achieve. Is it a 100% reduction in exposure to FF/energy stocks, a more moderate relative underweighting of such stocks, or gaining more positive exposure to low-carbon opportunities? The answer to these questions determines the implementation route(s) they can take.
I regularly highlight to clients that a current challenge is that FF-free fund options are limited – it’s almost a chicken-or-egg prospect, whereby fund managers say they are waiting for client demand, while clients tell us they are waiting for products to invest in. FF-free fund options are broader for actively managed strategies than passive one, although the avoidance of FF stocks tends to be implicit (e.g. it doesn’t fit within a specific sustainable theme) rather than explicit (i.e. set out in a list of exclusions).
The product gap is particularly acute within passive equity funds. In the UK, there are relevant pension scheme vehicles available but charities, for example, cannot invest in these. And while fund managers can create specific FF-free index tracking products, they require relatively high minimum commitments, which can range from £50-100mn for a new fund.
This brings us back to objectives and implementation options. Investors need to consider what climate risk they are seeking to manage before considering the type of index or fund to opt for. In a world where the cost of carbon is likely to rise, managing exposure to high carbon companies is an intuitive step to take. The “premium” associated with these indices is reduced carbon exposure rather than performance. That said, reduced carbon exposure may be rewarded in financial terms, all else equal, as policy measures develop to reward lower carbon activities.
My view is that there are three broad index categories to consider:
- Broad-market optimised: Does not exclude any companies but tilts allocations to companies with lower-carbon intensities.
- Best-in-class: Typically involves screening out companies with the highest carbon intensity. Maintains parent index sector exposures but re-weights towards companies with the lowest carbon intensity within each sector.
- Fossil fuel free: Excludes fossil fuel companies (typically companies who have fossil fuel reserves or are involved in the extraction process).
Investors need to be fully aware of the underlying construction methodology — in particular, “fossil fuel-
free” does not have one consistent definition across asset owners, index providers, or investment
managers. Style or factor biases and the ultimate constituents in the final index are additional issues to consider.
Ultimately, which category of low-carbon index is most suitable for the investor comes down to goals and objectives. For example, some of my clients are concerned about the financial risks associated with “stranded assets” i.e. the possibility that a proportion of existing fossil fuel reserves will never be utilised due to changes in regulation, demand, and technology. These clients are more likely to consider an index that reduces exposure to FF reserves (option one or two, above). A growing group of clients are keen to remove all exposure to FF, driven largely by reputational concerns. For this group a FF-free index (option three) would be more appropriate.
But the use of such indices should not be seen as equivalent to, or as a substitute for, actively managed equities with a high level of ESG integration or that specifically target the investment opportunities arising from the shift to a lower carbon economy – an opportunity set that we expect to grow. Low carbon indices are one element of an investor’s approach to managing a risk that in our view is here to stay.
Aled Jones is principal, responsible investment at Mercer.
