Bridging the Gap: Carbon and Fiduciary Responsibility

June 20, 2016 |
3 minute read
|

Most institutional investor discussions and actions regarding global warming have been at two ends of the spectrum: either divest from fossil fuels entirely or remain fully invested. A better approach would be to change the conversation from a tug of war over a binary decision, between investment considerations and environmental appeals, to a more balanced discussion centered on common objectives.

By focusing on fiduciary responsibility, Chief Investment Officers can bridge the gap between two seemingly opposite views. Our extensive research indicates that investors can manage endowment portfolio return and risk expectations and tradeoffs, while simultaneously reducing exposure to fossil fuel reserves and carbon emissions. In addition, investors can target positive investments and innovations. The combination of these approaches aligns with the aspiration to lower carbon emissions for risk related reasons and make the world a more sustainable place to live, without sacrificing investment objectives.

These risks can come from carbon taxation, regulations, and new technologies. To effectively address these risks investors can execute an approach that removes a portion of the carbon exposure from their portfolio while also adding investments that should benefit from the transition to a lower carbon economy. But, first, there are important issues to consider: a) defining and measuring carbon exposure in the portfolio, b) robustness of carbon screening methodology, c) expansion of investment opportunities, d) investment implementation, and e) portfolio risk management.

Defining and measuring carbon exposure addresses which aspects of the carbon footprint, such as carbon reserves or carbon emissions, are removed from the investment portfolio. The robustness of the carbon screening methodology tackles how successfully and consistently carbon exposure is removed from the portfolio. The expansion of the investment universe provides for access to a larger and different investment opportunity set by investing in new technologies and alternative energy sources. Investment implementation refers to passive or active investment management approach. Portfolio risk management focuses on measuring risk and factor exposures in the newly constructed portfolio and controlling for any unintended consequences that arise from removing or reducing carbon exposure.

The most common carbon screening methodology is to remove only all companies that own fossil fuel reserves (e.g., coal, oil, etc.). There are several public investment vehicles that follow this methodology. However, we believe this is an ineffective approach to removing carbon exposure from a portfolio.

A more robust approach to removing carbon exposure from a portfolio would address reserves and emissions, which both contribute to the overall carbon footprint and thus carbon related risks. Carbon emissions are important because they may be subject to taxation and restrictive regulations, both of which could reduce the profitability of companies across many industries. Carbon reserves represent potential future emissions, because as they are extracted from the ground and consumed they become emissions. Carbon reserves are also subject to risks posed by the introduction of new technologies. These new technologies may strand current business models and make current carbon based products and services outdated, inefficient or expensive, thereby reducing the long term value of those reserves and reducing the asset value of a company’s balance sheet.

If we look at a typical broad equity market index, about 5% of companies own reserves; however, virtually 100% of companies produce emissions. Carbon reserves can be easily screened out, but screening out all emissions would leave no investments. This barbell scenario of high concentration of companies with reserves on one end and high dispersion of companies with emissions on the other requires a thorough understanding of sources of carbon reserves and emissions. Investors need a sophisticated and systematic carbon screening process that can accommodate both concentration and dispersion simultaneously.

As companies are screened from the portfolio, the investment universe is reduced and potential investment opportunities may be missed. An approach that simply removes companies with carbon exposure does not address the opportunity to invest in new technologies and clean energy sources that are replacing carbon based energy sources. New technologies are continuously replacing current technologies, which inevitably make existing products and services obsolete. Rapid advances in energy generation, storage, transmission, and efficiency will lead to lower cost curves, which will create new business leaders and which will provide obsolescence for companies with outdated or stranded business models. By ignoring companies that are at the forefront of disruptive energy technologies, an investor may miss out on the opportunity to participate in future growth.

When we look at the investment solutions currently offered in the market, the majority of, if not all, low carbon investment options are based on passive carbon screening investment indices. This approach provides a simple, low cost alternative that may be appropriate for some investors. However, by employing passive products, investors forgo working with superior active managers who may uncover investment ideas that can generate alpha.

As a new portfolio is constructed with screening of carbon exposure and the addition of new technology companies, portfolio return and risk characteristics inevitably change. For an investor to adhere to fiduciary responsibilities, both the portfolio return and the risk should be expected to be similar to the traditional investment benchmark with the goal being to minimize active risk (tracking error). For example, equity factor exposures should be tightly controlled so as not to deviate from the benchmark and from overall investment return and risk objectives. Inflation and commodities are important macro factors to measure and track, while some of the equity style factors include size, value, and momentum.

Trustees, investment committees and CIOs are expected to address their respective fiduciary responsibilities with every single investment decision. Typical investment decisions are driven by the risk and performance considerations of a portfolio of individual investments or a portfolio of third party investment managers. However, in the current environment with elevated climate change risks, these traditional investment considerations may be challenged by the aspirations of constituents or by the mission of the institution.

With that in mind, we believe it behooves anyone who is considering low carbon investment opportunities to satisfy, first and foremost, his or her fiduciary responsibilities by reducing carbon risk. Second, consider investing in low carbon opportunities and new technologies. And third, manage the intended and unintended consequences to portfolio return and risk characteristics.

Commonfund

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Commonfund

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