A majority of people recognise that climate change is a real phenomenon, and acknowledge the impact it may have on the planet and on society.
However, climate change isn’t just a risk for society, it is also a threat to investment returns. Indeed, a growing number of institutional investors are taking climate change seriously, and they perceive that the related risks are not appropriately priced, compared to other risks such as another financial crisis, unemployment, data fraud, or cyber attacks. All investors have a fiduciary responsibility to maximise returns, and many are re-allocating capital away from carbon intensive companies – companies that either pollute, or that are exposed to so called stranded assets, including carbon reserves such as coal and oil that they will never be able to monetise.
This decarbonisation process is important because it can be achieved without requiring any negotiations or agreements between governments and without binding treaties. Importantly, this process is also cost-free: investors can go ‘green’ without sacrificing returns.
These decarbonised – or “green funds” – are building track records that hedge the risk of future regulation at no cost, while paving the way for higher future returns. In the unlikely event that there turns out not to be any climate change impact, investment performance will match the benchmark. If climate change does take effect, the investment strategy will generate outperformance.
How does it work? It centres around the construction of simple and transparent products.
Index providers have already done much of the heavy lifting. In September 2014, MSCI launched its Low Carbon Leaders indexes, in conjunction with institutional investors. The indices’ methodology aims to achieve at least a 50% reduction in the level of carbon emissions from the constituent companies and assets making up the index (present emissions and reserves representing potential future emissions) compared to the parent indexes, the MSCI World and the MSCI Europe, all the while minimizing the tracking error relative to them.
The indices, therefore, exclude one fifth of stocks in the parent index universe, based on the “carbon emission intensity criteria”, which is defined as the weight of carbon emissions (tons of CO2) of a company relative to market capitalisation, with a maximum exclusion of 30% for each sector market capitalization. They also exclude the largest owners of carbon reserves per dollar of market capitalisation, representing at least 50% of the reserves in the parent index.
So for instance, a heavy polluting steelmaker that emits large amounts of CO2 is more likely to be excluded than, say, a more energy efficient cement maker. Likewise, large oil majors valued on the basis of their energy reserves will have a reduced weighting in the indexes. The 70% floor for any sector means investors do not withdraw completely from that sector, they merely reduce their exposure to it.
In addition, the strategies retain a sectoral and geographical composition similar to the parent index. This is very important. We believe such indices have to offer a free option on carbon repricing, to encourage investor participation, so highly correlated performances to the underlying parent indices is crucial. Indeed, the MSCI Europe Low Carbon Leaders Index even outperformed MSCI Europe by 1% between November 2014 and April 2015.
Of course, critics might argue that this investment approach still leaves investors heavily exposed to carbon emissions, and so it becomes a fig leaf to show clients and shareholders that they are ticking the CSR box and ‘doing their bit’. But adopting an approach that combines exclusion and engagement should deliver results. It sends clear messages to companies to reduce their pollution, and/or to diversify their business away from carbon reserves. It also gives them time to adopt these strategies. This should accelerate the transition towards a low carbon economy.
The combined financial firepower of committed investors will force companies to take notice. Institutions that are concerned about climate change manage or represent $92trn, more than five times the entire GDP of the United States. All it takes is small incremental steps to make an impact, For instance, if those investors decided to decarbonise just 0.1% of their portfolio, that would amount reallocating nearly $100bn in capital from polluting companies towards carbon efficient companies.
Institutional investors are already doing just that. For example, AP4, one of Sweden’s largest pension funds with over $30bn under management, has gradually decarbonised its equity portfolio over the past two years, without sacrificing returns.
Similar experiments exist around the world. the Portfolio Decarbonization Coalition’s (PDC)is a not-for-profit coalition of investors whose main target is to bring together institutional investors who are committed to decarbonising at least $100bn in assets. After a few months of existence, $45bn has already been committed. This illustrates to other asset owners that portfolio decarbonisation is real, feasible and scalable.
Of course, the task to decarbonise ‘Global Inc’ cannot be left to investors alone. Governments can and should create strong policies to leverage this shift in investor awareness by providing clear commitments on future carbon pricing. This will send the right signal to both investors and polluting companies. At the same time, it will help guide investments towards renewable and green infrastructure. The quickest and simplest way to begin doing this is straightforward enough: by introducing mandatory disclosure of the carbon footprints of public pension and sovereign wealth funds. This policy has no cost: pension and sovereign wealth funds already communicate on all risks (interest rate exposure, equity market risk, etc.) except for this one. Greater transparency on climate risk will by itself encourage action: what gets measured eventually gets managed.
Investors need to move towards lower carbon investments today. Delaying portfolio decarbonisation will be costly for investors and for society.
Frederic Samama is Deputy Global Head of Institutional and Sovereign Clients at Amundi, the European leader and in the top 10 worldwide in the asset management industry with AUM of more than €950bn globally.