Linda-Eling Lee, global head of ESG Research
If 2014 was any guide, there is a shortening lag between when ESG issues emerge and when markets and regulators react.
Whether it is shifting regulations targeting the ‘tax gap’, a new market benchmark to define green bonds, or the adoption of low carbon investment solutions, our 2014 ESG Trends to Watch report highlighted areas where institutional investors showed growing appetite to address longer term risks and opportunities.
We head into the new year with the backdrop of swooning oil prices and (re)newed geopolitical fault-lines, juxtaposed against a return to growth in the US and emergence of the next generation of tech darlings.
Investors, companies, policymakers, and NGOs anticipate the upcoming climate talks in Paris with an equal measure of hope and fear. In this cacophony, which ESG trends will be most top-of-mind among investors in 2015?
Aligning to Fuels of the Future
Are institutional investors positioned for the transition to renewable energy?
With media and political attention already focused on the 2015 UN climate conference in Paris, the rush among institutional investors to reduce their carbon exposure is gaining momentum. In 2015, we foresee that widespread adoption of de-carbonization tools will be followed by interest in aligning portfolio exposure to our future energy technology.
Institutional investors worldwide have come up a tremendous learning curve in the past year on understanding their exposure to carbon stranded assets. Whether catalyzed by a concern over mis-priced fossil fuel assets or pressure from a persistent call for divestment, investors have begun to scrutinize the carbon-related risks embedded in their portfolios.
The options for investors have multiplied. From a simple snapshot measurement of companies’ current carbon emissions, investors can now adopt a total portfolio accounting of current and future emissions, measured against clear market benchmarks.
From exclusions based on blunt measures such as industry classification, investors can now choose from a menu of portfolio construction techniques that range from selective exclusions to tilts of portfolio weights based on current and future carbon characteristics of individual securities.
As institutional investors shift their portfolios away from carbon-intensive assets, the natural follow up question will be: to what extent can we shift investments to align with the energy technologies of the future?
According to the International Energy Agency, the share of global energy consumption from renewable fuels – including wind, solar, and hydro – will increase from 21% in 2010 to 25% in 2020. Already, in markets ranging from Germany and the US to India and Brazil, wind or solar power have reportedly reached cost parity with new fossil fuel-powered generation.
While uncertainty around future policy support for renewable energy development clouds the forecast in specific markets, few question that the long term, global energy picture – and our fundamental energy infrastructure – will shift from its current energy mix.
Institutional investors have tended to confine the bets they make on future energy sources and green technology more broadly into their ‘thematics’ allocation. Yet investors can be highly exposed – both positively and negatively – to fundamental shifts in energy technology in the broad, diversified equity and fixed income holdings that can make up the vast majority of a portfolio.
In the MSCI ACWI Index as of November 2014, the aggregate power generation capacity of the utilities sector breaks down to 29% coal, 7% liquids, 26% gas, 14% nuclear, 14% hydro and 7% non-hydro renewables. The diversity among these companies is instructive: while over one-third of the companies (by market cap) currently has less than 10% generation capacity from renewable sources, 11% of companies derive more than 50% generation capacity from renewable sources.
Using MSCI ESG Research’s data on the planned future capacity of all MSCI ACWI Index companies, we find that nearly 10% of power generation companies will increase renewables capacity by at least 10% in the next five years.
On the positive side, if all the additional renewable capacity that is currently planned by these companies is realized, an institutional investor replicating the MSCI ACWI Index would have increased its exposure to renewable generation capacity by 22% between 2013 and 2018, more than quadruple the rate of growth in coal and gas capacity.
On the other hand, this 22% growth rate pales in comparison to the 39% growth projected by IEA for renewable power generation between 2013 and 2018.
Further, despite this significant growth in planned renewables capacity, the share of renewable fuel (including hydroelectric) in the aggregate generation capacity of MSCI ACWI Index companies would roughly equal that of coal and gas.
In comparison, IEA’s projected growth rates would have the global installed capacity of hydro and other renewables overtake both coal and gas by 2018.
While the publicly listed equities universe will undergo a shift in the underlying energy mix, it may not capture all of the growth in renewables generation capacity that is happening in the real economy. In other words, without deliberately tilting more aggressively toward the companies with large and growing renewable capacity, investors potentially risk being under-exposed to significant growth in future fuel technology.
Measuring the exposure to these underlying, fundamental shifts in our energy future is the sort of exercise that institutional investors may increasingly undertake. Beyond electricity generation and taking account of clean technology more broadly across all sectors, investors will be armed with improved data and analytics that can inform more deliberate alignment of their overall portfolio with our energy future.
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