By Bruce Jenkyn-Jones
Is there an easy way for investors to capture the shifting dynamics and mitigate carbon risk without changing their overall portfolio risk profiles?
Given the increasing likelihood of a carbon tax or other policies to reduce CO2 emissions, investors face significant risks and opportunities across the investment landscape. We are pleased to see increasing understanding of these risks by asset owners, many of whom are now trying to find a satisfactory and consistent method of monitoring the high carbon intensity of their investments.
Carbon tilted indices (“CTIs) are one approach. Using information about the emissions from a company’s activities, CTIs seek to reweight traditional financial indices to emphasise those companies with the lowest carbon footprint across all the economic sectors. That way the investor does not change their sector factor risk but reduces carbon risk. So far, so simple. However, ’tilting’ methodologies are heavily dependent on an accurate database of companies’ activities and do not necessarily reflect their supply chains, and certainly not the carbon footprint of the end products. This can mean that the tilt is wrongly applied, resulting in an inaccurate reflection of risk.
In a typical CTI the highest emitters will inevitably include oil & gas, electric utilities and mining companies which will have their weights varied to the greatest extent. These companies are usually responsible for direct emissions (Scope 1) from sources that they own or control. Some CTIs will also take account of indirect emissions (Scope 2) arising from the company’s consumption of electricity. Scope 3 emissions, which are a company’s indirect emissions, the most significant is often business air travel, are not taken into account at all, but can be considerable for some non-manufacturing companies.
Industries that may be wrongly categorised could include manufacturers that make products that help to reduce future emissions. For example, a company where existing methodologies would not, in our view, give a meaningful rating would be Kingspan, an Irish manufacturer of insulating panels. Existing approaches only take into account the relatively high emissions from the company’s processes in the manufacturing of the panels and make no allowance for all the CO2 saved in their application over their lifetime. To put this in context, Kingspan emitted close to 100,000 tonnes of CO2 in 2013 as a business but the 60 million m2 of board and panel that they sold in that year would save 1,800,000 tonnes (assuming 3 tonnes saved for every m2 installed) per year suggesting a huge net carbon saving over the product lifetime. A CTI may tilt away from Kingspan, but it would actually be one of the biggest beneficiaries in a carbon-constrained world. There could be the opposite effect with a CO2-light business that makes high CO2-emitting products. Automation and other energy efficiency improvements on production lines are lowering Scope 2 emissions for many manufacturers. This is all to the good, and these savings are automatically taken into account in CTI methodologies. However, this can be highly misleading; for example for an automative assembly company building high-performance, high-fuel consumption vehicles where the future emissions from those vehicles go unaccounted for in CTIs at present.
CTIs can do part of the job to mitigate carbon risk but as illustrated above, in their current form are likely to leave investors underweight energy efficiency and recycling, and possibly over-exposed to products that are at risk in a carbon-constrained world. Further development and an added level of sophistication are required. Until then investors need to understand the methodology used to compile the indices and think carefully about how they are applied on a case by case basis – looking out for spurious exclusions of companies that are actually the solutions providers.
Impax does not offer CTIs, but we are supportive of their development – as long as the methodology is robust and genuinely mitigates the risk of carbon regulation. Impax funds seek to invest in companies offering cleaner, more efficient solutions in the energy, water, waste and food sectors and, as such, would be big winners in the event of a carbon tax.
Bruce Jenkyn-Jones is head of listed equities at Impax Asset Management
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