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How to reduce carbon in institutional portfolios

19 Nov 2019

Fawzy Salarbux, global head of consultant relations, Candriam

There was a time when discussions about the environmental concerns of pension schemes were gently put to one side as secondary to the fiduciary obligation to secure the best financial outcome for scheme members. In 1998 for instance, the Department of Labor in the US “allowed” pension plans to consider ESG, so long as they did not negatively affect financial performance.

Fast forward to 2015, and those same fiduciaries of US pension plans were being told that they “should” integrate ESG factors where appropriate. Under article 173 of France’s Energy Transition Law, institutional investors (including insurers) are required to disclose their exposure to climate risk on an ongoing basis. Justifying why an investor does not evaluate climate change in its outlook has become the exception rather than the rule.

What has shifted mindsets in the past 20 years has been the sheer evidence of the risks of climate change. Deep ice drawn from three kilometres beneath the North and South poles tell us that concentrations of CO2 in the atmosphere are higher than they have been for millions of years. The trend began with the Industrial Revolution, but the terrifying fact is its acceleration in recent times: since 1960, human activities have added one-quarter of the CO2 in the atmosphere.

We are experiencing more extreme weather-related events globally. Last year saw more than 800 such events, more than three times than during the 80s. Reporting this kind of data is essential for insurers, reinsurers but also their investors to understand and evaluate the risks in providing capital to such businesses. Equally, the reason why pension funds can give a fuller account of the climate-change risks in their portfolio is because most investee companies in those portfolios are obliged to report on carbon emissions too.

Optimise rather than exclude

It does not take a great deal of analysis to work out that certain sectors, such as energy, are responsible for the biggest chunk of emissions. Just 20 companies, mostly oil producers, can be directly linked to a third of all greenhouse gas emissions in the modern era, according to recent research by the Climate Accountability Institute.

So why not cut out or divest from the worst polluters? The answer is that doing so risks throwing out vital innovation in renewable technologies occurring in the energy sector. Power producers mixing high-CO2 generation with renewable technologies are more common than renewable pure players.

A few examples of such mixed power generators include: Huadian Fuxin Energy in China (35% coal power, 35% wind power, 22% hydroelectric), Idacorp in the US (three coal power plants, 12 hydroelectric power plants) and Electric Power Development in Japan (38% coal power and 39% renewable power).

Moreover, excluding the energy sector, materials and utilities would omit around 14% of the MSCI World index (based on February 2019 data) and lead to severe sector biases, higher tracking error and adverse portfolio behaviour in certain market conditions. Sector biases should not be underestimated; they can lead to unintended high sensitivity of the portfolio to commodity prices.

Maintaining some exposure to fossil fuels via such companies does, however, present asset owners such as pension funds and insurers with a paradox of how to proceed as responsible investors.

At Candriam, we believe the paradox is best addressed by using optimisation rather than absolute divestment from any industrial sector. This means combing through all the stocks in an equity portfolio and re-weighting them to achieve the same benefit as excluding that trio of the most carbon-intensive sectors, but without unintended consequences.

In one customized portfolio, our carbon optimised strategy achieved a 75% reduction in fossil-fuel intensity with 75% lower tracking error versus the MSCI index than simply divesting from all energy, materials and utilities would have achieved1.

This has three main advantages over an exclusion approach:

  • Sector-specific risk is significantly reduced in favour of stock-specific risk
  • We have an overweighting towards renewable energy (total exposure rather than via pure-play renewables, which are rare).
  • The portfolio is biased towards the most efficient and least carbon-emitting companies, contributing to the signal to promote energy transition within high-carbon sectors.

Conclusion

We end where we began, with the ESG obligations of institutional investors. A major client recently structured a mandate with Candriam using optimisation to address those obligations. The demands were to bring the current carbon dioxide emissions of the portfolio below 50% of the benchmark; to restrict revenue from coal of stocks in the portfolio to 20%; to restrict generation of greenhouse gases to 1,500 metric tonnes per €1m (£869,500) of revenue; and to tilt the portfolio towards companies making real efforts in energy transition.

These criteria acknowledge the paradox of dual players in fossil fuels and renewables whilst aiming strategically for a greener world.

1) For illustrative purposes only. Past performance is no guarantee of future results. For an explanation of methodology and results, please see “Reducing Carbon Risk in Institutional Portfolios”, July 2019. https://www.candriam.be/en/professional/market-insights/topics/sri/reducing-carbonrisk-in-institutional-portfolios/

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