bfinance: New data on equity fund emissions
Analysis identifies three practical challenges that investors face when cutting the carbon emissions associated with their equity portfolios.
Independent investment consultancy, bfinance, has released an analysis of key carbon-cutting ‘pitfalls’ in equity investing and how to avoid them, using new data on carbon emissions across global equity styles, sectors, and geographies.
While carbon commitments can represent a positive step within a broader ESG agenda, applying reductions in an overly simplistic way can lead to problematic consequences—undermining both investment-related goals and environmental ones.
The analysis outlines three potential pitfalls that investors can encounter when cutting carbon: a restricted manager universe, sub-optimal or unintended investment outcomes and undermining ‘climate’ objectives. Afterwards, the authors provide a series of practical questions that investors should address when defining objectives and implementation choices, with a view to minimising missteps.
Pitfall 1: Restricted manager universe
Not all active equity managers are willing to deliver carbon reduction targets. While it should theoretically be possible to create a portfolio with a lower carbon footprint in almost any type of strategy, the reality is more complex. In practice, an overly strict target can constrain the potential universe of equity strategies available to investors.
Importantly, managers’ willingness to deliver portfolios with low carbon intensity varies by ‘style’.
Proprietary analysis shows that global Low Volatility equity strategies have a median Weighted Average Carbon Intensity (WACI) that is 52% higher than the MSCI ACWI index and Value strategies have a median WACI that is 4% above the benchmark. Conversely, Quality and Growth strategies have median WACI figures that are 85% and 55% lower than the benchmark respectively. Investors should be careful when focusing exclusively on WACI figures: overall emissions numbers tell a different story.
There are other factors which may make a strategy difficult or easy to mould to a low-carbon target, such as the extent to which it uses quantitative portfolio construction techniques. It is also important to be aware of the diversity of manager approaches: there are large differences in the amount of dispersion in the WACI data for Low Volatility and Quality Value strategies, whereas High Growth and Quality Growth strategies are more homogeneous from a WACI perspective.
Pitfall 2: Sub-optimal or unintended investment outcomes
Depending on an equity manager’s style and approach, a strict target may limit an equity manager’s ability to execute their strategy as intended, perhaps increasing portfolio concentration or resulting in a significant performance differential between a separate account and the same manager’s pooled fund. This can be a double-edged sword: removing exposure to the ‘worst offenders’ (such as fossil fuel firms) would have been disadvantageous in the first half of 2022, when the Energy sector was up 23% in the MSCI ACWI, but proved beneficial in the first quarter of 2020.
It is also crucial to look at the effect that ‘Scope 3’ data will have on the picture. Investors that might have dramatically cut Scope 1 and 2 carbon figures by removing a few key offenders will find this approach less realistic when Scope 3 is included.
Pitfall 3: Undermining ‘climate’ objectives
A low carbon footprint today is typically achieved by severely reducing or eliminating exposure to the ‘worst’ emitters. However, these high emitters are often the firms that have the greatest scope for impact. They may be important to new climate-friendly technologies—as is the case for chip manufacturer TSMC—or they may have huge potential for reducing direct emissions, as exemplified by Danish multinational power company Ørsted. Engaging as a shareholder may allow investors to exercise greater positive influence than they would achieve by simply avoiding these companies.
Key questions for implementation
Ultimately, investors must take a pragmatic approach. As such, the report provides a list of practical questions that investors should ask themselves when determining carbon-cutting objectives, implementation choices and the approach to measurement.
Martha Brindle, Director – Public Markets at bfinance, said: “We observe a rapidly growing number of institutional investors setting carbon footprint targets for their equity portfolios. This is a positive environmental commitment on paper, but implementing these objectives in practice is more complicated that it may at first appear, and investors should navigate potential pitfalls with care.”