Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Confusion and conflict in climate equities
Climate risk has “never been higher on investors’ agendas” – but the strategies they use to combat it
often have conflicting features. Lack of data only compounds the problem.
Martha Brindle, director of equities in bfinance’s public markets team and Sarita Gosrani, director of ESG and responsible investment (both based in London) note that there are essentially three main “climate-aware” strategies within the listed equities space – the disparate features of which can conflict with each other.
“Notwithstanding the heightened incentives for ‘greenwashing’, asset managers’ products, methodologies, stewardship programmes are evolving in some innovative and interesting ways,” Brindle and Gosrani wrote in a paper titled “Carbon Cuts or Climate Impact? New Choices for Equity Investors”.
“These developments are also immensely helpful in supporting us, as advisors, in helping investors to take a robust approach to climate risk… Yet investors must also be cautious and select objectives, strategies and managers with care.”
What the authors call a “focus on carbon” strategy is essentially built on one of the foundational tenets of early ESG investing: negative screening. It aims to “materially reduce” portfolio carbon footprints and mitigate exposure to high emitters. Portfolios utilising this strategy can be relatively concentrated, underweight energy and overweight sectors like technology, software, and healthcare, and – due to the fact that they have little exposure to them – can limit avenues for impact investing or influence over companies that are high carbon emitters.
Following from this is strategies that “focus on climate risk” – which may result in a higher carbon footprint in the short- to medium-term as they usually hold companies that are high emitters but are intent on transitioning to a low carbon economy; an approach that the authors believe is “more intellectually-aligned with the TCFD philosophy” and which is seeing substantial interest from investors who do not want to take an exclusionary negative-screening approach.
“There is now a rapidly-growing universe of active and passive products that consider climate risk: recent product launches have chiefly sat in this part of the spectrum, rather than looking solely at carbon reduction,” Brindle and Gosrani wrote.
“These climate strategies espouse a holistic approach, incorporating both emissions data and analysis of a company’s trajectory into decision-making. This is intended to enable investors to capture opportunities created by climate change while also incentivising companies to put transition strategies in place.”
Of course, the fact that the strategy is a relatively recent development brings with it challenges – notably the short track records of funds that use it, and an “evolving regulatory and fund taxonomy” that can make it difficult for investors to compare strategies.
“Hurdles notwithstanding, we do now view this group as offering a highly credible opportunity for investors seeking to capture climate risks and support the energy transition,” Brindle and Gosrani wrote.
The third strategy is a “focus on impact” – which is “designed to generate financial returns while capturing opportunities created by climate change and the transitioning economy.”
“Here, we see a more concentrated focus on companies that can provide solutions to the existing environmental challenges thereby focusing on themes such as the clean energy transition, water, biodiversity, sustainable forestry, sustainable agriculture and so forth,” Brindle and Gosrani wrote.
“While sector skews may be evident in the previous group, here they are expected. From a portfolio style perspective, these strategies are likely to have a growth skew, with companies bringing out innovative (or even disruptive) products and technologies to solve environmental challenges.”
Equities have enjoyed something of a favourite child phenomenon when it comes to ESG activity, and modern data availability means they are “typically the first to receive attention when investors turn towards the subject of carbon emissions.” bfinance’s 2021 ESG Asset Owner Survey found that 57 per cent of investors are now monitoring carbon metrics in equity portfolios (up from 14 per cent three years ago) compared to 41 per cent in fixed income and 30 per cent in real assets.
But carbon data challenges remain. For example, scope 3 emissions (those that result from activities outside the ownership of the reporting organisation, but which can comprise ¾ of its emissions) are often omitted or unavailable, while verifying wider carbon data can be difficult due to lack of standardisation.
“Investors are increasingly seeking to understand the impact of climate risk within portfolios and take action,” Brindle and Gosrani wrote. “Motivations may sometimes be more intrinsic or extrinsic: regulatory pressure, data accessibility, stakeholder interest and investment product availability all play a role, alongside the now-widely-accepted premise that climate risk is systemic and financially material for long-term investors.”
