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.
A green Lehman Brothers moment on the ‘other side of the ledger’
The transition to renewables is chugging along, though some investors have been happy to resume their flirtation with fossil fuels in the aftermath of the Russian invasion of Ukraine. But one day soon the music will stop.
“Global capital markets are busy repositioning slowly,” said Michael Lebbon, CEO of carbon solutions provider Emmi. “When enough of them reposition, that’s when there will be a reckoning. Not for everybody, but if you’re the Bear Stearns or the Lehman Brothers of the world, you’ve got problems. You don’t want to be the last to the door.”
“It’s a confronting way to talk about it – people want to say the market does the right thing, but we live in a capitalist world… Once you get 50.1 per cent on the other side of the ledger, things are going to move pretty rapidly. When is that? I’m not sure. But do you want to chance being on the other side of the ledger?”
Emmi’s most recent research found that some 30 per cent of the ASX300 – or roughly $480 billion – would be at risk by 2030 if the world became carbon constrained. Closer to 2050, nearly half of the ASX300 is at risk for the same reasons. The same analysis is now being conducted on the S&P500, FTSE, and Nasdaq (notably emissions light, given the high representation of tech in that index).
Right now, companies are continuing to emit carbon without any real penalty. But carbon restraints will arrive in many forms; legal, reputational, regulatory, market, and technology risk all loom as a kind of Five Horsemen of the Apocalypse for heavy emitters. The allure of exclusion is almost understandable in that kind of dynamic. Nobody wants to wind up on the wrong side of the register, after all, though Lebbon firmly believes that engagement is still the way to go.
“It’s about positioning these companies to then start doing something,” Lebbon said. “Exclusion is a blunt instrument until there’s absolutely nothing else you can do. Until there’s absolutely nothing that can be done and there’s no way that a company is going to change, then that’s what you’re left with.”
“It’s the same as carbon offsets and carbon credits. Don’t use that as the first part of your decarbonisation strategy. Do all the work you can and reduce your internal emissions, and then when you can’t do anything else buy carbon credits.”
But recent events have threatened to divert attention from a transition that was only just now beginning to gather speed. We’ve been here before; the Global Financial Crisis saw sustainability efforts falter in the face of what was perceived as the greater threat. Lebbon was just starting out in carbon markets when the crisis broke.
“The biggest thing the GFC did was stall global carbon markets,” Lebbon said. “The Kyoto Protocol was up and running and everybody was saying “We’re going to do this – a global carbon price is going to come in, and we’re happy to pay for the slight cost of living increase to decarbonise.”
“Then because everybody just viewed decarbonisation as a cost at that time, the GFC hit and everybody tightened their wallets and didn’t have any money to spend. All the carbon prices except the EU one basically got shelved. That was a massive slap down for global carbon pricing, and it still hasn’t recovered.”
But here come those fateful words: this time is different. Back then the transition was viewed entirely as the responsibility of global governments; now carbon constraints are going to come from all corners. While oil and gas have gone through the roof amidst the Russian invasion of Ukraine, sustainability hasn’t been put on the backburner – rather, it’s been brought to the fore. Oil and gas are still riskier in an economy that is definitely going to decarbonise sometime in the future.
“If those oil and gas stocks continue to outperform and have super profits, you’re comfortable holding them because they’re rewarding you for the extra risk you’re taking on,” Lebbon said. “What’s different now is how much longer they can sustain those super profits, and when do the risk and reward reverse and (those profits) don’t come back?”
There’s also inflation to consider. Some investors believe the massive economic cost of the transition to renewables will be the ultimate inflationary force. China overinvested in its system, pushing through too many renewables and replacing assets that were still within the bounds of their useable life; similar actions, proceeding at the pace some investors seem to want, would absolutely be inflationary. But Lebbon believes that renewables will ultimately have a deflationary effect.
“A correct transition where you run out a coal- or gas-fired power station and don’t renew it and spend the capex on a more renewable form of energy that then has a marginal cost of zero – there’s been work that’s done that shows renewables over time reduce the cost of energy.”
“If there’s a hell of a lot of policy that’s put in place and we just run in and don’t think about how we invest, then yes, there’s a potential inflationary problem. But done correctly, I believe it has a deflationary point. Like everything, it needs to be done smoothly.”
Still, life occasionally delivers a reminder of the vast challenges of the transition. Lebbon has just returned from a surfing trip in remote Indonesia; at one point the tides went the wrong way, and the group wound up surfing in rubbish.
“Our natural world is what generates economic value and carbon emissions is a global problem, and we can’t just talk about the developed world. We need to bring the developing world along with us. It’s so stark… it has to be global solution, and that’s why I think global capital markets can provide the solution.”
