Decarbonisation is a means towards a sustainable end, but not an end in itself. Investors would do well to place any decarbonisation strategy in a broader light to ensure they avoid unintended risks, Northern Trust Asset Management says.
As the effects of climate change are increasingly felt around the world, with wildfires, floods and droughts affecting nearly every continent of the earth and with increasingly greater magnitudes, the need to transition to sustainable and renewable energy sources is more pressing than ever.
But some economies will be able to make that transition quicker than others and investors will need to adjust their decarbonisation strategies to these different trajectories in order to avoid taking on outsized risks.
The Australian economy is a case in point.
The weighted average carbon intensity in the Australian market is about 60 per cent higher than the global market, with most emissions concentrated in three sectors: energy, materials and utilities.
Focusing narrowly on decarbonisation in absolute terms can be very risky and a more holistic approach is required here, Scott Bennett, Head of Quantitative Investment Solutions for Australasia at Northern Trust Asset Management, says.
“Reducing carbon intensity and carbon reserves is a means towards more sustainable outcomes, however not the end unto itself,” Bennett says in an interview with [i3] Insights.
“Carbon intensity and carbon reserves are important indicators for any decarbonisation strategy, but we acknowledge that the historical reflections of a company’s activities only provide one perspective of what is happening within a company.
“We believe evaluating companies’ performances using ESG criteria enhances our forward-looking view of risk and opportunities. It is critical that we are not only historically aware, but also look forward when deploying decarbonisation strategies.
“The best way to do that is by looking at not just the carbon footprint, but also, as we migrate away from fossil fuels towards renewable energy, what are the types of businesses that are most at risk when we undertake that transition?”
Reducing carbon intensity and carbon reserves is a means towards more sustainable outcomes, however not the end unto itself
Northern Trust Asset Management takes a quantitative approach in their investment strategy and Bennett and his team have a process to translate qualitative environmental, social and governance (ESG) data into quantitative scores.
Including not just carbon intensity scores, but also more fundamental data points around the dependence of certain business models on current methods of energy generation enables Bennett to get a better idea of what may lie ahead.
“There are data elements that you can actually look at beyond a straight out carbon footprint and determine the ‘transition risk factor’,” he says.
“We believe material environmental, social and governance factors are pre-financial indicators that can affect a company’s future financial viability and clients’ long-term investment returns. By leveraging data tools at our disposal, we can start to build up relative scores relating to those business models,” he says.
Assessing the underlying business models can also help investors avoid transition risks that are less obvious. Bennett illustrates this point at the hand of petrol station operators.
“Energy is one of the larger carbon producing sectors in the market, along with materials and utilities. However within the energy sector there are different types of energy companies,” he says.
“For example, if you are a petrol station operator, then your carbon footprint is actually going to be relatively low compared to other energy providers.
“On the surface, you could say that might be a better place to be than large oil companies. However, if you look at the fundamentals of those business models, even though they have a low carbon footprint and practically zero carbon reserves, the risk of that operating model is very high as we transition away from internal combustion engines towards electric vehicles.
“The risk to petrol station operators is extremely high. So we can make an assessment of those businesses that actually have a high transition risk relative to others who are less susceptible to those changes,” he says.
The Australian listed equity market is a rather narrow market, heavily skewed towards energy, materials and utility companies. Bennett shows that 40 per cent of the market is made up by just a handful of stocks, including four banks, three miners, two supermarkets, two energy companies and one telecommunications business.
Decarbonisation in this market could quickly introduce skews in the portfolio and requires a thoughtful approach, he says.
“When we look at the micro structure of the Australian equity market, it is definitely a challenge,” he says. “And it is not just a challenge for sustainability-oriented investors, but for active managers as a whole.
“If you just look at the weighted average carbon intensity score, then it is about 60 per cent higher for Australia than it is for global equities. So the weighted average carbon intensity of the MSCI Australia Investable Market Index is close to 250, where it is about 150 for the MSCI All Country World Index.
“What we try to do is be somewhat realistic in terms of the level of carbon intensity reduction that we can achieve. Typically, for a global equity portfolio [a reduction of] about 50 per cent is currently the ideal achievement, and so that relates to a number that is close to 75 [for the MSCI ACWI Index].
“To achieve that same level of carbon intensity reduction (75 points) in the Australian equity market equates to about a 30 – 35 per cent reduction in overall emissions from that 250 score,” he says.
But even if investors target a carbon intensity reduction of 30 per cent in Australian equities, then there are still several key risks to consider.
It is not going to be a straight line in terms of how investors get from the starting point to the end point [of the transition]. We want to make sure that investors don’t take on more risk than they can bear in the short term, which will then compromise their longer term goals
“There is a significant amount of bias within the underlying distribution of carbon footprints,” Bennett says.
“If you think about the three main sectors: energy, materials and utilities – the EMU sectors – those sectors account for close to 85 per cent of the overall carbon emissions that come out of the Australian equity market. Materials alone make up over 55 per cent of the overall carbon footprint.
“One easy way to reduce a portfolio’s carbon footprint is to exclude all the higher carbon emitters. But the unfortunate thing is that all those carbon emitters are concentrated in those three narrow sectors and that introduces a significant amount of active risk into your portfolio and presents a whole range of challenges, especially in the current environment that we are facing under the Your Future, Your Super regulation,” he says.
Then there is also the problem of reallocating the capital. If investors choose to divest from the heaviest emitters in the market, then that leaves a significant amount of capital to be reinvested.
“The largest stock in the Australian benchmark is BHP. BHP is larger than most sectors, so that makes it difficult to effectively deploy that capital without taking on significant size and liquidity biases,” he says.
“Excluding the highest carbon emitters in the Australian market is fraught with unintended risk, as well as a significant amount of overall risk. We believe that identifying best in class operators and ensuring you are not naively excluding sectors, but actually managing those risks at the total portfolio level, will help in avoiding unintended risks.
“It is not going to be a straight line in terms of how investors get from the starting point to the end point [of the transition]. We want to make sure that investors don’t take on more risk than they can bear in the short term, which will then compromise their longer term goals,” he says.
As we get further into the energy transition, the available data will continue to increase and expand into new areas, requiring constant adjustments of investment processes. An example of this is scope III data.
Weighted average carbon intensity scores take into account scope I and II emissions, but don’t look at scope III emissions, which deal with indirect emissions in the value chain.
But as more companies start to report on scope III, the available datasets are starting to improve and Bennett and his team are constantly reviewing the quality of the sets available in the market.
Although he sees improvements every year, the data is currently still somewhat messy.
There is now a small number of companies that are reporting scope III, which is great, and we look forward to that increasing over time as well. Scope III will be part of the future, and we are doing the analysis now to ensure that we can execute it effectively
“There are differences between data providers as to how scope III is estimated and how it is used. At Northern Trust Asset Management, the process is about understanding the differences between those providers,” Bennett says.
“There is now a small number of companies that are reporting scope III, which is great, and we look forward to that increasing over time as well. Scope III will be part of the future, and we are doing the analysis now to ensure that we can execute it effectively.
“In a similar vein, there is a whole raft of other considerations outside of traditional decarbonisation that we are investigating for our clients. Other areas outside of scope III include biodiversity, which is a big theme for the market at the moment,” he says.
This article is sponsored by Northern Trust Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.