A majority of people recognise that climate change is a real phenomenon, and acknowledge the impact it may have on the planet and on society.
However, climate change isn’t just a risk for society, it is also a threat to investment returns. Indeed, a growing number of institutional investors are taking climate change seriously, and they perceive that the related risks are not appropriately priced, compared to other risks such as another financial crisis, unemployment, data fraud, or cyber attacks. All investors have a fiduciary responsibility to maximise returns, and many are re-allocating capital away from carbon intensive companies – companies that either pollute, or that are exposed to so called stranded assets, including carbon reserves such as coal and oil that they will never be able to monetise.
This decarbonisation process is important because it can be achieved without requiring any negotiations or agreements between governments and without binding treaties. Importantly, this process is also cost-free: investors can go ‘green’ without sacrificing returns.
These decarbonised – or “green funds” – are building track records that hedge the risk of future regulation at no cost, while paving the way for higher future returns. In the unlikely event that there turns out not to be any climate change impact, investment performance will match the benchmark. If climate change does take effect, the investment strategy will generate outperformance.
How does it work? It centres around the construction of simple and transparent products.
Index providers have already done much of the heavy lifting. In September 2014, MSCI launched its Low Carbon Leaders indexes, in conjunction with institutional investors. The indices’ methodology aims to achieve at least a 50% reduction in the level of carbon emissions from the constituent companies and assets making up the index (present emissions and reserves representing potential future emissions) compared to the parent indexes, the MSCI World and the MSCI Europe, all the while minimizing the tracking error relative to them.
The indices, therefore, exclude one fifth of stocks in the parent index universe, based on the “carbon emission intensity criteria”, which is defined as the weight of carbon emissions (tons of CO2) of a company relative to market capitalisation, with a maximum exclusion of 30% for each sector market capitalization. They also exclude the largest owners of carbon reserves per dollar of market capitalisation, representing at least 50% of the reserves in the parent index.
So for instance, a heavy polluting steelmaker that emits large amounts of CO2 is more likely to be excluded than, say, a more energy efficient cement maker. Likewise, large oil majors valued on the basis of their energy reserves will have a reduced weighting in the indexes. The 70% floor for any sector means investors do not withdraw completely from that sector, they merely reduce their exposure to it.
In addition, the strategies retain a sectoral and geographical composition similar to the parent index. This is very important. We believe such indices have to offer a free option on carbon repricing, to encourage investor participation, so highly correlated performances to the underlying parent indices is crucial. Indeed, the MSCI Europe Low Carbon Leaders Index even outperformed MSCI Europe by 1% between November 2014 and April 2015.