How useful is portfolio carbon footprinting?
Low emissions economy
Relentless evidence of the effect of climate change, combined with the significant political effort to put in place a global plan on climate change, are very clearly raising institutional client interest in how this will all affect long- and short-term asset returns.
The disclosure of more emissions data by companies is welcome and is allowing for more detailed analysis of portfolio and index “carbon footprints”, and there is a growing industry in marketing such low carbon indices and portfolio tilts to investors.
These initiatives and the attention that they bring to the issue are very welcome. However, we believe that climate change and the transition to a low emissions economy will represent such a major opportunity for growth in new industries, and massive disruption to others, that measuring carbon emissions at a portfolio level materially underestimates the significance and opportunity for excess returns by active managers.
The significance of the risk that emissions levels present to a business are completely different depending on how fundamental those emissions are to the main activity of a company, and how difficult it is to reduce those emissions.
Let’s look at a couple of examples as the best way to understand the issue:
In a carbon footprint analysis of the auto industry, most emissions analysis and disclosure focuses on the energy intensity of the production process.
However these emissions are frankly irrelevant compared to the emissions profile of the cars they make, and the business risk for auto manufacturers is arising from the inevitability of a rapid migration from combustion engine to electric vehicle powertrain products which are much cleaner.
Auto makers make very long life investments in engine plants, and will need to shift that capital allocation to cleaner powertrains, risking significant underutilisation of existing assets in the transition.
In addition, weaker players, or those that choose to focus on short term profits, will not have the resources to invest or be successful in the new technologies, and are likely to lose share to stronger incumbents and more innovative new entrants.
This has nothing to do with the emissions profile of current production that is picked up in the carbon footprint disclosures, and so tilting within the sector to lower ‘production’ footprint companies is missing the whole point.
In some sectors, the greenhouse gas emissions footprint is just not that important to an investment case today.
The main direct emissions from a retailer come from the energy consumption in the store and logistics chain of the retailer.
One retailer may have higher emissions than a competitor because of its existing electricity supply contracts.
Over a period of a few years those emissions can be radically shifted by changing the electricity supply contracts that they have in place, or by investing in clean energy generation of their own – i.e. the emissions profile is highly flexible in the medium term and so not particularly relevant to an investment case or business risk today.
In other industries the emissions profile can be the single most important driver of future value.
Most obvious among these is power generation assets, which have 20-30 year expected asset lives, and decisions to deploy capital today can be catastrophic for investors if those assets are underutilised because of a shift in future regulation.
With solar and wind generation continuing to become cheaper year after year, and regulation and public policy likely to continue to shift in favour of low energy technologies, oil, coal and even some gas fired power generation assets are looking increasingly stranded.
In this sector, greenhouse gas emissions profiles are vital to understand.
So in summary, the shift to a low emissions economy is becoming clear and it will be highly disruptive to many established industries.
We encourage the increased disclosure around company emissions that initiatives such as the Carbon Disclosure Project are achieving, but feel that investors need to think much more radically about where risk and opportunity lie in their portfolios.
Portfolio carbon footprint tools can be helpful in generating insights but can also provide a false comfort blanket for investors if they are not properly understood.
They are not the best gauge of the significant business risk that exists in industries like autos or utilities where there is significant change ahead.
Neither are they the best pointer to those companies that are enabling the transition to a low carbon economy, and it is in identifying those companies successfully positioning for change where the greatest returns could be found.