The role of Carbon in the Evolution of ESG Investing – Chapter 2

Apr 11, 2022

Climate Change considered “first among equals"

When MSCI ESG Research recently released their 2022 ESG Trends to Watch8, they named Climate Change ‘First among equals’, stating that ‘Climate is eclipsing governance and social issues at the top of the ESG agenda, reflecting both the existential threat of global temperature rise and the race against time to rein it in.’

This reflects the reality of the marketplace across Europe and beyond, where the importance of Climate Change as both a societal issue and a financial risk is broadly accepted. As an example, The Pensions Regulator in the UK followed up on their earlier guidance around ESG with specific requirements around climate change, requiring trustees to assess and report on how they consider the issue from both an impact and financial perspective. See excerpt below:

Excerpt from The Pensions Regulator UK

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Summary of governance and reporting of climate-related risks and opportunities

You must meet the requirements of the climate regulations, and you must have regard to the DWP’s statutory guidance in doing so.

To help us decide whether you have done this, we will be looking for clear evidence that you, as trustees:

  • are taking proper account of climate change when you are making decisions about your scheme, and that those advising you are helping you to do this
  • have carried out your analysis in a way that is consistent with the Taskforce on Climate-Related Financial Disclosures (TCFD) recommendations so that savers and others can be confident in it
  • have seriously considered the risks and opportunities that climate change will bring to your scheme, in its particular circumstances
  • have decided what to do as a result of this analysis and have set a target to help you achieve that goal

We acknowledge that the requirements of the climate change regulations are new and may appear daunting for trustees. However, the requirements are formed around the TCFD framework, and trustees might benefit from working through the governance and reporting requirements in a structured way.

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It is becoming critical in almost all markets and client channels in Europe to have a clearly defined approach to Climate Change in investment strategies, but there is no consensus on how best to achieve it. Existing solutions can help, but will not deliver change on the scale required on their own.

Options to address high polluting companies in ESG Portfolios

One option that has been widely adopted within ESG solutions is to screen out companies based upon their activities. This is essential in many markets (for instance, almost all product sold in the Nordics is screened) and this approach is also adopted by many of the world’s largest Asset Owners. Others view themselves as universal owners who should hold the entire market, but there is not a ‘right’ answer as there are pros and cons of both approaches. A purely screening, or business involvement-based approach has its limitations. There is a trade-off for investors between excluding companies or sectors based on values and the risk return profile of the resulting portfolio. Simply excluding broad swathes of the market will lead to an increase in tracking error and higher volatility as diversification is reduced. Perhaps even more importantly, as noted by the EU’s Technical Expertise Group in their report on climate benchmarking, simply excluding high impact sectors may not fundamentally address the problem.

Refusing to buy Oil & Gas stocks might make an investor feel better about their portfolio, but it does not reduce the number of cars on the road or their reliance on petrol. It also disregards the opportunity to engage with the management of companies as a shareholder to try to influence change. This is important to many large investors who focus on stewardship and argue that they should use the influence their holdings in high polluting companies give them to demand change. On the flip side, proponents of screening will argue that by not investing in those firms, they will thereby increase those firms’ cost of capital and hence influence their behaviour. As noted in a recent article on Bloomberg9, there is some evidence this is starting to happen, with financing costs of ‘dirty’ energy becoming more expensive than cleaner alternatives.

Of course, many solutions can and do use a combination of both business involvement screening and more detailed ESG data or ratings to screen out or reweight specific stocks. The key for managers is to understand who they are selling to, as what investors are looking for will vary widely by geography and by sector.

It is clear is that screening alone will not solve the wider problem of decarbonising our society however, as recent developments in European energy markets make clear. Many of the world’s biggest investors screen out coal from their investments, but when the price of gas spiked as global supply came under pressure in Q4 2021, European utilities still fired up their coal plants as that was the available alternative. To meet our climate change goals as a society, it is essential to change the behaviour of the biggest polluters. But that behaviour needs to actually reduce emissions, not just displace them. As a recent Economist article noted10, pressure from investors is causing listed energy firms to sell their most polluting assets to please ESG investors. But those assets are being bought up by private investors who do not feel the same pressure –$60bn worth in the last 2 years alone. To address this, carbon pricing is required. Chapter 3 examines the role that regulated carbon markets can play in helping to produce real world decarbonisation, whether you are pursuing a screening or engagement approach.

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8https://www.msci.com/research-and-insights/2022-esg-trends-to-watch
‍‍9https://www.bloomberg.com/news/articles/2021-11-09/cost-of-capital-widens-for-fossil-fuel-producers-green-insight‍
‍10https://www.economist.com/leaders/2022/02/12/the-truth-about-dirty-assets‍

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