How investors can cut carbon without hurting returns

In December 2015, under the Paris Agreement, nearly 200 governments adopted a consensus to limit the increase in global average temperature to “well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5°C above pre-industrial levels.” 

Governments across the world are becoming increasingly aware of the perils of greenhouse gases (GHGs) and are aiming to penalise the source of pollution while looking to incentivise low-carbon technologies. One approach is to price carbon emissions. As of 2017, carbon prices averaged around $40 per metric ton of carbon dioxide, but this is expected to increase soon. That could impose regulatory costs on company operations through energy and fuel price increases, or indirectly impact them as costs passed on by suppliers begin rising. 

This makes it important for asset owners, lenders, insurance underwriters, and portfolio managers to factor in the impact of climate risks in order to make informed investment decisions. Eventually, one could expect capital flight toward investment themes that are aligned with global climate commitments. 

We conducted a study to measure carbon efficiency of Asia Pacific listed companies, based on carbon intensity scores provided by Trucost*. The study covers Australia, China, Hong Kong, India, Japan, South Korea, and Taiwan, and covered the respective broad market-cap-weighted benchmark index with available carbon intensity scores. It covered the period from September 2007 to June 2018. 

CUTTING CARBON PORTFOLIOS

For our study we examined carbon-efficient portfolios with unconstrained and sector neutral approaches. With the unconstrained approach, we ranked all companies in the base universe by their carbon intensity scores. With the sector-neutral approach, we ranked companies in the base universe within each sector by their carbon intensity scores. 

The variation in carbon efficiency across sectors was substantial, which resulted in sector biases in the unconstrained carbon-efficient and carbon inefficient portfolios. 

The largest sector biases were observed in the financials and materials sectors for most markets. However, our observations suggest that the implementation of a simple carbon-efficient screen, either with or without sector constraints, resulted in far lower portfolio carbon intensity scores without sacrificing returns across Asian markets over the longer horizons studied

Despite a sizeable reduction in weighted average carbon intensity scores, the carbon-efficient portfolios also had a lower return volatility than their respective carbon-inefficient portfolios in most markets with the unconstrained (except in Taiwan) and sector-neutral approaches. We also observed that the carbon-efficient portfolios outperformed their respective carbon-inefficient portfolio across the seven markets on absolute and risk-adjusted bases over the studied period. 

Additionally, compared with the base universe, the carbon-efficient portfolios tended to deliver positive information ratios, while the carbon-inefficient portfolios offered negative information ratios in most markets with the unconstrained and sector-neutral approaches.

Essentially, our analysis suggested that implementing simple carbon-efficient screening, either on sector-neutral or unconstrained basis, resulted in significantly lower portfolio carbon intensity scores over the studied period, and it did so without sacrificing returns across longer time horizons.

This article is an abridged and edited version of a research report entitled ‘Integrating Low-Carbon and Factor Strategies in Asia’, by S&P Dow Jones Indices.

* Trucost bases its carbon intensity scores on the greenhouse gas emissions from a company’s direct operations and first-tier suppliers, measured in metric tons of carbon dioxide equivalent per $1 million of revenue (CO2e/$1 million).