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Long-Term Matters: Carbon footprint envy

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Carbon footprinting: the Montreal Pledge with $10trn (€9trn); and portfolio carbon management – the Portfolio Decarbonisation Coalition with $10bn – is all the rage. As a judge of the IPE Awards, I see this increasingly mentioned in nominations. An explosion of providers and events promise to turn investors into low-carbon heroes. Even campaigners use it to benchmark managers. What will it deliver?

To decarbonise portfolios, asset owners have adopted ‘low-carbon’  indices. But not all are created equal. One well-known index has ExxonMobil as its third biggest stock. According to the environmentalist Bill McKibben, “no corporation has ever done anything [as] big or bad” as Exxon in deceiving the market about climate change. Why would this index effectively endorse ExxonMobil?

According to academics who have studied these  indexes, they tend to miss most of the risk related to climate change by focusing only on direct carbon emissions. Scope-one (direct) and scope-two (from the consumption of energy upstream from the organisation) emissions leave fossil fuel companies looking pretty good and Exxon is particularly ‘efficient’. If one considers scope-three emissions, from the use of the products, then it clearly becomes different. 

Scope-three data is tricky because many companies do not report on it. A few index providers (such as ET Index) have found a way around this (for instance, by inferring that a company that doesn’t report on scope three is at the worst level for that sector).  

Portfolio footprinting also only provides data on relative improvement, without contextualising how this fits into the global carbon budget. The Science Based Targets initiative is helping resolve this issue in the corporate community, and could help with portfolio assessments.  

Even more important, “indexes are not tools to redirect capital towards climate solution providers for the energy transition”, say the academics. Why? As with divestment, when one investor reduces its exposure to greenhouse gas emissions, others buy that exposure. Changing the ownership of greenhouse gases (GHGs) has definite benefits – it is a good ‘smart beta’ strategy, it sensitises the quants to climate risk and it is good PR. But it does not address climate-related systemic risk.  

The best way to do that and shift the trillions in assets is for investors to push investee companies to change how they allocate capital internally. Politicians do not yet understand that capital markets do not play a big role here, this being the key conclusion of the Kay Review. Quite understandably, this isn’t something the investment industry highlights either.  

Yet investors could be a big part of the solution by using their collective stewardship influence to change capex decisions. Instead, we see 60% of investors voting inconsistently – ‘for’ 2°C stress tests at BP, Shell and Statoil but ‘against’ at Chevron and ExxonMobil. 

Low-carbon indices can support stewardship when the index construction methodology is transparent and ‘roughly right’ as opposed to being ‘precisely wrong’. When the big index providers and their fund manager clients start to use these ‘low-carbon’ indexes to guide the allocation of core assets, this could change the cost of capital.  Until these two conditions are met, forceful stewardship is required. 

Quants like precision. But this is an industrial revolution that is going to be messy. Carbon footprinting has benefits. But footprinting, especially with misleading indicies, can easily become window dressing.  It can also become a straitjacket on strategy: the impact of News Corporation on climate change is poorly captured by its carbon neutral status.

As the low-carbon energy transition kicks off, investors will find that many sectors have made costly capex and reputational errors. Intelligent carbon footprinting can contribute to prioritising where stewardship is needed, while there is still time to prevent this value destruction. 

Dr Raj Thamotheram is CEO of Preventable Surprises and a visiting fellow at the Smith School, Oxford University

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