Established 12 years ago as a spin-off from Switzerland’s renowned University of St Gallen, Finreon is a quant asset management specialist that styles itself as an investment adviser and a think tank. It has recently weighed into the debate on portfolio decarbonisation with a novel solution for listed equities.
ESG can be a matter of debate among pension fund board members when it comes to agreeing on policy and how to implement it – particularly in the ‘S’ of ESG and to some extent in the ‘G’. So the debate is twofold: first, policies must be agreed; and then there must be agreement on how to implement them.
The ‘E’ should be easier, at least in as much as this pertains to carbon emissions, particularly given the growing pressure from members, society, lawmakers and regulators to account for and manage portfolio carbon risk, as well as to commit to net-zero emissions targets or Paris alignment. This still leaves the problem of implementation.
In a listed-equities portfolio, large institutional investors have two main tools at their disposal to reduce port- folio carbon exposure. One is to exercise voting rights and to engage with companies to reduce the carbon footprint.
The other tool, broadly speaking, is through market and non-market sig- nals of a greater or lesser magnitude. This can range from indices with a tilt towards low-carbon stocks to outright divestment from fossil fuels. While divestment can help keep stakeholders happy, it forfeits the possibility to exercise a market signal on carbon- intensive stocks or laggards.
Ralf Seiz, CEO and founder of Finreon says: “It doesn’t make sense just to buy a standard ESG index because this kind of index is just underweighting the brown economy or excluding it. This has almost no impact on these companies because you don’t really exert price pressure, since these are large listed companies and they don’t have financial constraints.
“And second, if you’re going to sell them, you don’t have them in the portfolio and you cannot talk to them anymore. You cannot put pressure on them, so from an impact perspective it doesn’t make sense.”
A third tool would be a carbon-reducing strategy – for instance, by funding forestation projects. This creates real-world carbon reduction (at cost) but sends no market signal.
Seiz’s solution at Finreon is to create a total-return swap overlay based on the carbon emissions footprint of the portfolio, which goes long lowcarbon footprint and short high footprint. Unlike indices with a low carbon tilt, the tracking error remains low, with the only effect on the return being the cost of the hedge.
By going long green, Finreon’s contention is that the hedge produces “negative carbon footprint” which can be applied to any underlying.
Quite a lot can be achieved with a small hedging volume, Seiz explains. A kind of leverage effect increases the magnitude of the decarbonising effect because the carbon footprint of the brown stocks is so much higher than the green.
Assuming their positions are large enough and they go public, investors can send a third, non-market signal by short-selling a company, channelling the disapproval of society at large towards polluters.
Taking the example of two stock pairs in the automotive sector, buying $1m of Renault shares creates carbon exposure of positive 148 tonnes. Shorting $1m of Stellantis stock, off- sets 1,243 tonnes, creating a net carbon effect of negative 1,095 tonnes per $1m, while sending market signals to the board of Stellantis.
Similarly in pharma, paring ‘green’ Roche with ‘brown’ GSK creates a net effect of negative 7.5 tonnes of carbon dioxide per $1m.
Because it is highly carbon-negative, Finreon contends that just a 10% allocation to the carbon-offset strategy is therefore enough to neutralise an entire global equities portfolio.
Seiz says: “We think that our approach is really very consistent in that we have the most impact through market signal because we short the stocks. We have a lot of non-market signal because we can talk about what we are doing and engagement is still possible because you still have the brown economy in your remaining portfolio that has been offset.”
Since the tracking error is essentially very low, and looking beyond this month’s COP26, a further contention is that there is a free call option, essentially on a steeper global carbon price.
This echoes Mats Andersson, Patrick Bolton and Fréderic Samama’s seminal 2015 Financial Analysts Journal paper Hedging Climate Risk, which paved the way for the first generation of low-carbon indices.
Across asset classes, the principle can be applied to corporate bonds and to gold, which some Swiss pension funds like to hold, and which carries its own carbon footprint in terms of the production process.
A key barrier is data – while large listed companies produce a good carbon data set for equities and bonds, and estimates are available for the carbon footprint of gold production, less perfect data is available for asset classes like real estate.
There is sufficient data, so far, only to run an efficient equity hedge using Scope 1 and 2 data. Finreon has started to implement Scope 3 data in its carbon-offset strategies although this is more volatile.
Seiz also has firm views on the role of investors. Companies do the actual work of decarbonisation, he states, not investors or politicians.
“It’s in the realm of politicians to price carbon but investors are free to exercise pressure in whatever way they see fit. This is an important ques- tion: sometimes I think there is a misunderstanding around what investors should and should not do.
“Some people thought investors should change the world and politics should push them to do that but I think this is not the right way. Investors cannot save the world, but companies can.
“It was not the intention, I think, of any policymaker to force investors to remove carbon from the atmosphere. What they want is for capital to the green economy, instead of the brown economy, to make an impact.”
As a financial solution to carbon reduction, the notion that short-selling creates real-world negative carbon footprint is starting to gain traction. In a recent article on Bloomberg, Richard Slocum, CIO of Harvard Management Company, supported allowing a short-seller to deduct the associated carbon emissions from its overall carbon footprint.
But for short-selling carbon footprint to take off among institutional investors, asset managers and pension funds will need an agreed mechanism to report the impact of their short positions. For this to happen, politicians and regulators will have to think deeply about the – sometimes unpopular – role of short-selling in the investment value chain.