Institutional investors are increasingly aligning their investments with energy technologies of the future, a new report claims.
According to the 2015 ESG Trends to Watch, from MSCI’s global head of ESG research Linda-Eling Lee, investors have begun to scrutinise the carbon-related risks embedded in their portfolios, using a sophisticated range of tools.
In addition to the measurement of companies’ current carbon emissions, investors can now adopt a total portfolio accounting of current and future emissions, measured against market benchmarks.
They can also access portfolio construction techniques ranging from selective exclusions to tilts of portfolio weights based on current and future carbon characteristics of individual securities.
But the report warns: “Investors can be highly exposed – both positively and negatively – to fundamental shifts in energy technology in the broad, diversified equity and fixed income holdings that can make up the vast majority of a portfolio.”
For example, the diversity among utility companies in the MSCI ACWI Index, a global equity index consisting of developed and emerging market countries, means that while more than one-third of the companies by market capitalisation currently derive less than 10% of their generation capacity from renewables, 11% of companies get more than 50% generation capacity from renewables.
The report says: “Without deliberately tilting more aggressively towards the companies with large and growing renewable capacity, investors potentially risk being under-exposed to significant growth in future fuel technology.”
Another theme highlighted is corporate governance.
While a plethora of company scandals have highlighted the more sensational details of directors’ behaviour, the report says institutional investors are making more systematic efforts to assess the effect of two types of factors on company performance – the industry expertise of individual board members, and the diversity of perspectives across the full board.
A governance analysis by MSCI ESG Research showed that, within the MSCI ACWI, those financial institutions with boards composed mainly of industry experts generated a larger return on equity (ROE).
The analysis also found that ROE for the one-third of MSCI ACWI constituents with no women on the board averaged 13.15, compared with 20.21 for the benchmark.
Lee said: “As the availability of analytical tools improves, we anticipate institutional investors will shift beyond targeted scrutiny of corporate ‘blow ups’ and towards systematic integration of these types of factors that are less about meeting best practices and more about capturing material impact.”
The report also highlights the increasing interest of large institutional investors in linking investing to positive social impact.
So far, they have been hampered by the lack of comparable outcome measures across projects, the small scale of projects and illiquidity.
To discover the feasibility of using public equities as an investment route, a sample portfolio of companies was created from the MSCI ACWI.
Companies were screened for characteristics including products having an impact (such as a high percentage of loans to small and medium-sized enterprises) and strong innovation capacity for addressing social needs (such as telecommunications companies targeting lower-income groups).
The resulting sample of 100 companies demonstrated some promising upside, including increased exposure to markets with social needs, and risk-adjusted returns during the sample period that are comparable with the benchmark.
Lee said: “Social impact investing does not necessarily improve returns by itself, but, by opening access to markets that have been underserved, as these markets get bigger, these companies will be in a better position for growth.”
She added that the ability to overlay exposure to social impact opportunities across broad, diversified public equity portfolios was expected to attract new investor segments with the potential to shift significant capital towards social needs.
Institutional investors are also looking to invest in infrastructure where it is most needed and least politically risky.
The key financial characteristics of infrastructure investments – higher income yield, stable quality cash flows and lower market volatility that is less correlated with equities exposure – are gaining appeal in the shift towards alternative investments in the asset allocation process.
And the report says the sector represents an even more attractive investment proposition than might first be thought.
It said: “While public attention to potential losses has often focused on the threat to poor island nations, of the 20 countries projected to have the largest number of people living in areas at risk of flooding, six are developed markets including Germany, Japan and the US. Others include some of the fastest-growing economies of the past decade, such as Brazil and China.”
The report analyses countries in the MSCI ACWI Index, finding that the top five European Union economies (excluding Spain) all face potential vulnerabilities to flood risk that require attention to climate adaptation investments.
It concludes: “We anticipate that, as institutional investors increase allocations to this asset class, they will rely on an ESG lens to help target growth opportunities in building climate resilience and to minimise governance-related risks that currently present barriers, especially for non-domestic infrastructure investments.”
Meanwhile, a study from the UCL Institute for Sustainable Resources has found that one-third of oil reserves, half of gas reserves and more than 80% of current coal reserves globally should remain in the ground and not be used before 2050, if global warming is to stay below the 2°C target agreed by policymakers.
The study, funded by the UK Energy Research Centre, also identifies the geographic location of existing reserves that should remain unused, setting out the regions that stand to lose most from achieving the 2°C goal.