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Carbon footprints: Only so deep

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Key points

• Stakeholder initiatives and regulation have encouraged the take-up of carbon footprinting.
• But carbon footprints have limitations as a measure of risk.
• Alternatives are being developed as investors gain a better understanding of climate-related risks.

Carbon footprinting is a popular practice among institutional investors. Initiatives such as the 2014 Portfolio Decarbonization Coalition and Montreal Pledge as well as regulatory pressure in countries such as France have fuelled the use of carbon footprints.

As of June 2016, 120 international investors with €8.8trn in assets had signed the Montreal Pledge, committing to measure and publicly disclose the carbon footprint of their investment portfolios annually. More than 80% of the signatories, mostly asset managers, had disclosed data about their carbon footprint by this time.

Earlier this year the Financial Stability Board’s high-profile Task Force for Climate-related Financial Disclosures (TCFD) published its final thoughts on what would constitute best practice in climate reporting. It recommended that asset owners and managers report the weighted average carbon intensity associated with their investments.

However, the TCFD acknowledged “the challenges and limitations of current carbon footprinting metrics” and that they should not necessarily be interpreted as risk metrics.

Indeed it is widely accepted that carbon footprints have their limits and weaknesses, in particular if they are intended to serve as a measure of risk to an investor’s portfolio.

Carbon footprints’ weaknesses, it is argued, include that they are backward-looking, and that there are significant variations in the estimates that different research firms make for company emissions.

Not all companies report their emissions so in these cases they would need to be estimated.

In the institutional investment industry, a carbon footprint refers to the total greenhouse gas emissions associated with a given portfolio via its investments.

There are two main ways of calculating carbon footprints, according to a report from Schroders on management of climate risks.

One way to calculate a business’s so-called carbon “intensity” is by dividing a company’s emissions by its revenue, and another way is to use market capitalisation as the denominator.

Emissions in this context means those generated by the operations a company owns (Scope 1 emissions) and those created to generate the power companies consume (Scope 2). They can be emissions reported by the companies or estimated.

Scope 3 emissions, which are supposed to represent those produced by the company’s suppliers other than electricity providers and by the use of a company’s products, rarely feed into carbon footprint calculations, according to Schroders.

The investment manager says carbon footprints calculated on the basis of sales are “a reasonable” measure of how effectively companies manage their carbon or energy efficiency, but that this is not a measure of investment risk.

Carbon intensities calculated using market capitalisation are a measure of emissions associated with investments in a fund, but say little about the effect of those emissions on a company’s earnings or value.

These, says Schroders, depend more on the company’s business model, cost structure, industry dynamics and pricing power than on its carbon footprint.

Carbon footprints also do not communicate potential investment risks related to the physical impacts of climate change.

If carbon footprints do indeed have these shortcomings, why do institutional investors use them?

One reason is that there were not many alternative tools or measures available or known when carbon footprinting started to gain traction.  

Stephanie Maier, director, responsible investment at HSBC Global Asset Management, says there are “clear” limitations to current carbon footprinting metrics but says they can still be useful.

“As signatories to the Montreal Carbon Pledge, HSBC Global Asset Management finds value in this metric,” she says. “While it does not tell us about the physical climate risks – the most important risk for some securities – it can act as a reasonable proxy for understanding transition risk, identifying the most-exposed securities.”

carbon value at risk vs carbon footprint of global equities

The TCFD’s recommendations are likely to spur improvements in the use of climate footprint analysis, Maier adds.

Research carried out for Schroders shows that 68% of investors are planning to increase their low carbon investments in the year ahead.

Institutional investors might also be using carbon footprints for ethical reasons. Ethics are almost never explicitly mentioned as a motivation for carbon footprinting or other climate change-related action by institutional investors.

Still, in a report on climate-related risks the Dutch regulator, De Nederlandsche Bank (DNB), discussed carbon footprints under the heading of what it called ethical considerations.

“Many financial institutions told us they wish to contribute to achieving the Paris climate goals and disclose their own climate impact, no doubt encouraged by their stakeholders,” the report says. “Our survey among financial institutions revealed that two-thirds measure the carbon footprints of some or all of the businesses they finance in order to demonstrate their own climate impact. More than half seek to reduce the carbon footprints of their investments in the next few years.”

In France, the €28bn public service pension scheme ERAFP measures the carbon footprint of its equity, corporate bond and public sector bond portfolios and in the past year also included convertible bonds. Its annual report states that 89% of its assets are covered by carbon footprint measurement.

Measuring the carbon footprint of non-equity holdings is relatively unusual among institutional investors. A spokesperson for ERAFP tells IPE that carbon footprints make it possible to rank businesses belonging to the same sector by comparing the carbon intensity of their turnover.

She acknowledges that carbon footprints are “static” but says investors can and should ask their investees about the quantity of emissions associated with their pension fund.

ERAFP says it has settled on a carbon intensity measure that it considers “the most appropriate for factoring in the exposure of ERAFP’s portfolios to the transitional risk associated with climate change”.

The pension scheme recently began tracking new indicators “to obtain a more comprehensive picture of its impact on the environment and its management of climate risk”.

However, David Lunsford, co-founder and head of development at Zurich-based research firm Carbon Delta, warns that carbon footprints are a useful starting point for engaging with companies but “the wrong place for managing money better”. He adds: “They are not a panacea, and some people consider them useless.”

Schroders’ report states: “Carbon footprints remain the dominant measure of exposure, but at best provide an incomplete and at worst a misleading picture of the risks carbon pricing presents.

“There is a danger that investors in low-carbon investment products will find themselves more exposed to climate risks than they expect.”

The Schroders report is about a “Carbon Value at Risk” (Carbon VaR) tool that the manager has developed out of a concern that “our industry has focused more on urging action and marketing products than on developing robust analysis and risk management”.

It said the tool analyses the effect of higher carbon prices on companies’ earnings and value.

“While simplified, it reflects a realistic view of the ways industries work, which measures like carbon footprints don’t even attempt,” the manager said.

The Carbon VaR analysis involves Schroders taking Scope 1, 2, and some Scope 3 emissions and then imposing a price of $100 (€85) on every tonne of CO2 created at any part of the company’s value chain.

That is the lowest the carbon price would need to be for the political commitments made under the 2015 Paris agreement to be met, according to Schroders.

Under its Carbon VaR analysis the investment manager assumes that all cost increase associated with higher carbon prices is passed on to customers. It then estimates falls in demand in response to this and adjusts earnings before interest, tax, depreciation and amortisation (EBITDA). This is then compared with a baseline EBITDA figure to provide a measure of the value at risk from an increase in carbon prices.

Its conclusion: about 20% of the cash flows global companies generate could be lost if carbon prices rose to $100/tonne.

Lunsford says it is good to see a big institutional investor like Schroders taking a cost-based approach to climate risk, even if it is somewhat regrettable that the name of Schroders’ tool was so close to Carbon Delta’s own (Climate Value-at-Risk).

“This market needs to grow and I certainly hope other analytics firms also come round and start thinking about costs,” says Lunford.

To a degree this is already starting to happen, including among investors. MSCI surveyed 25 institutional investors during November 2016 to January 2017 and found that although carbon footprinting was a priority for most, there was growing demand for integration of climate transition risk in portfolios.

“The state of the art has advanced very rapidly,” said Manish Shakdwipee, vice-president, new models and methodologies and head of climate change research at MSCI ESG Research.

“Investors initially focused on carbon footprinting, which led some to screening, divestment and allocation to funds that replicate low-carbon indexes. Now, a growing number are moving to assess ‘transition risk’ posed to carbon-intensive assets by increased regulatory and non-regulatory drivers.”

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