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Special Report ESG: Carbon Risk, A low-risk path to carbon reduction

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  • The MSCI Europe versus the low-carbon alternative (backtest)

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A growing consensus says that future action against climate change will most likely lead to a considerable increase in the cost of CO2 emissions when governments finally agree a mechanism to restrict emissions and the exploitation of fossil fuel reserves. And this would have major implications for all investors.

In 2012, Bob Litterman drew attention to the price of carbon emissions, arguing that climate risk is a “risk management problem”. Writing in the New York Times in June last year, the former US Treasury secretary Hank Paulson drew parallels between the current “climate bubble” and the credit bubble of the past decade. Martin Wolf, chief economics commentator of the Financial Times, drew attention to the risk of stranded assets in an op-ed article in the same month. 

According to research published by the University College London’s Institute for Sustainable Resources in January last year, it will be impossible to exploit a third of global reserves of oil, 50% of gas reserves and more than 80% of reserves of coal before 2050 if the widely accepted 2°C global warming target is to be met.

The financial sector has, arguably, so far produced few practical solutions aimed at minimising carbon asset repricing risk. A widely discussed approach of late has been divestment from fossil fuel companies and some high profile university endowments have taken this path. But it is impossible to engage with companies following divestment and there is no discrimination in favour of companies on the basis of their relative efforts in the area of carbon reduction. 

For institutional investors, one path has been to invest in renewable energy, which involves considerable illiquidity and a bet on the renewable energy sector. A first generation of green indices focused on renewable energies and sector-exclusion criteria, but this leads to wide tracking error discrepancies against mainstream indices. 

And all these strategies involve considerable timing risk if the repricing of carbon does not occur – for example, due to international foot dragging and inaction.

At a glance 

• Investors, academics and commentators increasingly recognise the financial risks of stranded hydrocarbon assets and carbon asset repricing.

• Existing approaches to mitigate climate change risk involve high tracking error or sector bets.

• An index approach pioneered by Sweden’s AP4 reduces carbon emissions without introducing significant tracking error risk. This is effectively a ‘free option’ on climate change risk.

• Portfolio Decarbonisation Coalition aims to reduce the carbon footprint of institutional assets worth $100bn using this approach. 

For AP4’s CEO, Mats Andersson, listening to the likes of Bob Litterman at an academic seminar convinced him to act to mitigate his fund’s climate-related risks. And Andersson takes the credit for the first low-tracking-error carbon index strategy, which AP4 implemented against the S&P500 in 2012 (see panel).

AP4, with €30bn in assets, and France’s €36bn Fonds de réserves pour les retraites (FRR), also worked intensively with Amundi and MSCI on a low-carbon version of the MSCI Europe index between June and September last year, with a dedicated group of specialists from all the parties involved. 

“It was a very Co-operative and inclusive way of working,” notes Fréderic Samama, deputy global head of institutional clients and sovereign entities at Amundi. “We established a task force that integrated people from portfolio management, research, ESG and coverage. It was important to have the perspective of everybody and this was very transparent.”

AP4 and FRR, have each committed €1bn to the MSCI Europe low-carbon index strategy, which Amundi has licensed. “We like to be good citizens of the world but we are, first and foremost, financial investors looking for good returns on our investments,” says Olivier Rousseau, member of the executive board of FRR. “This is the sweet spot between a savvy, prudent long-term investor and being an ESG stalwart. We have to deliver returns; we are not fulfilling our mandate if we subsidise ‘good citizen’ projects. 

“It’s about making your portfolio tilted towards less carbon risk but not being zero or one. If you want to give a signalling effect, it’s not fair to say suddenly we have no carbon. On the contrary, by saying we are reducing our exposure, we say we do not systematically disqualify anything that has carbon in it but we are indicating that we will pay a lower price if there is carbon in your company and if there is a follow-on effect from other investors, then the impact will be even more powerful.”

The MSCI Europe versus the low-carbon alternative (backtest)

As Rousseau and Andersson concede, there is considerable uncertainty about the measurement of carbon emissions. While calculations of proven oil and gas reserves are much more likely to be accurate, there is much work to do in the corporate sector to improve data on emissions, despite considerable progress in this direction by the CDP (formerly the Carbon Disclosure Project). 

Would it have been better to wait a few years, when emissions data might have improved? Samama believes the approach will speed up the carbon price discovery process, the quality of data and carbon analysis in general. “The more you have money going in this direction, the more responses all the players will have,” he says. “It will accelerate the transition towards a more transparent economy related to this risk.”

Rousseau sees the strategy as a first step, and a reasonable one at that. “This is a new family. It is a promising family and there will be many children in this family,” he says. “But what we have tried to achieve for the first child is something that seems reasonable, not just to the minds that provided critical input but also to selected institutional investors.”

As for the next stages, Amundi is developing an Asia Pacific ex Japan version of the index. FRR is considering expanding the low-carbon-index approach to other geographical regions, but will look carefully at how the index fits in with its smart-beta-composite approach.

Andersson sees more work in the disclosure of carbon emissions data on the part of institutional investors and asset managers. He is currently working with politicians in Sweden to introduce carbon disclosure targets for domestic institutions and is aiming towards full transparency for AP4’s portfolio.

“I am amazed that if you ask pension funds or asset managers about alpha, beta, information ratios, tracking errors, what have you, they can answer down to whatever decimals you like but ask them about their carbon footprint and, up to now, you get very few answers,” adds Andersson. “I think it should be mandatory for every pension fund around the globe to disclose their carbon footprint. I think this is one of the biggest risks we are carrying.”

In September 2014, AP4, Amundi and CDP launched the Portfolio Decarbonisation Coalition together with the United Nations Environment Programme Finance Initiative. This aims to reduce the carbon footprint of $100bn of institutional assets by December 2015, and eventually to measure and disclose the footprint of assets worth $500bn. Amundi says $30bn has already been committed

Rousseau expects the December 2015 COP21 climate change talks in Paris “to beat the drum heavily” on the issue of climate change, carbon reserves and investors’ carbon footprints.

“If the effort is successful, then it will accelerate the scenario of people realising it is dangerous to have unrewarded carbon risks, and some governments could take new action,” he says. “After all, the plan is to get a successor for real to the Kyoto protocol.”

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