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Climate change is one of the most important ESG risks and investment opportunities. Increasing investor attention on fossil fuel exposures has been brought into stark focus by the Paris climate agreement and increasing central bank and regulator attention to the financial stability risks of climate change.
At the first conference on climate risk for financial regulators and central banks in April 2018, Bank of England governor Mark Carney said “once climate change becomes a clear and present danger to financial stability it may already be too late to …. as climate related risks become re-evaluated, [this] could destabilise markets and spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate Minsky moment”. He advises that such a future could be avoided by “early transitions in thinking and action”.
The financial stability concern, among other factors, is the potential of an abrupt revaluation of asset prices in response to the risks of unburnable carbon or stranded assets, as well as physical climate risks. According to research published by Carbon Tracker in April 2013, to reduce the chance of global temperature rising to no more than 2ºC above pre-industrialised levels, the world has an estimated global carbon budget for 2000–50 of 886Gt CO2. Accounting for emissions from the first decade of this century leaves a carbon budget of 565Gt CO2 for the 40 years to 2050.
However, the total carbon potential of known fossil fuel reserves is an estimated 2,860Gt CO2; 65% of this is from coal, 22% from oil and 13% from natural gas. This means governments and global markets are treating reserves equivalent to nearly five times the carbon budget for the next 40 years as assets. Not surprisingly, investors want increased reporting of fossil fuel reserves and potential CO2 emissions by listed companies and those applying for listing to assess these risks more closely.
Investors are also beginning to assess broader systemic risks posed by unburnable carbon and seeking reassurance that financial stability measures are in place to prevent a potential carbon bubble bursting. This has led an increasing number of investors to commit to divest from fossil fuel investments. This started with US universities and colleges, but over the past few years has seen significant growth in the total assets of institutions committed to divest. Recent growth in divestment commitments has come from private sector investors that have committed to phase out coal and/or fossil fuels or to divest after an (unsuccessful) engagement programme.
Some investors question the effectiveness of fossil fuel divestment in publicly listed companies. For instance, research by Oxford University concluded that the direct impacts of divestment campaigns are likely to be limited: share prices are unlikely to suffer precipitous declines and holdings will likely be taken up by neutral investors. If divestment is to have any impact on company valuations, changes are needed in market norms and by constraining debt markets.
These factors may therefore have contributed to divestment programmes that are less aggressive in scope. Rather than the complete elimination of all fossil fuel companies, divestment can be confined to companies developing high-cost, high-carbon reserves, such as in the coal and oil sands sectors, or to companies not managing climate risk sufficiently strongly.
Development of ESG indices
Investor demand has led to the launch of a growing number of sustainable equity indices in recent years. In all cases, sustainable or ESG indices can be classified according to three investment styles:
• Thematic investing.
There is $15trn (€12.7trn) invested globally in indices that use exclusion criteria, representing more than 65% of overall SRI assets. These indices generally exclude stocks from existing investment universes based on what they produce, how they operate and where they generate their revenues.
The most common exclusions are based on involvement in nuclear weapons, cluster munitions and landmines. Indices also exist based on criteria ranging from alcohol to stem-cell research. Positive screening, also known as best-in-class or ESG integration, focuses on investing in stocks with superior ESG performance relative to regional and industry peers.
Strategies excluding the bottom performers, overweighting the best performers, or overweighting stocks that are significantly improving with regard to ESG metrics, fall into this category: examples include the MSCI ESG Leaders indices.
Finally, thematic indices are new to the ESG index space, representing a fraction of overall assets. These target specific issues, including companies that meet scores in certain areas, or that derive a certain amount of revenue from particular activities. Examples include gender diversity indices or climate change-based benchmarks.
The majority of ESG indices, especially those deploying positive or negative screening, are based on a parent index, with stocks removed and/or re-weighted to create the ESG version. These types of indices are used extensively by ETFs.
For the MSCI ESG Leaders indices, MSCI first applies negative screens to the 1,644 stocks, excluding companies involved in controversial industries, including nuclear power and weapons. Revenue-based screens are also applied to areas such as alcohol, gambling, tobacco and conventional weapons, varying from 5% to 50%, or $100m to $3bn of revenue, depending on the area.
A ‘controversies screen’ is then applied to exclude companies deemed to be involved in serious ESG controversies. A best-in-class filter, which screens out companies with the lowest ESG ratings relative to their industry and country peers, is also applied, producing a total of 847 exclusions from the parent index.
Some ETFs track indices that apply the methodologies set out by MSCI, but with additional filters for carbon exclusions based on assessments of current and potential emissions, leading to further filtering out of carbon intensive companies.
Over recent years institutional investors have become focused on the risks associated with investments in controversial sectors such as tobacco as well as across high carbon intensive industries. In addition, there is increasing evidence that highly-rated ESG companies display the most stable earnings per share over the medium term, as well as the hazards from carbon-intensive company investments. This reflects the dangers of government regulation to meet climate agreements made in Paris in 2015 as well as rapid advances in clean and renewable technologies, which are increasingly stealing market share from higher-carbon activities, notably in the power generating sector.
Not surprisingly, these trends are encouraging the growth of thematic ESG indices that aim to address pressing environmental and/or social challenges. The development of these indices reflects growing interest in divesting out of fossil fuel investments to address the threat posed by global warming as well as excluding investments in conflict with the UN Sustainable Development Goals.
Michael Lewis is head of ESG thematic research and Murray Birt is senior ESG strategist at DWS
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