Reducing an equity portfolio’s carbon footprint on the basis of companies’ absolute emissions does not necessarily reduce its carbon financial risk, according to a study by BNP Paribas Securities Services and Singapore-based consultancy Avalerion Capital.

The companies developed a stress-testing approach to assess the impact of several climate change mitigation-related policy factors on companies’ profit-before-tax (PBT), as a proxy for a firm’s value, and investor equity portfolios.

They initially focused on carbon pricing as a “key policy lever” to measure the impact on PBT.

Trevor Allen, product sales specialist at BNP Paribas, told IPE: “We started with a very simple premise, and that premise is that carbon is an underpriced risk.

“Pension funds in particular and any asset owner need to protect themselves against the future price of carbon. How do they go about doing that?”

Using baseline, moderate and aggressive forecast scenarios for climate warming trajectories and carbon prices, the study found that “carbon price does pose a material performance risk to equity portfolios” by way of the impact on companies’ PBT.

The impact could be material in four high-emission sectors, according to the study: utilities, basic materials, energy and industrials.

It found that, under the baseline “business-as-usual” scenario, which assumes a warming trajectory of 3-4 degrees Celsius and a carbon price of $7-18 across the six core carbon markets (excluding Japan), companies’ annual PBT could be reduced by 1.5-15.3% by 2020.

The study back-tested three approaches by which investors can address the risks presented by emerging carbon-pricing policies – the “low carbon” method, a “profit before tax hedged” method and a “Smart carbon hybrid” method.

The first is designed to minimise a portfolio’s overall carbon footprint, the second to hedge the risk of carbon price fluctuations to reduce potential financial losses, and the third combines the former two approaches.

The study found that the low-carbon method reduces the carbon emission of a benchmark portfolio by more than 60% but “only buffers about 22% of the PBT potential loss”.

This, according to the study, “indicates that reducing the carbon footprint of the portfolio does not necessarily reduce the carbon financial risk of the portfolio”.

The “profit before tax hedged” method offers better protection but comes with a tracking error of 2.3% per annum and an annual turnover of more than 160%, which “can be at odds with institutional investors’ typical long-term investment horizons and the standard annual review of their strategic asset allocation”.

The “hybrid” method offers “the advantage of immediate carbon reduction and insurance against carbon price movements” and could be “a stepping stone for institutional investors on the path to the full decarbonisation of their portfolios”.

As noted in the study, many pension funds and other asset owners are concerned about climate change and the implications for their portfolios and investment actions.

Measuring a portfolio’s carbon footprint and subsequent action to reduce it – decarbonising – has been a focus for many, with various approaches taken.

Attention is also increasingly being paid to being positioned to take advantage of the opportunities posed by the transition to a low-carbon economy.

A new fund launched by Legal & General Investment Management and used by HSBC Bank UK Pension Scheme, for example, has a carbon-footprint reduction element while also being designed to increase exposure to companies generating “green revenue”.