A new term has entered the institutional investment lexicon: the carbon footprint. This can mean both the level of carbon dioxide emissions of the investments made by an institution, or its own internal carbon emissions from functioning as a company: business travel, etc. It is the former, however, that is most important to investors and whose implications institutions worldwide are grappling with.  Asian investors will be well aware of the Kyoto agreement on climate change, which aimed to reduce by 2012 the emissions of global greenhouse gases to 5% under 1990-levels. Kyoto led to the introduction of related market mechanisms to reduce CO2; the most notable being the European Emission Trading Scheme (ETS), which is under review by the Japanese government as it weighs up its own emissions trading system. The Japanese initiative is likely to be one of a growing number of such schemes in Asia, particularly with increasing global political pressure on China to reduce dependency on fossil fuels and cut greenhouse gas emissions.

The US is also considering the introduction of a similar scheme. Under the EU ETS, the first compulsory market in the world, European countries distributed emission rights (EUAs), initially for free, among the highest polluters. These emissions rights have gradually been allocated a market price above a pollution ceiling: the so-called cap and trade system. This obliges companies to buy emissions rights if they exceed the cap, or offset their emissions excesses with the purchasing of credits based on carbon reduction products in developing markets. The European Commission recently reiterated its target for 20% of Europe’s energy to be producing from renewable sources by 2020. As a result, the price that CO2 polluters must pay for excess emissions will increase. This is often referred to a ‘the price of carbon’, due to the trading of carbon in units of CO2 tonnes. The accompanying chart from Innovest indicates which sectors are likely to be hardest hit by carbon compliance.

What does all this mean for investors? Firstly, that investors need to pay increasing attention to the price of carbon in the sectors in which they invest; particularly in utilities companies, which are among the biggest carbon emitters.

Carbon risk exposures can vary widely among industry sectors and even within the same sector. A number of investment research firms, the biggest of which include Canada’s Innovest, London-based Trucost and Switzerland’s CentreInfo, plot the carbon emissions of corporations worldwide. Innovest’s Carbon Beta Analytics Platform, for example, identifies carbon risk exposures on company-specific issues and across entire investment portfolios to give a carbon footprint audit. Investors can then evaluate the strengths and weaknesses of investments in each sector and move away from carbon-intensive businesses or minimise exposure within a particular sector. Risk levels in individual portfolios can also be compared to existing investment benchmarks.

Trucost has started marketing an index against which investment funds can be benchmarked to be more carbon friendly. The index, based on the FTSE 350, takes an overweight position in companies with low carbon footprints and goes underweight in those that are inefficient compared to the sector average. It maintains the index sector weightings and holds all the same stocks. Trucost said back-testing of the index from 1998 to 2005 showed it had a 25% lighter carbon footprint with performance tracking error plus or minus against the index of 0.5%. The company sells the index data for a percentage of the fund’s management fee. Advocates say such approaches are the equivalent of a call option on the price of carbon becoming more expensive. Another important supporting argument is that pension fund and asset managers are increasingly being pushed to ensure that their portfolio assets are being managed and protected prudently with respect to climate risk. Notable European pension funds that have already had the carbon footprint of their investments measured include the €34.5bn French State Reserve Fund (FRR) and the UK Environment Agency Pension Fund. Both funds have a public onus to ensure they are not contributing to global warming, but have also adopted investment mandates in the growing venture capital clean technology space. A carbon footprint portfolio assessment ensures they are not seeking clean returns on the one hand while making dirty environmental returns on the other.

The million-dollar question, of course, is whether a carbon assessed investment approach can make investors money?

A majority of academic and broker research has concluded that integrating environmental, social and governance factors (ESG) into investment decisions could match or improve current performance. In a review of the major research available in the market, the United Nations Asset Management Working Group of its Environment Program Finance Initiative (UNEPFI) and Mercer, the investment consultant, found that out of 20 academic studies, 10 found a positive relationship between ESG factors and performance, seven were broadly neutral, and three negative. The report, called “Demystifying Responsible Investment Performance” found that ten similar studies by brokerage houses gave three positive reviews and seven neutral indicators. No brokers concluded that performance could be negative as a result of ESG integration. As a result, some institutions have already taken a view on carbon markets. ABP, the Dutch pension giant, is believed to be the largest investor in emission rights with a total trading allocation of €500m. The fund believes it can profit from first mover advantage and use emissions trading as a hedge against its exposure to fossil fuels. ABP also invests in funds and companies involved in projects in emerging countries and in 2006 invested €363m in the Carbon II Fund of Climate Change Capital, the London-based investment house. The number of such products coming to market is extensive with investment banks and specialist houses launching new ‘carbon’ funds on a monthly basis. A report issued at the start of this year by The London Accord, the largest ever private-sector investment research project into climate change and backed by some of the biggest global financial services groups, said institutional investors should now be putting money into carbon markets if they believe in their long-term prospects. The project says market activity and government measures - dependent on the recent Bali summit and subsequent global climate meeting outcomes ahead of the Copenhagen conference in 2009 - could produce medium to long-term carbon prices in the range of €30 to €40 per tonne of CO2. This is a significant predicted rise from the €20 per tonne that carbon has recently been trading at. Investors that understand the implication of their carbon footprint today will be placed to profit from it tomorrow and contribute at the same time to the fight against global warming.