Assessing climate risks in an investment portfolio can be a hell of a job. Investors who want to reduce this risk and also make an impact in speeding up energy transition are looking for ways to do this… but how?
A common instrument used is decarbonization of the investment portfolio: this means measuring the carbon footprint of the fund and reducing it by selling the largest contributors. This is a good first start, but there are several other issues to be considered, says Masja Zandbergen, Head of ESG Integration at Robeco.
“The largest contributors are often only found in a few CO2 intensive sectors, meaning you will divest from those sectors completely, and therefore have no impact on the much-needed energy transition,” she says.
“The current footprint of a company does not necessarily say anything about its future footprint. If one were to take two identical companies with the same footprint, but one company is considering making an energy transition of strategic importance and is preparing for the future, it is clear which company you would want to invest in.”
“Meanwhile, by only measuring the footprint of the company’s operations, and the energy used in these operations, you miss part of the risk. What about the use of the company’s products? A car maker might be less carbon intensive than another manufacturer, but its products have a high carbon footprint through emissions. And the risks lie in a change in market behavior and preferences too, for example, in the switch to electric cars.”
“Similarly, a food company has high exposure to agriculture, and thereby to generating large amounts of CO2 emissions in its supply chain. What about companies whose clients are all in the energy sector? It’s not as simple as it looks.”
These issues were illustrated by Isabel Reuss, Portfolio Manager for European SRI Equities at Allianz Global Investors, at a recent Sustainability Investing Forum that Allianz GI jointly hosted with Robeco. She says divestment simply transfers a problem, and an investor cannot sell out of an entire sector anyway if they want to make a long-term impact.
Creating a lower-carbon society effectively means investing in things such as more efficient buildings and renewables to keep global warming below two degrees Celsius – so it is therefore impossible to avoid the energy, materials and utilities sectors while doing so, she says. Instead, extensive engagement with the largest generators of greenhouse gas emissions is necessary.
“Does divesting make an impact? No; at best it is neutral and at worse it may even be negative,” says Reuss. “Achieving a lower-carbon economy means you must use energy, materials and utilities. Divesting an entire sector may lower the carbon footprint of a portfolio, but it makes absolutely no impact on the environment.”
“We want to reach a two-degree economy, so how are we going to do that if we don’t use these three sectors? If you divest it, whoever is buying it is not interested in climate – so they’re not sitting at the table. We cannot then discuss climate with divested companies, or engage with them.”
Reuss cites the example of building insulation, which has a net beneficial effect on the environment. “For every kilogram of CO2 emitted in the production of insulation, 330 kg of emissions are avoided once it is installed,” she says. “It is part of the materials sector, so if everybody divests that, then why would the sector invest in R&D to find better insulation materials? It’s not black and white.”
Reuss says that in terms of portfolio construction, there are three dimensions to choosing stocks: the companies that are the best performers in cutting carbon; those that are making the best efforts to reduce emissions; and those offering the best solutions for others. This is shown in the graphic below.
“For us, the best solution is looking at something like washing detergent,” Reuss says. “What if a company makes an enzyme that means you can wash your whites at zero degrees, using less energy, and it still all comes out white. This is something that has a real impact. We need to find solutions; you have to look for them and find them.”
Robeco and RobecoSAM believe that such solutions like plainly in portfolio construction, using enhanced research, Zandbergen says. “This can be done first of all by decarbonizing the portfolio to reducing its environmental footprint, and then adding a more forward-looking component by using the environmental score of the RobecoSAM Corporate Sustainability Assessment to assess which companies are more adaptive to this issue,” she says.
“Furthermore, engagement is used as a tool to address these issues at companies, encourage them to make the transition, and gain more information for our investment teams to apply at the same time. Finally, we can invest in companies that are providing a solution to climate change, such as green bonds in our credit portfolios. That then makes a difference.”