In this memo I discuss a topic which I have been heavily struggling with for a while. It is about whether we should attach a carbon footprint to financial derivatives. Several earlier attempts to get insight in the matter have failed. Also asking Google has not been very helpful. Below I share my thoughts on the matter.
Consider someone named Daniel, who decides to invest in a local farm. The investment is for one year, and after that year Daniel gets his investment back. Given the plans of the farm, Daniel expects to earn a nice positive return, but he knows the return can become negative in case of adverse events. Given the capital structure of the farm, we can calculate that Daniel ‘owns’ 1% of it. In such a situation we would also say that Daniel is responsible for 1% of the greenhouse gas emissions (mostly methane from the cows).
Half a year later, Daniel finds out that his dreamhouse is for sale. Transfer of ownership should take place in half a year, which is around the time the loan for the farm is due. At first, Daniel is incredibly happy, but soon the realization kicks in that he will not have enough money if the investment outcome is disappointing. As the house is really a once-in-a-lifetime opportunity, he desperately decides to look for a solution.
He starts with the most obvious option and asks the farm whether he could already receive his investment back. The farm replies that they used his investment to increase livestock, and that they are not willing to sell any cows at the moment. Therefore, he starts thinking of other ways to fulfil his dream. After drinking many cups of (virtual) coffee with colleagues, he finds someone named Carola able to help him realize his dream. They agree that Carola will get all the profits from Daniel’s investment. Thus, in a good year for the farm, Carola will get all the profits, but in a bad year she needs to make up for the losses.
After formalizing their financial agreement Daniel claims that Carola is now responsible for the greenhouse gas emissions. Daniel states that with transferring the economic exposure of the farm’s business activities to Carola, she is also responsible for the emissions. Carola, on the other hand, is convinced that Daniel remains responsible for 1% of the greenhouse gas emissions, since he has still invested exactly the same amount as before, while she has not invested anything at all. I agree with Carola and let me explain why.
I believe what ultimately matters for carbon accounting is who ‘owns’ a company. All the owners of a company together provide the capital that enables its economic activities and emissions. Suppose, for instance, that Daniel would not have invested at all; then the farm would have less capital, could buy less cows, and hence would have lower emissions. The farm’s emissions are thus directly related to the capital.
On the other hand, transferring the economic exposure from Daniel to Carola has no impact on the financial capital structure of the farm, nor on the amount of cows, and therefore the emissions stay exactly the same. Thus, for the footprint of the farm, it is totally irrelevant whether Daniel or Carola carries the risk. As the emissions are directly related to the total amount of capital, but it is irrelevant who carries the economic exposure, it perfectly makes sense to also attribute footprint based on ownership and not on economic exposure. Therefore, Daniel should remain responsible for the emissions.
I guess you have already noticed that Daniel has hedged his risk using a short position in a forward.1 Consequently, Carola has a long position in the same forward. My story above actually implies that financial derivatives should not have any carbon footprint, as holders of derivatives do not ‘own’ a company.
Not assigning footprints to derivatives could lead to greenwashing. For instance, the economic exposure of an oil and gas company stock can easily be replicated by a cash position plus a futures position.2 Holding the stock would then result in a high carbon footprint from an energy company, while the replication would result in a low footprint from the cash deposited at a financial company.
Conversely, assigning footprints to derivatives could also enable greenwashing opportunities. Given the large differences in carbon footprint of some large oil giants, almost market neutral long-short futures positions with a large negative carbon exposure can easily be constructed.3
Thus, from a fundamental perspective, derivatives should not have a footprint. However, clear legislation and guidance should be developed on the use of derivatives for green labels to avoid greenwashing.
1As the interest rate is around zero at the moment we can ignore that component
2Similar logic can be applied to other derivatives (for instance treasury + CDS = corporate bond).
3Short positions in futures should have a negative footprint, otherwise total global emissions become enormous.
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.
This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.