Carbon reduction strategies are becoming increasingly sophisticated but investors should remain wary of practical limitations and claims of outperformance of ‘green’ portfolios, according to new Russell Investments NZ research.
In a sequel to a study published earlier this year, the new Russell paper outlines four common carbon-shrinking options for share exposures currently available to investors, namely: exclusions; decarbonisation; proxy voting/engagement; and, green impact investing.
“The implementation strategies we highlight are used by many of the largest global investors and can be customised to meet the specific requirements of local investors,” the report says. “These strategies can assist investors in meeting new carbon exposure reporting requirements, while also providing a concrete path towards building portfolios that align with New Zealand’s net zero 2050 targets.”
However, the latest study – authored by Matthew Arnold and Mihir Tirodkar, respective Russell NZ director and senior analyst – says that despite rapidly improving data and better real-life solutions the carbon reduction investment process is relatively immature.
“… globally diversified, multi-asset investors should acknowledge that carbon mitigation strategies are still a work in progress,” the report says.
For instance, underlying carbon data largely excludes the so-called Scope 3 information (which creates a more complete picture of corporate emissions from ‘upstream’ activities such as supply chain to downstream effects like customer use of products).
And, to date, most investors have focused on reducing carbon exposure only in equity holdings – as per the new KiwiSaver default scheme fossil fuel exclusion policy, for example.
“Through their holding of bonds of some sovereign states, for instance, some ethically minded environmentally focused investors may inadvertently be funding high carbon footprint activities, such as fossil fuel exploration and extraction,” the Russell paper says. “Index providers and fund managers have made significant progress in recent years in development indices and investment products that provide a means for investors to target the carbon footprint of their fixed income portfolios, but this remains a nascent part of the investment landscape today.”
The study lays out the pros and cons of the four approaches to cutting carbon exposure in share portfolios, noting, for instance, that exclusion-based strategies – while simple to execute – can significantly alter the investment risk-return characteristics as well as potentially creating “internal contradictions”.
“Divesting from companies that are making substantial investments in green energy through blunt ‘no fossil fuels’ policies highlights a particular challenge,” the paper says. “Likewise, holding the bonds of sovereigns or corporates that are involved in harmful environmental activities, while divesting from shares involved in those same activities, opens investors up to criticism of window-dressing.”
Meanwhile, decarbonisation strategies that tilt away from emission-heavy companies can offer a more effective method to meet climate targets in share portfolios.
“Unlike the blunt divestment approach, decarbonisation strategies acknowledge that most companies sit on a [greenhouse gas] GHG emissions spectrum and provide an avenue for ongoing investor exposure and engagement with a company,” the report says. “Managed well, decarbonisation strategies can provide investors with greater flexibility than exclusions-based strategies while also recognising the grey areas of carbon metrics.”
But investors still need to take care that decarbonisation does not unduly distort their portfolio risk attributes with active strategies, in particular, requiring special attention.
The Russell study suggests large-scale active investors using multiple underlying managers could consider controlling carbon exposure of the overall scheme rather than relying on specialised individual mandates.
Applying such decarbonisation overlays at the scheme level would involve some complexity but “once complete it offers an efficient way for investors to manage the carbon exposure of their equity portfolio at the aggregate level while reducing the potential loss of alpha that one might expect were it done on a portfolio by portfolio basis”.
As investors seek to limit carbon exposure, though, they should remain skeptical about reports linking green portfolios with higher returns.
“… academic evidence has yet to determine if there is a relationship between carbon exposure, risk and investment returns,” the study says.
“Our advice to investors is to evaluate claims of ‘low carbon’ outperformance with a critical eye.”
The Russell paper also says that portfolio decarbonisation efforts – while necessary – are unlikely by themselves to make much of a dent on climate change.
“Signalling, engagement, tilts, divestments, and proactive funding of ‘green’ companies may make a positive contribution in the global effort to combat the negative effects of climate change, but government intervention and behavioural changes by the general population are simultaneously required,” the report says. “Indeed, carbon taxes, trading schemes, government investment and environmental regulations are all likely to have a more immediate impact.”
Former Russell Investments consultant, Julian Darby, also contributed to the latest portfolio carbon reduction study.