Kris Nelson, Russell Investments Senior Director, Head of ESG, Investment Management, discusses why fund managers may need to evolve their ESG strategies to address both the risks and opportunities of a low-carbon transition
Investment solutions designed to tackle the net zero transition are rapidly evolving as early strategies reveal their limitations.
Initially, many fund managers adopted a “standard decarbonisation” approach – in other words, the aim was to reduce an equity portfolio’s exposure to carbon emissions and/or divest from fossil fuel reserves.
At face value, this makes sense. Avoiding the biggest contributors to climate change appears logical for investors who want to avoid climate-driven stranded asset risk and choose to apply environmental, social and governance (ESG) principles to a portfolio.
However, in practice, this approach proves overly simplistic. Research by Russell Investments reveals that it can unintentionally reduce exposure to renewable energy and even lower the overall ESG profile of a portfolio.
Incorporating three additional key elements into an ESG-focused strategy can help overcome these issues:
- Higher exposure to renewable energy: An enhanced strategy might consider not just the future risks of an energy transition, but also future opportunities. Utilising a green energy score, which measures the proportion of a company’s total energy produced from renewable sources, can positively impact a portfolio’s overall ESG profile and by extension may lead to improved investment outcomes.
- Material ESG scores: Employing analytical systems that calculate ESG scores based on issues that are specific issues to individual companies proves more effective than the traditional one-size-fits-all approach that overlooks industry differences.
- Targeted reduction in coal exposure. Explicitly excluding thermal coal stocks from a portfolio acknowledges the necessity of significantly reducing coal energy use to meet a 2-degree warming scenario.*
Refined strategies
These principles are reflected in the Russell Investments Sustainable Global Shares Fund (the Fund) – which is designed to help investors align portfolios with a low carbon transition while maintaining the risk and return profile of its index and avoiding unintentional risks. Investment strategies have evolved from one-size-fits-all ESG metrics to more customised approaches that align to institutional investors’ specific investment goals.
The Fund aims to generate returns in line with the MSCI All Country World Index (ACWI) – Net, which represents approximately 85% of the global investable equity market, encompassing both developed and emerging markets.
While managing active risk, the Fund targets a 50% reduction in carbon missions and carbon reserves as compared to the index. It also excludes investment in companies which are involved in the production of the core weapon systems (for anti-personnel mines, nuclear weapons and cluster munitions); uranium mining; the manufacture of tobacco; and companies that derive more than 10% of their revenue from coal power generation or mining thermal coal (i.e. thermal coal extraction).** Instead, the Fund tilts its holdings towards those expected to benefit from the energy transition and with stronger ESG credentials relative to the Fund’s benchmark.
The strategy results in underweight positions in high carbon emitting sectors such as energy, materials and utilities. This includes a reduced focus on utility and energy companies with significant carbon footprints.
On the other hand, the strategy favours companies with an above average ESG score or higher green energy ratio relative to the Fund’s benchmark. This includes energy companies which generate a higher proportion of their power from renewable sources, as well as companies from other sectors with a strong commitment to sustainability.
As of July 2024, the Fund’s carbon footprint was 60% lower than the index, with a 58% reduction in carbon reserves. The Fund’s Material ESG score (based on Russell Investments’ proprietary Material ESG scoring system) was 104% of the index, while its green energy ratio was 124% of the index.
In certain markets – when energy and materials stocks are rallying, for example – short-term volatility in returns may occur. However, since its inception in December 2021, the Fund has broadly met its stated objectives of decarbonisation relative to the Fund’s benchmark, with index-like returns.
Active ownership is considered an important component of effective ESG investing. At Russell Investments, it plays a vital role in enhancing long-term outcomes through regular dialogue with company management and consistent proxy voting. This helps to achieve the transparency and impact sought by end ESG investors.
Our focus is on helping clients achieve their investment goals. If decarbonisation aligns with those goals, we facilitate that without changing the return profile or introducing unintentional risk. Portfolio decarbonisation remains an evolving field which relies on an ability to assess outcomes and refine strategies with empirical evidence. By staying responsive to these challenges, Russell Investments is well positioned to deliver innovative solutions that drive both financial and sustainability goals for clients.
*As per the Paris Agreement, which aims to hold the increase in the global average temperature to well below 2°C above pre-industrial levels.
** For full details of the Fund please read the PDS which is available at www.russellinvestments.com/nz/
Disclaimer:
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