At Mirova,1 we increasingly see that those businesses most exposed to the impacts of climate change are taking action. As a result, the few that benefit from the status quo have begun to falter. As companies seek to protect themselves from the cost of compliance with future regulations or against the physical risks associated with a changing climate, they are changing the way they consume and create energy.
We are seeing these actions spark new trends: increased use of energy-efficient technology and buildings, along with growing use of alternative energy.2 Separately, we’ve watched traditional energy’s share of global markets, as measured by the MSCI World Index,3 shrink from over 10% to under 7% in the last decade.4
Despite these structural changes, many financial professionals and retirement plan sponsors feel compelled to maintain exposure to these at-risk industries. In our global conversations, we hear similar themes: While investment plans have long-term objectives, those responsible for managing them have short-term incentive plans. So how can portfolios be managed to maintain their risk/return profile yet participate more fully in the coming low-carbon economy?
We offer a few ideas focused on what we believe is the simplest solution – green bonds. Our investment parameters and objectives include:
- Compliance with a 2°C global warming scenario – the significance of the Paris Agreement and how to measure a portfolio's alignment with it.
- The risk/return profile of a plan or portfolio – a review of the various measurements of risk and ways to bring portfolios into compliance with a 2°C scenario, consistent with long-term liabilities and risk tolerance.
- Hedging against transition risk and physical risk – a brief examination, as these risks are largely beyond the scope of this paper, but the issues need to be addressed.
Commonly used terms like COP21, Paris Agreement, and 2.0°C scenario are rarely defined, although they are often used interchangeably. All pertain to climate change. There are many gases associated with causing climate change, also known as greenhouse gases. Carbon dioxide is the most common; as such, all other gases are generally referred to by their carbon equivalency.
Greenhouse gases, which occur both naturally and as a result of human activity, trap heat from the sun on the earth. Climate models can predict the extent of changes to the earth’s climate with reasonable accuracy, based on quantities of global greenhouse gases emitted via fossil fuel, or cattle raised, or methane leaked. The Intergovernmental Panel on Climate Change (IPCC) provides these data and forecasts, and also offers perspective on potential weather changes, sea level fluctuations, and the general environmental well-being of the planet under various temperature scenarios. The established temperature scenarios refer to increases in global average annual temperature since the start of the Industrial Revolution (when people started burning hydrocarbons in earnest).
IPCC research suggests that:
- We are at 1.0°C above the pre-industrial average.
- A 1.5°C increase is inevitable, given economic and environmental momentum.
- 2.0°C is a tipping point where social, economic, and environmental well-being become broadly and irreparably compromised. The Paris Agreement was established at the 21st Conference of Parties (COP21), held in Paris in December 2015. The agreement seeks to keep global warming to a 1.5°C scenario with a hard cap at 2.0°C (though the International Energy Agency suggests that current commitments resulting from the agreement put the earth on target for a 2.7°C scenario). As a result, the three terms are often used interchangeably. A big open question for many, however, is how can we measure our own impact (and by extension, the impact of our investments) and how can we work to improve it? At Mirova we have developed what we believe to be a very conservative and comprehensive approach to answer this question.
Greenhouse gas footprint analysis calculates carbon-equivalent emissions in metric tons. Standard assessments use two scopes of analysis. This is a common approach because the data tend to be readily available and easy to apply.
- Scope one assesses the emissions created by the manufacturer or service provider itself.
- Scope two measures the emissions from energy purchased to run the factory or service. An overly simple example is that drilling for oil and gas doesn't emit a tremendous amount of carbon dioxide. In contrast, the process of creating fiberglass insulation requires massive ovens and blowers and is energy intensive. Naïve application of a two-scope carbon footprint analysis would favor oil and gas over fiberglass insulation. But we know intuitively that fiberglass insulation will play a bigger role in creating a low-carbon economy once it reaches the end user – the third scope.
- Scope three measures the carbon footprint related to the consumption or use of a service or product over its full life cycle. Using the complete set of data demonstrates that oil and gas extraction is more carbon-dioxide intensive than fiberglass insulation manufacturing. Oil and gas result in significant emissions by the end user, while fiberglass insulation minimizes emissions by creating more energy-efficient buildings (Figure 1).
In many ways green bonds are the same as ordinary bonds, priced on duration5 and the creditworthiness of the issuer. However, green bonds have one important difference: earmarked proceeds intended for environmentally beneficial projects, such as energy efficiency, renewable energy, water system improvement, pollution control, or biodiversity. These types of projects are effective at reducing greenhouse gases.
Energy efficiency simply reduces the amount of energy consumed, which lowers greenhouse gas emissions. Renewable energy sources generally do not require burning biological materials like coal or oil in the first place.
Better water management can lower emissions because the process of cleaning, storing, and transporting clean water is very energy intensive. Simple measures like repairing leaky, aging pipes lowers municipal energy consumption significantly. Finally, preserving biodiversity, particularly plant life (which absorbs CO2 to make oxygen) can offset growing carbon dioxide levels. Each year a land mass the size of Ireland becomes a desert due to poor land management practices.
Compliance with 2.0˚C Scenario
While there are many tools available for measuring carbon footprint and compliance with the Paris Agreement, none offers a proper analysis of lifecycle emissions and avoided emissions. In “Estimating Portfolio Compliance with Climate Scenarios” (January 2018) by Samantha Stephens of Mirova’s ESG research team, we offer a carbon impact measurement that incorporates both induced and avoided emissions.
The first stage in Mirova’s process is to aggregate carbon emissions data for the full lifecycle of a product or service, both the emitted carbon from scopes 1, 2, and 3 and the avoided carbon from scopes 1, 2, and 3. Calculating avoided emissions requires understanding where the business is located and in which industry it operates. In a business-as-usual scenario, we can establish a base level of emissions across industries and regions. Businesses that emit less than this base level have avoided emissions.
Consider two parts of the US – California and Massachusetts. On the West Coast, using coal to produce electricity is considerably less common than in the Northeast. So producing electricity with gas (which is half as CO2 intensive as coal) results in zero avoided greenhouse gases in California but creates some avoided emissions in Massachusetts. A wind turbine will have impact in both states, but greater impact on reducing emissions – and therefore mitigating climate change – in Massachusetts. Understanding this baseline provides a clearer sense of the impact specific investments might have.
Mirova has researched and compiled these data working with Carbone 4, a leading consulting firm specializing in climate change adaptation and the energy transition. The complete formula and regression study can be found in the paper cited above. Our analysis assumes that all the world’s assets are invested in line with the tested portfolio, a virtual impossibility. Therefore, the next step in the process is standardization. We first placed upper and lower limits on the results: 1.5°C at the lowest, as it is generally regarded as inevitable, and 6.0°C at the highest because the magnitude of global calamity above this level makes further assessment irrelevant. In the middle are the actual results based on the formula, accounting for all the industries that are low carbon but do not have an impact due to the nature of their business. For example, a portfolio of media companies, regardless of its carbon footprint, is not part of the fight against climate change.
Building a Portfolio
In our tests, we created two portfolios, one conservative and one aggressive, using the MSCI World Index6 and the Bloomberg Barclays Global Aggregate Bond Index (rebalanced quarterly).
Using our models, the conservative portfolio (40% global stock / 60% global bond) was an investment in a world that could be 4.6˚C warmer by 2200. But adding merely 9% green bonds to the portfolio brought the model into compliance with a 2.0˚C scenario. Reducing the 60% Global Aggregate Bond allocation to 51% and replacing the 9% with Bloomberg Barclays MSCI Green Bond Index, we saw the potential temperature increase drop to 1.8˚C. The risk/return profile of the portfolio changed only very slightly. Looking at the period from January 2014 (Green Bond Index inception) to June 2018, the difference in return for the two portfolios was 0.23% (23 basis points) cumulative, in favor of the 1.8˚C portfolio. Over the same period, the Sharpe ratio would have been 1.14 for the 1.8˚C portfolio and 1.13 for the 4.6˚C portfolio.
In the aggressive portfolio (60% stock / 40% bond) the climate scenario was estimated at 4.7˚C warming by 2200. Once again, an allocation of 9% to the Barclays MSCI Global Green Bond Index would have brought the portfolio in line with the Paris Agreement, at 1.8˚C. From January 2014 to June 2018, the 1.8˚C portfolio would have outperformed by 0.22% (22 bps) cumulative and the risk/return profile would have changed by a single basis point.
In both cases, the climate change scenario would be dramatically different, but the overall historical risk/return changed insignificantly in favor of the Paris Agreement compliant portfolio.
We accept that this seems an overly simple solution, but we also believe that the facts about climate change have been made needlessly complicated. For example, most estimates of investment required to keep temperature rise below 2˚C are about $44 trillion over the next 30 years9 while the global treasury is $280 trillion and by some estimates expected to grow to $341 trillion by 2022.10
At $1.4 trillion per year, the required investment is comparatively de minimis. Importantly, while an allocation to green bonds does provide some hedge against a sudden change in policy or innovation that makes fossil fuel unattractive, it is only an imperfect one. Green bond issuers tend to be entities helping others improve through lending programs or improving their own place in a low-carbon economy. These issuers should themselves become more resilient to climate change risks and better exposed to the opportunities associated with climate change. Understanding the value at risk in the rest of the portfolio is equally important, but requires more involved analysis.
Hedging against Transition Risks and Physical Risks
In the capital markets, properly priced externalities create both risk and opportunity. The risks are obvious: A business with significant external costs will see its operational expenses increase when the externality is properly priced. The opportunities can be found in providing alternatives and solutions.
Sudden catastrophe created by climate change (flooding, drought, storm damage) that has a heavy price on assets and operations may lead to harsher regulation. Conversely, the advent of a critical piece of technology, more efficient solar panels, spray-on photovoltaic cells, cheaper batteries, or other innovations might make renewables more attractive than traditional energy sources.
The probability of a transition risk from regulatory change seems low given that most governing bodies are careful not to shock their economies. The media also tend to follow technological development closely, making surprise entries to the market unlikely. However, there are reasons to be concerned. Power plant operators have little agility; traditional energy companies have booked the value of assets below ground that may take decades to consume, if at all. Such inertia might make timely adaptation difficult. Catastrophe, on the other hand, has been shown to lead governments to extremes. For example, Japan’s 2011 nuclear disaster upended Germany’s nuclear power industry.
Green bonds can and should finance much of the world’s energy transition, but they may not provide an adequate portfolio hedge against a sudden change in policy or innovation that makes fossil fuel unattractive. While investment solutions for these risks are outside the scope of this paper, it’s important to appreciate that there are other courses of action investors might want to consider.
The impacts of climate change on portfolios are not impossible to measure, though they do require careful analysis. Importantly, bringing a portfolio into compliance with the Paris Agreement does not necessarily require changing its risk/return profile. Green bonds can play a significant role in accomplishing this result.
2 International Energy Agency (IEA)
3 MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is composed of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both US dollars and local currencies.
5 Duration is a bond's price sensitivity to interest rate changes.
6 Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.
7 The Bloomberg Barclays MSCI Green Bond Index provides a broad-based measure of global fixed-income securities issued to fund projects with direct environmental benefits according to MSCI ESG Research’s green bond criteria. The green bonds are primarily investment grade, or may be classified by other sources when bond ratings are not available. The Index may include green bonds from the corporate, securitized, Treasury, or government-related sectors.
8 S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
9 Bullis, Kevin, "How Much Will It Cost to Solve Climate Change?" May 15, 2014
10 Credit Suisse, "Global Wealth Report 2017"
Sustainable investing focuses on investments in companies that relate to certain sustainable development themes and demonstrate adherence to environmental, social and governance (ESG) practices; therefore the Fund’s universe of investments may be reduced. It may sell a security when it could be disadvantageous to do so or forgo opportunities in certain companies, industries, sectors or countries. This could have a negative impact on performance depending on whether such investments are in or out of favor.
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