Comment: Decarbonising a Portfolio Versus Decarbonising the Economy

Policymakers and non-state actors from all around the world convened at the international climate conference COP23 in Bonn last month to discuss how to implement the targets set out in the Paris Climate Agreement. When some investors spoke about decarbonising their portfolios, policymakers interpreted their efforts as a way to reduce global greenhouse gas emissions. However, these investor efforts are not necessarily aimed at mitigating climate change. The confusion stems from an unclear definition of the term decarbonisation in the investment context.
In general, when investors speak about ‘decarbonisation’, it is important to understand if their objective is to decarbonise their portfolios or the real economy. The answer depends on each investor’s underlying motivation and actions. There are two types of motivations to consider: impact and risk.

1. Impact
Investors with a focus on impact want to ensure that their investments help – or at least, do not harm – the climate. Historically, impact was the most common motivator to address climate change and it was mostly mission-driven actors, such as churches and foundations, that developed approaches around it.

2. Risk
Investors with a focus on risks are primarily interested in ensuring that climate change does not threaten their investment returns. Risks can be linked to regulation (transition risk) and/or the physical effects of climate change on assets (physical risk).
For impact investors, investing in a low-carbon equity index, for example, might not support their objective of decarbonising the real economy. However, investing in climate optimised indices might help investors with a risk focus to reduce their exposure to companies that run high risks of getting hit by climate legislation or carbon pricing schemes. It could also allow them to become aware of investment opportunities through exposure to trending, climate-friendly technologies.

When investors speak about ‘decarbonisation’, it is important to understand if their objective is to decarbonise their portfolios or the real economy

Are public equities in general an asset class that does not allow for direct impact, then? Not necessarily. By making use of engagement – and especially voting rights – an equity investor can impact the real economy by actively changing a portfolio company’s ‘DNA’ towards climate resilience and positive climate contributions, ultimately impacting the real economy in that regard. In 2017 in the US alone, for example, 89 shareholder resolutions on the topic of climate change have been filed to date and of those that came to a vote, some received investor support of well above 50%, with an overall average of 23%. Another way to create impact on the real economy through equity investing can be achieved by an investor calculating the carbon footprint of its investments and offsetting the greenhouse gas emissions of those investments through financing emission reduction projects in developing countries. An example might be a reforestation project. When combining a low-carbon index investment approach with engagement, voting and/or offsetting, both the portfolio and the real economy can be impacted by decarbonisation.
An interesting case in point, where the distinction between impact and risk investing can be seen, is around divestment. An increasing number of investors divest from companies involved with fossil fuels, using different approaches. For example, an investor with a risk focus could define a threshold and divest from companies that generate more than a certain percentage of their revenues from coal-related business activities. In that case, if the coal industry gets hit by climate regulation, the damage to the portfolio will be limited. In this model, a company such as Glencore can still be bought into such a portfolio because although it is among the world’s largest coal producers with almost 2% of global market share, it derives less than 5% of revenue from this business.An impact investor, on the other hand, would probably not include the world’s largest coal producer in its investment mix. Rather, an impact investor would probably acknowledge that divesting alone might not be enough to achieve the aim and instead apply the divestment movement’s logic of full “divest-invest.“ In the associated pledge, an investor not only excludes fossil fuel-linked investments, but also takes part of the funds that have been freed up by the divestment to invest directly into low carbon solutions – typically in asset classes such as private debt and equity, project finance, lending or other real asset investments.

By not participating in IPOs for climate reasons, equity investors could influence the value of companies

A special case might be IPOs. Given that stock market investors are indeed directly providing liquidity to companies going public and thus are primary market participants, this might create a special ‘divestment’ opportunity with real-economy impact. By not participating in IPOs for climate reasons, equity investors could influence the value of companies, to the extent that the companies might consider adopting a climate strategy that would help attract investors. An interesting case might be the envisioned listing of the world’s largest oil and gas company, Saudi Aramco. The IPO is reportedly planned for 2018 and comes at a time when some of the world’s largest investors, typically at the forefront of such IPOs, have announced they will no longer invest into oil and gas. For example, Norway’s sovereign wealth fund, the world’s largest by assets under management, disclosed plans for such a policy in November 2017 and might therefore not participate in the IPO.
This potential outcome leads to the conclusion that primary market divestment might actually create an impact. A more common example for this is the credit and fixed-income world. By not participating in debt issuances or by not granting a loan to a company with an unsatisfactory climate record, investors and capital providers increase the cost of capital for those companies, governments, or other issuing entities to a point where they might reconsider their climate strategy. Such ‘debt denial’ can be a powerful instrument to effect change, especially for larger investors that traditionally back financing initiatives of large corporates as part of their fixed-income or credit business. Based on the above, impact investors might adopt a mixed approach of divesting from climate-harming fixed-income and credit activities combined with using engagement and voting on the equity side to achieve impact.

‘Debt denial’ can be a powerful instrument to effect change

Back to COP23. Policymakers at the conference rightly pointed out that industry initiatives such as Europe’s High-Level Expert Group on Sustainable Finance (HLEG) and the Financial Stability Board’s Task Force on Climate-related Financial Disclosure (TCFD) are landmark initiatives, transforming the financial industry. These initiatives are useful for determining the state of the financial market regarding climate change, but it is important to note that they are driven by different motivations. The HLEG has an element of impact in its mandate, as it states that “the financial system shall become more sustainable.” The TCFD is a reporting initiative and focuses solely on risk.
Decarbonising a portfolio for reasons related to risk and decarbonising the economy to achieve impact are both relevant objectives. They do, however, require different approaches, data sets, and measurements.

Maximilian Horster is the Managing Director of Climate Solutions at Institutional Shareholder Services (ISS), a corporate governance and responsible investment services provider.