Decarbonising portfolios: Smarter strategies for emissions reduction

Decarbonising is also likely to lead to improved investment performance

The formation of the Portfolio Decarbonisation Coalition and its participation in the UN Climate Summit in 2014 marked a major step forward in the fight against climate change. The UN-backed multi-stakeholder initiative provides a platform that can help drive significant reductions in greenhouse gas emissions, by mobilizing a critical mass of institutional investors committed to decarbonizing their portfolios.
In a new white paper published today, we argue that asset owners can play a vital role in driving meaningful change. Ultimately, their choices will help determine how individual companies are funded by the market. It is therefore important they use the right information when constructing their portfolios. Carbon footprint is typically measured by looking at a mixture of carbon emissions and carbon intensity. Whilst these are valuable indicators of a portfolio’s carbon attributes they can produce simplistic decarbonisation strategies, dedicated to shedding the most carbon intensive assets, resulting in sectors with high carbon emissions being excluded from portfolios. Underinvestment in these sectors raises the cost of funding for the affected companies, limiting their ability to invest in cleaner production methods, meaning high emission levels are sustained.
Similarly, strategies that do not account for regional disparities are likely to produce ineffective results. Countries exhibit varied demographics, have uneven access to resources and benefit from different levels of economic development. Decarbonisation strategies that are blind to these variations fail to support relative improvements in each market.

These dynamics are replicated within the utilities sector, which accounts for the majority of direct carbon emissions. Utilities are ten times more carbon-intensive than the S&P500 average, but this presents an incomplete picture. Water and gas utilities and transmission and distribution networks are not particularly carbon-intensive activities; the exceptionally high level of carbon intensity in the sector is directly attributable to power generation.
Power generation is an essential activity to any economy and widespread electrification will ultimately be required to meet international carbon goals. According to Bloomberg New Energy Finance, ‘greening’ the grid globally will cost an estimated $47 trillion; clearly this will not be possible without extensive investment by utilities companies with power generation assets. But while this increased investment in clean generation is urgently needed, simplistic approaches to decarbonisation have a counterproductive effect. Switching an investment from a power generator to a water utility will make a portfolio less carbon intensive but will do little to reduce emissions.Regional variations are also significant. The establishment of a gas power station in predominantly renewables fuelled New Zealand would constitute a regressive step, but in coal dependent China it would be a comparatively positive development, meriting support from investors.
Decarbonisation strategies therefore need to be modified to assess companies on their own merits, distinguish between sectoral and geographical variations in emissions profiles and recognise the unique status of the utilities sector.

By withdrawing capital from carbon-intensive companies, projects and technologies in each sector and re-investing that capital into carbon-efficient companies, projects and technologies in the same sector, investors can better support emissions reduction.
Given the power generation industry’s unique dynamics, it must be considered separately from the wider utilities sector. Asset owners need to favour companies that are contributing the most to ‘greening’ the grid and encourage companies that are underperforming to invest more in clean generation.
In association with Carbon Analytics, Ecofin created a global database of all listed utilities with power generation assets. By tracking the generation mix for each company and for each country we can more accurately assess variations in carbon footprints. By comparing each utility to that of the grid in which it sits, we can identify the utilities that are effectively “greening their grid” and those that are lagging behind. Applying this intelligence in the portfolio formation process ensures capital is diverted to cleaner generators.
Armed with this knowledge investors can further support decarbonisation through active and targeted engagement with selected companies. Investors can incentivise managements with emissions targets based on the performance of their appropriate peer group, and the knowledge that success could open up investment from members of the Portfolio Decarbonisation Coalition, responsible for managing $3 trillion of assets.
While decarbonising portfolios for the sake of emissions reduction is in itself a laudable goal, it is also likely to lead to improved investment performance. Older inefficient technologies, subject to higher costs and regulatory risks are under significant pressure from rapidly improving clean technologies. Over time we expect the performance of carbon neutral power producers to outperform dirtier power generators, producing better returns for investors and helping to deliver a more sustainable future for us all.

Deirdre Cooper is Head of Research at Ecofin, the independent investment management firm.
The PDC is partnering with Responsible Investor’s Decarbonise 2.0 series of workshops in April and May 2017. Link here for further information.