Figure 2: Substantial impacts and related losses and damages attributed to climate change (sourced from page 7 of this report)
Given this monumental list of outcomes, institutional investors are facing pressures to divest from fossil fuel companies and focus on sustainable investing.
Regulations across jurisdictions are evolving and many are enforcing investors and companies to be more transparent about their climate mitigation and adaptation plans.
With this backdrop, institutional investors are wondering: how green are my investments? How can I design a prudent sustainability strategy and what are my choices to shift to a low carbon investment strategy? Below we explore four different approaches to low carbon investing.
Approach 1: Divestiture from Fossil Fuel Companies
While this strategy may help in the near term there are three critical challenges that investors need to consider.
1) Excluding fossil fuel companies can lead to large tracking error to the parent index as most of the energy sector can be removed. This approach can lead to unintended consequences like under performance against the parent index during energy price shocks, such as those we have experienced over the last few years.
2) By divesting, the investor is not engaging with these companies, but that can still be detrimental to our long-term goal of net zero. Climate science has shown that emission reduction alone will not get us to net zero and investment in low carbon solutions are necessary. In his book “How to Avoid a Climate Disaster,” Bill Gates noted that through the Covid-19 pandemic we only reduced annual GHG CO2e emissions in 2020 by 5% which is shockingly low considering energy demand shuttered overnight. Many energy companies are evolving their operations and investing in new renewable technologies, so continuing to engage with them to promote this type of investment will be instrumental in transitioning to a low carbon economy.
3) The investment strategy may not track or report on emissions, making it difficult to assess investor sustainability goals.
Approach 2: Remove the Highest Emitting Companies
Another approach is to remove the highest emitting companies from your investments. Investors may appreciate this tactic as it is a market weighted approach which is simple to understand and benchmark against. This approach addresses two out of the three deficiencies we noted with the divestiture approach. First, it allows for emissions tracking which can support sustainability goals and/or regulatory requirements. Second, it allows for continued engagement with certain firms as the exclusions are not explicitly focused on the oil and gas companies.
Exclusions will evolve through time as companies improve their operations due to sustainability goals and regulatory pressures. Tracking error will depend on the parent universe and how concentrated the highest emitters are to a particular sector. This approach can be used to design Paris Aligned Benchmark (PAB) and Climate Transition Benchmark (CTB) indices per the European Union’s Benchmark Regulations (EU BMR).
Approach 3: Optimized Decarbonized Indices
The optimized decarbonized indices meet all three objectives and go beyond. These indices can be designed to closely track their parent index with minimal turnover. They can incorporate constraints to reduce concentration risks to a given country, sector, company, and/or security.
For fixed income, these indices can be designed to closely track parent index duration and improve upon the yield-to-worst (YTW) of the parent index. Transition risk constraints can also be considered to increase exposure to companies which invest in green technology or to companies that have more robust sustainability plans that are environmentally friendly per the EU Taxonomy. Clients can also increase exposure to green, social, and sustainable (GSS) bonds to support environmentally friendly projects.
Optimized decarbonized indices can allow investors to engage with companies, track and measure emissions, support green companies, and meet both sustainability goals and regulatory requirements while minimizing transaction costs.
Approach 4: Transition Pathway Indices
Transition pathway indices are optimized decarbonized indices that go one step further. Earlier we discussed the fairness question of whether developing nations should be required to curtail emissions at the same rate as developed nations. If you believe that different nations should decarbonize at different rates based on fairness, then transition pathway indices can be utilized.
Transition pathway indices use the latest Network for Greening the Financial System (NGFS) climate models which incorporate policy ambition, policy reaction, technology change, and CO2e removal estimates to forecast decarbonization pathways across global regions and sectors. For example, transition pathway indices can account for different decarbonization pathways between the automotive and cement sectors due to differing low carbon technology innovations.
Visit I <GO> on the Terminal or browse our website to find out more about Bloomberg’s Sustainable Indices and request a consultation with an index specialist.
Bloomberg
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