Reducing the carbon footprint of portfolios has become a must. Regulations are tightening, requiring investors to measure and publish the carbon footprint of their portfolios as well as their carbon reduction policy. The research conducted by Candriam’s quantitative equities team prove that it’s possible to substantially reduce a portfolio’s carbon footprint without significantly altering its risk/reward profile.
Minimising GHG emissions means knowing how to measure them. Right now, though, barely half of listed companies provide full disclosure on their CO2 emissions. Furthermore, their methods and scopes of measurement vary widely, making any comparison a tricky endeavour. Results can vary significantly or even lead to contradictory conclusions on the level of greenhouse gas (GHG) emissions by various players and economic sectors.
There are three scopes for measuring a company’s GHG emissions. Scope 1 only measures direct emissions generated by sources owned or controlled by the company. Scope 2 measures indirect emissions associated with the company’s activity. Finally, Scope 3 measures all indirect emissions generated upstream in the Corporate Value Chain (the company’s suppliers) and their use downstream (the company’s clients). To be completely effective in terms of carbon reduction, we have to be able to cover the company’s entire value chain. That said, measuring Scope 3 emissions poses considerable methodology challenges, which have to be examined on a case-by-case basis.
In light of these considerations, our studies have shown that excluding the highest-emission sectors (energy, utilities and materials) can reduce a portfolio’s carbon footprint by +/-75%. There are two disadvantages to this approach, however: First, it is not optimal from an environmental standpoint because it automatically excludes renewable energy producers and companies making an effort to improve their carbon footprint. Second, it involves a tracking error relative to the market and thus generates major financial risks for any portfolios using this approach.
Ultimately, the exclusion route is counterproductive. It is even less attractive if we consider that company-by-company carbon selection can reduce a portfolio’s footprint even more, by over 90%. Plus, this selection can limit financial risk and even improve a portfolio’s projected return thanks to the carbon effect. This is because carbon footprints vary widely, not just in high-emission sectors but also in sectors such as industry and finance.
Another way to build the portfolio is the minimise the carbon footprint by applying a very limited tracking error constraint, thereby exposing the new portfolio to a similar level of financial risk as that of the global equity portfolio. That way, we can show that the carbon footprint reduction for a market portfolio managed with the aim of optimising the contribution of the constituent companies to carbon risk is higher than that achieved exclusively by ruling out the highest-emission sectors.
For example, the carbon footprint per million invested is 11 metric tons of CO2 equivalent (tCO2-eq) in the optimised portfolio versus 38 metric tons in a portfolio excluding the three highest-emission sectors, the difference being 16 to 56 metric tons for the emissions-to-revenue ratio. These examples show it is possible to actively manage the carbon risk of a global equities portfolio while significantly limiting the impact of this risk on its financial characteristics.
The Best-in-Class approach of the ESG analysis adopted by Candriam, which also incorporates carbon risk management, lends itself quite well to this objective by ensuring the optimal application of the conclusions drawn from this study. Taking this approach, the portfolio managers can steer clear of pitfalls and build portfolios with a significantly reduced carbon footprint.