Better Climate Risk Hedging (Summary)

Not all investors accept that climate change is taking place or that it may affect their portfolios. Some investors acknowledge that carbon-intensive assets are likely to suffer permanent value destruction but have not acted because the risks seem too remote. Even for sceptical investors, climate change and related mitigation policies cannot rationally be regarded as a zero-probability risk. The tipping point is likely to come in the form of investor concerns and expectations rather than climate change disaster. Changing expectations may well be brought about by regulation, which is likely to front-run climate change science.

The strategy the authors of this article propose offers a long-term carbon-hedging solution for the nearly $11 trillion held worldwide in traditional index investments. Future underperformance of these investments versus a decarbonized strategy could severely affect long-term investment outcomes and, consequently, the lifestyles and retirement prospects of millions of clients.

So why, then, do so few investors allocate to climate-hedging strategies? First, the design of most green indexes lends itself more to a bet on clean energy than a hedge against carbon (CO2) risk. Second, achieving a near-100% reduction in the MSCI Europe carbon footprint would come at the price of a large tracking error of more than 3.5%. Finally, asset managers divesting from stocks with high carbon footprints run the risk of underperforming their benchmarks for as long as climate mitigation policies are postponed and market expectations about their introduction remain low. Asset managers with low-carbon strategies could be wiped out long before serious limits on CO2 emissions are introduced.

Rather than a risky bet on clean energy, the authors propose a decarbonized index with minimal tracking error that offers passive investors significantly reduced exposure to carbon risk. The low tracking error allows investors to “buy time” and limit their exposure to the timing of climate policies and carbon taxes. In effect, investors in the decarbonized index hold a “free option on carbon.” That is, while awaiting significant limits on CO2 emissions, they can obtain the same returns as the benchmark index. But from the day CO2 emissions are priced meaningfully, the decarbonized index should outperform the benchmark.

The essence of implementing the decarbonized strategy is to construct a portfolio with fewer composite stocks than the benchmark index but with similar aggregate risk exposure. The first step is to apply a “green filter,” which essentially involves the divestment of high-carbon-footprint stocks. Ideally, the green filter should take into account not just today’s footprint but also expected future carbon reductions resulting from current investments in energy efficiency. Similarly, the filter should penalize oil and gas companies that invest heavily in exploration with the goal of increasing their proven reserves, thereby raising the risk of stranded assets.

The second step is to optimize the composition and weighting of the decarbonized index in order to minimize the tracking error. Tracking error can be virtually eliminated, with the carbon footprint of the decarbonized index about 50% lower than that of the benchmark index.

According to the authors, the decarbonized strategy should outperform over the long term because financial markets systematically underprice carbon risk. Only in 2014 did a discussion about stranded assets make it into a report from a leading oil company. And so far, only a few specialized financial analysts refer to carbon-pricing risk in their reports to investors. At some point, however, financial markets will begin to price this risk, which represents, in the authors’ view, a clear investment opportunity.

Another benefit of the decarbonized strategy is the transparency it offers. Institutional investors are increasingly tasked not only with meeting performance targets but also with investing in a way that has a beneficial societal impact. Clearly communicating which constituent stocks are in the decarbonized index sends out a positive message about institutional investors adopting a proactive approach and also encourages companies to care about their carbon footprints.

For sovereign wealth funds of oil-and-gas-exporting countries, the decarbonized strategy can help meet one of their central aims of diversifying from high-carbon assets.

So, what’s the catch? An obvious potential flaw in the decarbonized strategy is the possibility that financial markets currently overprice carbon risk. The authors do not adhere to this argument because the current level of carbon risk awareness remains low. A more valid concern is whether companies’ carbon footprints are correctly measured and, therefore, whether filtering for the index is meaningful. However, decarbonization methodologies have existed for many years and will develop further over time, reducing the risk of faulty measurement and filtering.

There is also the fear that investment returns may suffer in the short term. This is always possible but, so far, decarbonized indexes have matched or even outperformed the benchmark indexes. In other words, investors holding a decarbonized index have been able to reduce their carbon footprint without sacrificing financial returns.