This is a summary of “Decarbonizing Everything,” by A. Cheema-Fox, CFA, B. LaPerla, G. Serafeim, D. Turkington, CFA, and H. Wang, published in the Third Quarter 2021 issue of the Financial Analysts Journal.
Different climate risk metrics lead to portfolios with different carbon and risk–return profiles. Analyzing the merits and applicability of various climate data can help investors manage climate risk and improve risk-adjusted returns.
What’s the Investment Issue?
The authors construct decarbonization factors to determine how useful company-specific climate metrics, such as carbon emissions and analyst ratings, are for investors. Understanding how well the different metrics work and what they tell us is important in investing in the transition to a low-carbon economy. The authors construct decarbonization factors for 43 industries to comprehend the characteristics of industries, the type of climate data investors could use to form portfolios that manage climate risk, and the effect on risk-adjusted returns.
How Do the Authors Tackle the Issue?
The authors evaluate three metrics to measure how much companies are exposed to the risks of climate change:
• Operational carbon (OC) emissions uses company-reported scope 1 and 2 carbon emissions from each company’s operations scaled by revenue. The data are obtained from S&P Trucost.
• Total value chain (TVC) adds the estimated upstream and downstream (scope 3) carbon emissions to operational emissions for each company scaled by revenue. Again, the data come from S&P Trucost.
• Analyst ratings are the third measure. They take into account the transparency of each company regarding climate change activities, the existence of company-defined carbon targets, and other practices that indicate whether a company is serious (or not) about dealing with climate change risks. Specifically, the authors choose data provided by MSCI environmental, social, and governance intangible value assessment ratings.
The authors test a rules-based strategy (or “decarbonization factor”) that is long companies with better emissions-based metrics and short those with higher emissions. The analysis is conducted using data from 2,087 companies across 43 industries over the period 2013 through 2020.
They use three separate weighting methodologies: market-cap weighting, equal weighting, and weighting by the size of the industry dispersion of carbon outcomes.
What Are the Findings?
The performance of the factors shows significant variations across industries. For instance, the OC and TVC factors, both emissions based, show strong positive returns in the Semiconductors and Aerospace & Defense industries. Meanwhile, using these factors in the Energy Equipment & Services and Trading Companies & Distributors industries results in large negative returns.
The authors also find that the carbon-based metrics (OC and TVC) perform far better when the industry has a greater dispersion of carbon outcomes as measured by OC or TVC. That finding helps inform two ideas. First, portfolio weighting of the industry groups in proportion to the dispersion of carbon outcomes in that industry might improve performance. Second, some metrics might be better used for some industries and not others.
What Are the Implications for Investors and Investment Managers?
The carbon-based metrics (scopes 1, 2, and 3) tend to perform better in industries where the degree of variation in emissions between individual companies is greater.
The authors conclude that investors should comprehend what the different metrics can and cannot tell them. “Investors will be well served by understanding different climate metrics and their applicability within an investment framework,” they state.