Posted inESG

Measuring carbon intensity in portfolios

Against the backdrop of the ongoing war in Ukraine, oil and gas companies are making record profits and governments granting new drilling licences. But whatever the short-term impact of the energy crisis, we all know the global economy is going to have to wean itself off carbon over the coming years.

Managers need to think about how to reflect that in portfolios and the task is to understand how important carbon is to the businesses you are investing in. If you have two businesses doing the same thing and one is using more carbon to produce the same amount of revenue as the other, consensus is growing that it makes sense financially to invest in the one with lower carbon intensity, as it is better prepared for what lies ahead. Many investors also increasingly see a moral obligation to favour lower carbon investments.

Similarly, as with any future cost, managers who are prepared for the carbon transition and factoring it into decision-making now are doing a better job for their clients. Even if you are fully onboard, however, there are some challenges.

First, as we have been powerfully reminded by recent events, carbon is necessary in the short term – and more so in some sectors and industries than others. As yet, for example, there is no commercially viable substitute for coal in high-temperature production processes such as those for steel and cement.

Understanding the complexities of each industry and making sure you are comparing like for like will be important as the transition progresses. Engagement with the high-carbon companies of today is also a vitally important tool for positive change – one reason why many managers reject divestment as a solution.

Comparing trajectories

Second, the data is backward-looking. Companies often only report ESG information once a year – in the annual report. By the time data providers have collected, assessed and published that data, it is often up to two years old. That makes it difficult to capture and compare the trajectories companies are on. Amazon, for example, is buying private windfarms to safeguard its green energy supply, making its net-zero commitment potentially more robust than those of peers reliant on external providers to source clean energy. 

Of course, regulation will improve the timeliness of data in the end but, for now there is a gap to bridge. Large asset managers are finding various ways to do that, supplementing carbon0-intensity analysis with measures ranging from scoring companies on their climate strategy policies, risk management procedures, climate value-at-risk and declared net-zero commitments to the use of qualitative overlays or higher-frequency data from other sources.

Third, there is no one way to calculate the carbon intensity of a portfolio. Emissions can be assessed in absolute terms or relative to revenue, value or a combination of the two.  Measures currently capture only Scope 1 and 2 emissions (the emissions made directly by a company and those from the energy it sources) but need to go further and take into account Scope 3 (those for which it is indirectly responsible throughout its value chain).  

A widely used measure is ‘weighted average carbon intensity’, which looks at the carbon intensity – that is, tons of CO2 or equivalents per million dollars of revenue – of the companies within the portfolio, adjusted for weighing in the portfolio.

There are, however, some downsides to this measure, including sensitivity to outliers and a tendency to favour companies with higher valuation levels and bigger resources to provide the regulatory disclosures. Combining this approach with other measures can help address these biases.

Finally, all these challenges relate largely to equity investing. As soon as you factor in other asset classes and multi-asset investing – where, for example, sovereign bonds are included – everything becomes more difficult by another degree of magnitude.

Greater standardisation

As a result of both regulatory change and consumer expectations, the challenges are gradually being addressed and greater standardisation is coming. Innovations such as the EU’s Paris-Aligned Benchmarks, where eligible constituents must follow a defined path to reduce carbon emissions intensity, can also help with stock selection and benchmarking of outcomes.

In the meantime, it is about pragmatism – what do you need to know about the exposure of your portfolio to the carbon transition, and how can you form the clearest understanding from the information that’s available today?

For portfolio constructors, it’s also about understanding client preferences and needs. Some investors are not concerned about sustainability at all. For that group, thinking about carbon intensity becomes a pure risk management exercise. Some want a low-carbon portfolio today and, again, it is clearer how to meet this need – for example, with thematic and impact solutions.

The group in between – the two-thirds of investors who care ‘somewhat to a lot’ about the environmental sustainability of their investments, including carbon intensity and other issues – is more challenging.

For these, is it okay to build a barbell portfolio that includes, say, a couple of large oil and gas companies that are environmental leaders in their sector, balanced with many low-carbon investments so the overall carbon footprint is low? In an environment in which energy companies will be returning significant profits to shareholders, are income-seeking investors happy to miss out? Do investors share the EU’s view that gas is a transition asset or not?

These debates roll on – and rightly so. We are all seeking to understand how to do the best we can for our clients and for the planet. Flexibility, adaptability and an eye on the evolving data disclosure environment will be key.

Ben Goss is CEO at Dynamic Planner

Part of the Bonhill Group.