Low-carbon investing is gaining ground, not just as an en-vogue trend, but also for solid economic reasons. It is part of a growing realisation, based on findings that go back almost two centuries, that climate change is real and requires action now.Greenhouse effect
Before I became a fund manager I spent many years reading and researching chemistry and physics. I first came across the physics of the greenhouse effect back in my undergraduate days at FCUL. The theory was proposed by Joseph Fourier in 1824 and re-addressed by Claude Pouillet in 1827 and again in 1838. Experimental verification was provided in 1859 by John Tyndall. So we have known for a long time that greenhouse gases (GHG), like carbon dioxide (CO2), act as a blanket over the atmosphere, regulating its temperature by reducing the Earth’s heat radiation into space. Adding more CO2 is equivalent to adding new layers of blankets, keeping us warmer and warmer.
Alexander Graham Bell was perhaps the first to note as long ago as 1917 that burning fossil fuels would add to the greenhouse effect. He suggested that the net result would create “a sort of hot-house", proposing even then the use of solar energy instead.
The physics is in fact more complicated than what I have described above. What matters is the total energy imbalance between what comes in from the sun and what goes out. Calculating the level of this imbalance means taking into account all the Earth’s heat reservoirs including oceans, reflective ice surface and complex factors like the solar cycles or the changes in the orbital eccentricity, obliquity, and precession of the Earth's movements. Uncertainty around these issues has fuelled some scepticism. But overall scientists have over time become increasingly worried about the impact of fossil fuel burning. Challenging the notion that burning fossil fuels is increasing the concentration of CO2 in the atmosphere is increasingly difficult.
The impact of carbon emissions
Back in 1981, in “Climate Impact of Increasing Atmospheric Carbon Dioxide” published in the Science magazine, J. Hansen, D. Johnson, A. Lacis, S. Lebedeff, P. Lee, D. Rind and G. Russel forecast that “potential effects on climate in the 21st century included the creation of drought-prone regions in North America and central Asia (…),erosion of the West Antarctic ice sheet with a consequent worldwide rise in sea levels, and opening of the fabled Northwest Passage”. These phenomena are now observable realities. Back then, CO2 atmospheric concentration was at already at a high 335ppm and the models suggested a mean warming of 2° to 3.5°C in the case of a doubling of the CO2 concentration from 300 to 600ppm. Today, we have reached 400ppm and it looks likely that 2016 will be the warmest year on record, probably by the largest margin to date.
Scientists are now devoting more and more time to the question of CO2 emissions and their consequences. A list of recent research papers can be found on the website of the Institute of Physics, of which I am still a member. Politicians are also starting to take the issue more seriously, as demonstrated by the recent United Nations Convention on Climate Change 21st Conference of the Parties (COP 21) in Paris, although perhaps not yet seriously enough.
The price of carbon emissions
From an investment point of view the key question is what is the right price of CO2 emissions? A recent paper by Bob Litterman, still better known for his work with Fischer Black on portfolio optimisation, addresses this pricing issue. He highlights the difficulties: (i) the unusually long period of time before environmental damages become apparent and; (ii) the relative uncertainty surrounding the potential for a low-probability, high-damage scenario to materialise.
He concludes that, given the uncertainty of an unimaginable and unmanageable catastrophe, a cautious approach that weighs the cost of catastrophic outcomes above the potential benefits of hedging future economic growth is justified. CO2 emissions should be priced no lower, and perhaps even well above, a reasonable estimate of the present value of expected future damages, allowing the price to respond to new information as it becomes known. However, as he points out, this is clearly not the case today. Instead of taxing emissions, in 2011 alone, subsidies of USD 523 billion boosted CO2 emissions to a total of 33.376 gigatonnes.
Money is starting to talk and financial players are starting to take climate risks more seriously. “Stranded assets” and “decarbonisation” are recent additions to financial jargon. And we are seeing initiatives such as the Portfolio Decarbonization Coalition (PDC), a multi-stakeholder initiative (of which BNP Paribas Asset Management is a signatory) to cut GHG emissions by mobilising institutional investors committed to gradually decarbonising their portfolios.
Portfolios can be decarbonised by reducing or withdrawing capital from carbon-intensive companies and by re-investing it in carbon-efficient companies in the same sector. Targeted engagement by investors can stimulate decarbonisation. When institutional investors, in particular the largest, start engaging and even re-allocating capital on the basis of a company’s GHG emissions, that provides a strong incentive for those companies to re-channel their own investments from carbon-intensive to low-carbon activities, assets and technologies.
Decarbonised strategies at BNP Paribas Asset Management
At BNP Paribas Asset Management we have been decarbonising portfolios for a number of years with the help of our Paris-based analysts in our Social Responsible Investments teams. This is applicable not only for the SRI funds managed by this team, but also for some of our index funds managed by THEAM.
More recently, we have extended the low-carbon investing approach to our equity multi-factor strategies managed by THEAM. These active stock-picking strategies use value, quality, momentum and low risk factors to generate returns in excess of those from pure index investing as well as higher Sharpe ratios. Although still embryonic and not yet funded, the decarbonised versions of our equity multi-factor strategies are designed to deliver the same performance as their ‘dirty sisters’. When it comes to carbon emissions, we can reduce the level of carbon in the decarbonised versions to half of what we find in the respective market capitalisation benchmark indices, without sacrificing performance. Our investment process, based on optimisation and extensively described in our paper “An integrated risk-budgeting approach for multi-strategy equity portfolios” published in the Journal of Asset Management – March 2014, is based on a framework that efficiently controls factor exposures and captures factor premiums even when applying a set of portfolio constraints, which is this case includes a limit on carbon emissions.
While still unfunded, the paper performance of the cleaner, decarbonised global equity multi-factor strategy ‘THEAM DEFI Decarb50 / Global Low Carbon’ can be followed on the amLeague website.