Investing In A Low-Carbon Economy

The Buzz Around Carbon

There is no shortage of controversy currently surrounding global warming and climate change. With the Trump administration rolling back environmental regulations and changing course on global climate treaties, the degree of uncertainty has risen substantially. Many investors are contemplating the implications climate issues could have on their personal well-being and financial stability, along with broader humanitarian consequences. While there are differing views on the severity, timing and potential effects of climate change, there is considerable discussion among both institutional and individual investors about reallocating capital away from fossil fuel-centric companies toward more sustainable operators, including those investing in clean energy technologies and infrastructure. As companies continue to disclose more reliable data related to their carbon footprint and overall environmental impact, investors will gain a clearer picture of leaders and laggards and have the ability to make better-informed decisions.

Climate Science & Environmental Impact

There is consensus in the scientific community that carbon intensity in the atmosphere is the major contributor to global warming. Empirical data show that temperatures have risen consistently over the past few decades, with the past 15 years among the warmest since the 1880s, when temperatures were first recorded (see Figure 1). Climate experts have identified a strong correlation between rising temperatures and an increase in carbon dioxide concentration in the atmosphere. Over the past 150 years, CO₂ concentration jumped from 280 to 400 parts per million (ppm), which represents a 40%+ increase over previous peak levels (see Figure 1). In fact, 97% of active climate scientists agree that industrial activities, particularly the burning of fossil fuels, are responsible for the sharp increase in CO₂ concentration, due to the "greenhouse effect" caused by the heat trapped in the atmosphere (see Figure 2).

The environmental effects of global warming include extreme weather events such as heat waves, droughts, wildfires, floods and hurricanes. For example, there was more rain in San Francisco during the final two weeks of 2017 than during all of 2013, causing flooding, power outages, and wide-scale destruction. At the same time, drought in east Africa, combined with extraordinarily high temperatures, has forced thousands of people from their homes and left at least 17 million people dependent on humanitarian aid for food.

While these events may cause only temporary disruption, geographical changes such as melting polar ice caps, rising sea levels and warming ocean temperatures pose a permanent threat to our planet. Essentials like food, water and medicine are commodities that may be abundant today but whose supplies could be strained in the not-too-distant future due to global warming. And there are also significant economic implications as societies wrestle with relocating costal population centers, rebuilding infrastructure, responding to negative effects on health, and securing adequate fresh water and food supplies. Bank of America Merrill Lynch Global Research analyst Sarbjit Nahal estimates that under a status quo scenario, climate change inaction could result in a 1% to 5% annual loss in gross national product each year worldwide.

Government Intervention & Adaptation

Over the past few decades, government bodies have responded to the potential threats of climate change by implementing international treaties, the most important being the Paris Agreement, a landmark accord among 196 countries at the 21st Conference of Parties in 2015. This agreement provides a framework for nations to address climate change, requiring them to develop and share plans on limiting carbon emissions in their respective countries. The agreement, which went into effect in 2016, is ultimately designed to prevent global temperatures from rising 2 degrees Celsius relative to pre-Industrial levels; beyond that point, many scientists believe, it will be difficult to prevent irreparable harm to the Earth. In order to achieve this target, atmospheric concentration of carbon should be permanently reduced to below 350 ppm.

The United States, the second largest emitter of carbon after China, pulled out of the Paris accord on June 2nd, a move that risks setting back the global climate change agenda. Fortunately, California, Washington and several other states, as well as municipalities across the country, vowed to redouble their efforts to address global warming. So, too, did many of the accord's other signatories, many of which already are making significant progress "decarbonizing" their economies. For example, China and India are starting to make real progress in limiting their carbon emissions for the first time. China in particular is investing aggressively in new green technologies to accelerate the shift away from a carbon-dependent economy, staking a global leadership position in strategic markets.

A key component of any effort to mitigate the impacts of climate change is increased production of alternative energy, such as from solar and wind. Fortunately, the economics are increasingly favorable to alternative energy production, even without government subsidies. Bloomberg¹ estimates that investments in renewables will outstrip fossil fuels by a 2:1 ratio this year. Coal may, ironically, serve as the figurative canary in the coal mine as it is no longer an economically competitive input for electricity generation. There is the potential that the shift away from other carbon intensive fuels (oil and natural gas) to cleaner alternatives may present financial risk to fossil fuel assets that may not be priced into energy companies' balance sheets. These fossil fuel reserves at risk of losing value are commonly referred to as potential "stranded assets."

Investor Risks & Opportunities

Investors have differing views on how to best position a portfolio for the transition to a low carbon economy. A key decision is whether to fully divest from carbon-intensive market sectors, such as energy and fossil fuel-burning utilities, or to invest in companies, from all market sectors, that are best positioned for this transition. Some investors believe that divesting entirely from fossil fuel companies is the "right" thing to do. (While energy companies and fossil-fuel burning utilities account for the majority of carbon exposure, there will always be small traces across other sectors such as industrials and materials.) One can argue that starving fossil fuel development projects of capital will raise the cost of extraction and further level the playing field with renewable energy sources. Investors also see the power in a public statement around divestment as a key driver of policy action. On the other hand, the energy sector (which is still dominated by integrated oil companies) can serve as an effective hedge and diversification tool in a portfolio.

A less restrictive approach involves avoiding more carbon-intensive fuels like coal or oil from tar sands, while looking for companies with a positive trend towards reducing carbon intensity. This method allows investors to maintain energy exposure but with an environmental focus. For example, businesses providing renewable energy infrastructure, clean technology and resource efficiency tools are likely to thrive in a carbon-regulated environment. In addition to solving environmental challenges, investing in these products may lead to better operational and resource efficiency, improving the bottom line and driving long-term growth. Some investors choose to retain exposure to energy companies in order to play an activist role, lobbying for greater disclosure, carbon policy development, and risk mitigation strategies.

Environmental Stewardship & Sustainability (E2S) & Carbon Reserve Free (CRF) Portfolios

U.S. Trust's Socially Innovative Investing (S2I) team offers two proprietary investment strategies with an environmental focus, Environmental Stewardship & Sustainability (E2S) and Carbon Reserve Free (CRF). Both strategies seek to identify companies within the S&P 1500 universe with leading environmental policies and practices with respect to their industry peers. The two-part due diligence framework examines corporate disclosure of policies relating to the environment, and considers a company's track record and performance on quantifiable factors to ensure that policy decisions produce the intended outcomes. While this "scoring" process takes into account a variety of ESG factors, environmental metrics have a more significant contribution to the overall company assessment. The E2S portfolio seeks to invest in the top-performing companies in each economic sector, even those industries with a poor reputation for environmental performance. Companies that provide "green" solutions are often looked at favorably within the context of the S2I framework; however, it is unlikely that a speculative "pure-play" renewable energy company will qualify for inclusion, due to size, maturity or other fundamental factors.

For investors who choose to divest from fossil fuels, the CRF portfolio uses the same rigorous stock selection methodology while removing energy and fossil fuel-burning utility companies. In order to avoid adding unintended risk, the resulting portfolio is "optimized" to reduce tracking error to the benchmark. This final step aligns the portfolio to the overall market, with the exception that its environmental performance may be superior, allowing the potential for more favorable risk-adjusted returns over the long term.

Conclusion

When considering making changes to your portfolio, it is important to consider the entire scope of your investment strategy, paying close attention to your core values. Even with the heightened scrutiny around carbon intensity and climate change, evaluating your investment portfolio for environmental and economic risk should be an ongoing process. There is no one "right" solution and your implementation strategy will likely evolve over time. Be mindful of your options and make prudent decisions that align with your personal objectives