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How green is your portfolio?

02 October 2020

8 minute read

By Damian Payiatakis, London UK, Head of Impact Investing and Olivia Nyikos, London UK, Investment Strategist

Given the inevitable implications of climate change, how can a portfolio’s carbon footprint help investors to manage risks and potentially boost returns?

As climate breakdown accelerates, so too do potential financial risks and opportunities for investors. Currently, the sum of all national plans do not deliver the commitment to keeping temperatures within 2C of their pre-industrialised levels, let alone the 1.5C ambition, of the 2015 Paris Agreement. Already the physical effects of climate change continue to intensify, most visibly in this year’s California wildfires.

Next year, nations are scheduled to convene to review their progress and nationally determined contributions at the UN Climate Change Conference – COP26. Given the current trajectory, expanded efforts and pledges will be required to achieve the committed targets.

Understanding transition effects

As governments and industry seem to move to a low- carbon economy, investors may want to increasingly understand both the potential physical impacts as well as the transition risks for portfolios (explained in February’s and March’s Market Perspectives respectively). Carbon footprinting has emerged as a useful tool for investors to inform and implement a portfolio strategy that can prepare for these challenges.

In this article, we review the foundation of carbon footprinting, calculation methodologies and then using carbon footprinting to aid investment decision-making and portfolio positioning.

Foundations of a carbon footprint

Carbon footprinting measures the impacts of an activity on global warming by calculating the GHG emissions of these activities

Greenhouse gas (GHG) emissions are embedded throughout business and society. Accounting for an activity’s carbon footprint can be useful to understand the nature and relative extent of climate risk and opportunities in an investor’s portfolio.

Carbon footprinting measures the impacts of an activity on global warming by calculating the GHG emissions of these activities – both the direct and indirect emissions. This is done to express key greenhouse gases (such as carbon dioxide, methane and nitrous oxide) as a common unit, allowing easier comparison across different geographies, industries and organisations.

Emissions are categorised by the GHG Protocol under three distinct categories, generally known as Scope 1, 2, and 3, which helps to systematically define different emission contributors. The categories allow for standardised emissions calculating and reporting, and a better understanding of emissions sources:

Scope 1 – Direct emissions from company-owned and controlled sources. In other words, emissions released as a direct result of a set of core business activities. It is divided into four categories:

  • Stationary combustion: all fuels that produce GHG emissions (for instance, fuels and heating sources)
  • Fugitive emissions: leaks from GHGs which are often dangerous (such as refrigeration or air conditioning units)
  • Process emissions: GHG released during industrial processes and on-site manufacturing (such as, cement manufacturing, factory fumes and chemicals)
  • Mobile combustion: all vehicles owned by a company, burning fuel (for instance, cars, vans and trucks. The increasing use of electric vehicles mean that some organisations’ fleets could fall into Scope 2).

Scope 2 – Indirect emissions generated by the electricity purchased and consumed by the organisation. In other words, all emissions from the generation of purchased energy from a utility provider. This covers, all GHG emissions released in the atmosphere, from the consumption of purchased electricity, steam, heat and cooling. For most organisations, electricity will be the unique source of Scope 2 emissions.

Scope 3 – Indirect emissions – not included in scope 2 – which are generated from sources that the company does not own or control, covering emissions associated with business travel, procurement, waste and water. These emissions occur in the rest of the value chain, including both upstream and downstream emissions:

  • Upstream activities (cradle-to-gate): emissions that occur in the life cycle of a product or material up to the point of sale by the producer
  • Downstream activities: emissions produced in the life cycle of a product after its sale by the producer, including distribution, storage, product-use and end-of-life.

Today most public companies report on the emissions from their primary activities (captured by Scopes 1 and 2) and few reports incorporate disclosures about their upstream and downstream emissions that occur in the value chain. However, Scope 3 emissions often represent a company’s most significant GHG contribution. Calculating Scope 3 emissions is also significantly more complex given scarce and incomplete data and methodology challenges.

While companies and investors do not always have an exact picture of their full footprint, appreciating the fundamental sources and drivers of risk and opportunity can still valuably inform the investment process.

Calculating a carbon footprint

For investors seeking to calculate their portfolio’s carbon footprint, the first step is to understand where emissions specifically come from. At its simplest, the carbon footprint is the sum of a proportional amount of each portfolio company’s emissions (proportional to the amount held in the portfolio). Typically, to calculate the footprint:

  • Obtain carbon emissions data on companies or projects owned in a portfolio, either from verified disclosure or from estimated/interpreted sources;
  • Calculate the total emissions of the owned percentages of each company and add them together resulting in a total owned carbon emissions figure per portfolio; and
  • Normalise the results, using factors such as annual revenue or market capitalisation.

While there are various approaches to provide a single carbon footprint measure, carbon intensity is a commonly used one that determines the amount of emissions, in tons of CO2, that the companies in the portfolio produce for every million dollars of sales, abbreviated as tCO2e/$m sales.

Off-the-shelf and customised services are available for measuring a portfolio’s carbon footprint. While there are limitations, such as consistency and availability of data, availability across all asset classes, approach to Scope 3 emissions and different estimation methodologies; nonetheless, these tools enable investors to consider not only carbon but also natural capital, fossil fuel reserves and exposure to stranded assets.

Additionally, having a carbon footprint allows investors to compare their results to global benchmarks, identify priority areas for reducing emissions and track progress in making those reductions.

From footprint to investment pathway

Understanding a portfolio’s footprint can serve as an informed starting point for an investor to create and implement a broader climate change strategy. It provides insight to identify a portfolio’s climate risk exposure to physical and transition risks. It can help consider allocation strategies for creating a lower-carbon portfolio and inform asset selection. It also can support investors to uncover diversifying or growth opportunities in green investments.

Most importantly, it shows investors their contribution to GHG emissions through their investments. By understanding their current path and serving as a reference point for their investment plans, investors can address climate change on a personal level too. While climate crisis is a global and systemic challenge, it is with collective action that it can be overcome.

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Market Perspectives October 2020

Financial market sentiment has taken a turn for the worse as COVID-19 infection numbers climb and the US presidential election nears.

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