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A Low-Carbon Option for Asset Owners

A Low-Carbon Option for Asset Owners

Nov. 28, 2016

Nov. 28, 2016

Paul Fisher, the ex-deputy head of the Bank of England’s Prudential Regulation Authority, last month made a bold statement that climate change could spark the world’s next financial crisis.1 Interestingly, he mentioned that investors don’t even need to believe in climate change for it to matter. The fact that governments have decided to take action to address this issue is enough for investors’ portfolios to feel the impact.

A number of asset owners fall in this category. While they do not have a strong enough view yet on climate change or on the impact of carbon emissions and pricing to adopt a divestment or exclusion policy in their portfolios, they would still like to play their part in reducing the carbon footprint of their investments.

On the other spectrum, there are asset owners who strongly believe in the challenges posed by climate change and are serious about taking action. But they may not necessarily believe that excluding ‘the problem’ holdings is the best approach. The reasons for this stance may vary. Some consider such divestments as a marketing strategy rather than a genuine or robust low carbon policy. Others question the impact of divestment and favour active engagement as a more positive channel to combat climate change. Lastly, a few (mostly pension trustees) are still trying to grasp the link between tackling climate change and their fiduciary duties.

No matter the context, many investors tend to be hesitant when it comes to adopting a divestment policy in their search to reduce the carbon footprint of their equity portfolio. The problem is most acute with asset owners who invest passively, as divestment usually leads to a different risk-return profile and to performance deviation.

This is where the STOXX® Low Carbon indices offer an attractive proposition. The indices aim to generate a similar risk-return performance to their respective market capitalization-weighted parent indices, whilst reducing the carbon footprint without any divestment.

The STOXX Low Carbon indices are exposed to the same constituents as their parent benchmarks. That is, there are no exclusions or sector divestments – apart from coal (for obvious reasons). This means the tracking error relative to the broader benchmark is low. The portfolios are, however, tilted towards stocks that reduce the overall carbon footprint.

There are STOXX low-carbon indices for all major regions. STOXX analysis estimates, for example, that using the STOXX® Global 1800 Low Carbon index results in a 38% reduction in the carbon footprint relative to the STOXX® Global 1800 Index.

Figures 1 and 2 compare the characteristics of a low-carbon index strategy against the broader benchmark.

Source: STOXX. Overall: Dec. 19, 2011 to Sept. 30, 2016; 1y: Sept. 30, 2015 to Sept. 30, 2016; 3y: Sept. 30, 2013 to Sept. 30, 2016

Our discussions show that asset owners are not always comfortable with a divestment approach and the low-carbon index solution alleviates that concern. In offering broad-benchmark performance with a lower carbon footprint, the STOXX Low Carbon indices can be an ideal passive replacement for market-cap portfolios. Asset owners now do not need to have a strong view on the impact of climate change to reduce the carbon footprint of their equity portfolios. They, however, need a strong reason not to.

1 “’Climate change ‘could trigger next financial crisis’”, Independent, 25/10/2016.

 

 

By Ashar Muhammad, Head of Asset Owners and Consultants, STOXX. For more on the STOXX Low Carbon Indices, please click here.

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