Public concern over global warming has presented companies of all sizes with a mandate to account for, and reduce, their greenhouse gas emissions. Still emerging, however, are the legal and fiscal implications of carbon emissions caused by corporations. The following is an excerpt from a report compiled by Trucost, which analyzes the carbon footprint of some of the United Kingdom's largest equity investment funds, by way of demonstrating the legal and financial risk of failing to measure and mitigate carbon emissions.
Executive Summary
Carbon Counts 2007 provides valuable information to fund managers looking to control and measure the risks associated with carbon emissions in their portfolios, as well as individual investors seeking to get the most out of their investments while taking greater responsibility for the environment
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Trucost has calculated the carbon footprint of 185 U.K. Equity Investment Funds
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The carbon footprints of the funds analyzed varies dramatically. The most carbon-intensive fund has a footprint almost ten times as large as the least carbon-intensive fund
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The three funds with the lowest carbon footprint are Socially Responsible Investment (SRI) funds
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Although three quarters of SRI funds have a smaller carbon footprint than the benchmark, one quarter of SRI funds are more carbon-intensive than the benchmark
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Half of the ten most carbon-efficient funds are growth funds
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The Trucost Carbon Optimized Tracker Portfolio matches the financial performance of the FTSE 350 (ex. Investment Trusts) whilst increasing the carbon-efficiency by an average of 25% per annum over an 8 year period
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Trucost have carbon optimized a growth fund from the study, improving the carbon-efficiency by 21% without effecting the financial performance
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There is no correlation between the carbon footprint of funds and financial performance
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There is no correlation between the carbon footprint of funds and fund size
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Fund managers are now able to reduce the carbon emissions of their investments without sacrificing financial performance by using Trucost's data and analysis.
Overview
Climate change presents a new category of risk and opportunity for individuals, companies and investors alike. When Sir Nicholas Stern released his report "Economics of Climate Change" in October 2006, he identified Climate Change as the "biggest market failure the world has ever seen." Increased recognition that investments contain carbon risk has driven demand for investment products that specifically address this issue. Companies are increasingly aware that they may face higher costs as they are increasingly forced to bear the environmental costs of their carbon emissions and those in their supply chain. Trucost helps companies and investors to identify and manage this risk.
Carbon Counts 2007-The Study
In this study, Trucost analyzes and ranks the Carbon Footprint of 185 of the U.K.'s largest investment trusts and mutual funds. Together, these funds have a total of £73.65 billion of assets under management. The carbon footprint is the total carbon emitted by the companies that make up each fund's holdings per million pounds invested. This is calculated by measuring each company's CO2 emissions and allocating them to each fund in proportion to its shareholding. This measure is referred to as the "carbon intensity" or "carbon footprint" and allows valid comparison between funds irrespective of the size of different businesses. Funds have been categorized according to their investment strategies: SRI, FTSE All-Share and FTSE 100 Trackers, Income and Growth using the Investment Management Association (IMA) classification. IMA classifications broadly divide funds into those that aim to provide income and those designed to provide growth. Together the holdings of the funds analyzed are responsible for greenhouse gas emissions totalling 41 million tons of CO2 equivalents per annum. To get a feeling for the scale and value of these emissions, it is interesting to multiply this figure by the average price of European carbon emission permits; €19.47 for 2008 settlement. If credits were to be purchased for these emissions, they would cost in the region of £535 million per annum.
Nicholas Stern valued the social cost of carbon at $85 per tonne. Based on this value, the total assets under management have a carbon cost of $3.5 billion (£1.9 billion) each year. The difference between the most carbon- efficient fund and the most carbonintensive fund is extremely pronounced. The most carbon-intensive fund, Invesco Perpetual High Income, has a Carbon Footprint that is almost ten times larger Prudential Ethical Trust. In this report we have found that Socially Responsible Investment (SRI) funds usually have smaller Carbon Footprints than their mainstream equivalents. Indeed, the best three funds overall were all SRI funds, Prudential Ethical Trust, AXA Ethical, and Sovereign Ethical. Three quarters of the SRI funds analyzed had smaller footprints than the benchmark indices. A quarter of SRI funds have carbon footprints that are larger than the market benchmark. This is because SRI funds typically select portfolio companies on the basis of a broad range of criteria including social, ethical, and governance factors, and these may sometimes conflict with carbon-efficiency. Interestingly, half of the ten most carbon-efficient funds were growth funds, which do not have an environmental mandate at all. Many of these growth funds have a bias towards small and medium-cap companies, and there is a tendency for larger capitalized companies to be more carbon-intensive.
In order to demonstrate how fund managers can reduce their fund's exposure to climate risk, Trucost has constructed a portfolio of stocks based on the FTSE 350 (ex. investment trusts). The Trucost Carbon Optimized Tracker tilts the FTSE350 by overweighting the more carbon-efficient companies and underweighting those that are inefficient compared to sector averages. Relative to the underlying index it remains sector neutral, and it holds all the same stocks. A back-test from 1998 to 2005 demonstrated a 25% lighter carbon footprint relative to the benchmark. Financial performance matched that of the FTSE 350 with minimal tracking error (+/- 0.5%).
Trucost applied the same optimization technique to one of the growth funds analyzed in this study in order to demonstrate that it is possible to reduce the carbon associated with any investment strategy. The effect was to improve the carbon footprint of this fund by 21% while maintaining the same level of financial performance. Trucost analyzed the three-year returns for 167 funds and compared this to their carbon-intensity. The coefficient of correlation was -0.1 with an R-Squared of 0.01 showing that the relationship is not statistically significant. This means that investors can effectively manage their exposure to carbon risk without sacrificing returns. Indeed, portfolios which have smaller carbon footprints are well-positioned with respect to carbon costs, which are expected to increase as the E.U. Emissions Trading Scheme and other measures to constrain carbon emissions elsewhere in the world take effect. Funds positioned in this way could be described as having a free call option on carbon emissions becoming more expensive.