Carbon risk as a fiduciary duty

Fund managers have a fiduciary responsibility to take into account all major long-term financial risks to an investment portfolio. Understanding carbon risk should be high on the fund managers’ agenda; if significant carbon costs are incurred by companies in the portfolios this can dramatically alter the investment returns. However, by being proactive, fund managers can turn risk into opportunity.

In the US a recently published study showed that the companies in the S&P 500 were responsible for nearly 2,200 million tonnes of carbon dioxide equivalents in 2007. This figure is higher than the total emissions of all US buses, trucks and aircrafts combined. The same study estimated the carbon costs could exceed USD92 billion at a market price of USD28.24 per metric tonne of emissions from the companies in the S&P 500 and their direct suppliers. This is equivalent of about 5.5% of these companies’ operating result.

In Australia, the “Carbon Counts” study in 2008 showed that companies in the ASX 200 index emit some 370 tonnes of greenhouse gases for every million Australian dollars of revenue generated. This carbon intensity is 20% above the global average but is hardly a surprise given Australia’s high exposure to energy- and resource-intensive industries, such as agriculture and mining. As a result, Australian equities portfolios often carry significant carbon risk. The main question, however, is once you have established your portfolio’s carbon footprint, what do you do about it?

More than half of the funds under management in Australia have signed up to the United Nations Principles of Responsible Investments (“UN PRI”). This includes a commitment to consider environmental, social and governance (“ESG”) issues in their investment analysis and decision-making. The carbon footprint is one of the most important issues in the “E” component of ESG and needs to be part of the investment analysis.

In the context of ESG research, a carbon footprint can be defined as the amount of greenhouse gas emissions caused by an organisation or a product. Carbon atoms exist in fossil fuel and are released as carbon dioxide when they are burnt. In other words, carbon dioxide emissions are predominantly associated with the conversion of energy carriers, such as natural gas and crude oil.

In contrast to fossil fuel, non-combustion energy sources, such as nuclear, hydropower, sunlight and wind, do not convert hydrocarbons to carbon dioxide. There are plenty of companies with exposure to these technologies in the markets. As a result, fund managers have several investment alternatives to mitigate the total carbon risk of their portfolios, both through individual stock selection and through stock indices. This can be done without dramatically changing the sector weightings or the main investment strategy as data shows that greenhouse emissions can vary significantly between companies in the same sectors. In addition, clean development mechanisms and commodity exposures can be used as hedges.

Signatories to the UN PRI also commit to active ownership and incorporation of ESG in companies they invest in. Further, they commit to encourage appropriate disclosure on ESG issues in the target companies. In other words, large institutional investors could have an important role to play in changing companies’ attitude to reporting their carbon footprint and improve the data availability and comparability. In addition to encourage companies they can also support governments to establish uniform and compulsory reporting requirements for greenhouse gas emissions. This should be in the interest of all fund managers, whether you are a signatory of the UN PRI or not.

Measuring the carbon footprint
Carbon risk analysis is not as straightforward as it might appear. Before you can model the implications of various carbon price scenarios in the future, you must first establish the carbon footprint of the companies within the portfolio. This first step can be a major hurdle.

To begin with, only some companies currently report their carbon footprint. For instance, in Australia, only some 30% of the ASX-200 companies disclose their CO2 exposure. Secondly, the way companies report is not standardised, which makes relative comparisons difficult. Carbon footprint is complex. An important question is where in the value chain do you stop your analysis? Most reports only use two tiers of emissions in calculating carbon footprints: emissions from company activities and purchased electricity. However, emissions from the third tier, that is, the entire supply chain, are rarely factored in. Finally, the figures that are reported are not always very reliable.

The carbon disclosure project, which aims to encourage organisations to measure, manage and decrease their climate change impact, has collected data from 3,700 companies on a global basis and entered it into a comprehensive database. The data collected is based on information requests issued on behalf of 475 institutional investors, more than 35 purchasing organisations and UK government bodies.

Although the database is comprehensive, there are many gaps in the companies’ responses, which also vary significantly in terms of structure and style. Some companies declined to participate while others only partly filled in the answers, some gave very extensive answers and others disclosed very little. In other words, although it is a great initiative, the carbon disclosure project is subject to the same issues as mentioned above.

Another alternative is to estimate the carbon footprint using complex models. This can be a time-consuming task, however, as it requires a deep understanding of each company’s business activities, geographical exposure, etc.