Briand, Lee, Lieblich, Menou, and Singh (2015)
Briand, Remy, Linda-Eling Lee, Sébastien Lieblich, Véronique Menou and Anurag Singh. Beyond Divestment: Using Low Carbon Indexes. MSCI, April 2015.
From the Executive Summary:
Companies’ carbon exposure consists of two dimensions: current emissions and fossil-fuel reserves (representing potential future emissions). In the MSCI ACWI Index, Utilities, Materials and Energy companies accounted for more than four-fifths of the total current carbon emissions. Not surprisingly, Energy companies represent more than 80% of total fossil fuel reserves.
Up until now, much of the pressure to manage carbon stranded assets risks has focused on divesting from companies in the fossil fuel sectors. This approach effectively communicates to various stakeholders an investor’s concerns about climate change. But, from a financial perspective, the strategy is not optimal as it can create significant short-term risk by potentially deviating sharply from market risk and returns. In addition, such an approach largely ignores fixed assets from non-Energy sectors in the portfolio that are at risk of being stranded due to their dependence on burning fossil fuel reserves, such as coal-based power plants.
The shortcomings of the divestment approach have led major asset owners to seek more financially practical solutions to managing carbon risk. Instead, investors are starting to turn to strategies that re-weight the market-capitalization portfolio to effectively minimize broad carbon exposure while using optimization to reduce tracking error. These approaches take into consideration both current emissions and fossil-fuel reserves, thus aiming to capture a broader exposure to carbon-intensive companies while seeking to minimize short-term risk. MSCI offers indexes designed to reflect divestment and re-weighting strategies to reduce carbon exposure. These approaches are summarized below:
• Divestment strategies aim to enable institutions to have simple and clear communications with stakeholders but ignore short-term portfolio risks. For example, a portfolio replicating the MSCI Global ex Fossil Fuels Indexes aims to eliminate 100% of the policy benchmark’s carbon reserves exposure by excluding companies that own oil, gas and coal reserves.
• Re-weighting strategies, such as those applied to portfolios that track the MSCI Global Low Carbon Target Indexes, seek to increase exposure to more carbon- efficient companies while reducing short-term risk against the benchmark.
• Combining selection and re-weighting strategies may offer a clear message in communicating with stakeholders while taking into account short-term tracking error and long-term risk exposure to carbon-intensive companies. A portfolio replicating the MSCI Global Low Carbon Leaders Index would include companies with low carbon exposure while seeking to minimize ex-ante tracking error.
LK comment: Won 2015 IRRC Institute Research Award for practitioner research