A here-and-now approach to addressing carbon emissions (Archived)

Jason Lejonvarn, managing director-global investment strategist of Mellon Capital Management (MCM)1, examines ways investors can encourage corporates to lessen carbon emissions to mitigate the effects of global warming.

Addressing Carbon Emissions

In the investment arena, the fossil fuel divestment campaign has brought to the fore the question of climate change blamed for rising sea levels and extreme weather. This campaign has largely been built around the contention that the majority of carbon reserves are ‘unburnable’ and will have to stay in the ground, rendering them ‘stranded’ and overvalued. This, in turn, is the main strand of the economic argument for fossil fuel divestment.

Global warming, if unchecked, is forecast to increase the earth’s average temperature by at least two degrees Celsius (2°C) above pre-industrial levels. In 2010, governments around the world agreed to limit global warming to below 2°C relative to pre-industrial levels in order to prevent dangerous climate change. Consequently, in order to stay within this two-degree limit, only a small portion of carbon reserves can be burned.

Of note, global temperatures increased 0.68°C above the long-term average in 2014, making it the warmest year on record, according to a recent research study by NASA and NOAA2. The ‘greenhouse’ gases emitted today will stay in the atmosphere for many decades to come, lending a sense of urgency to the need to reduce carbon emissions. To some extent, almost every company emits greenhouse gases and contributes to global warming. As we invest, we have a choice to make regarding the selection of companies we invest in and how much capital we allocate to them. That choice can have an environmental impact as we support those companies that seek to make the world greener.

Immediate impact

While the ‘stranded asset’ argument is powerful and has a number of prominent advocates, it involves, in our view, assumptions about energy supply and demand that are influenced by many complex factors, such as regulations and innovation. Over the near term, a wholesale shift away from fossil fuels and the technologies that use them would have a significant economic impact as the global economy is so dependent on energy. While some countries have taken steps to increase energy produced by alternative means, no viable alternative energy infrastructure exists able to meet present energy needs on a global basis.

This would appear to suggest that significant changes in energy production and usage would likely come about in a gradual fashion. Consequently, a way to have a more immediate impact is needed. In the meantime, our preferred focus is on carbon emissions, which are raising temperatures, creating air pollution and damaging fragile ecosystems today.

Losing influence

Investment performance considerations aside, those divesting their holdings in fossil fuel companies lose their voice of influence over those companies. There is also the risk that the holdings, and with them the influence on climate change questions, pass to other investors that are less concerned with such matters. Aside from coal, which has the highest level of carbon per unit of energy and faces many sensible substitutes in power generation, we believe oil and gas assets can benefit from innovations and technological advances in energy production.

Instead, engaging with companies that produce and use fossil fuels encourages them to adopt more environmentally friendly corporate policies in order to improve their carbon footprint. In addition, energy companies happen to be a very convenient target, while many companies in the other sectors – predominantly utilities, materials, and industrials – make profits, while paying scant regard to global warming or even dismissing it. Fighting global warming is a long journey, from reducing carbon emissions in the near term across the spectrum from producers to utilities to building a more environmentally friendly energy infrastructure globally. We believe divestment is a missed opportunity to influence change and engagement is a better strategy.

By evaluating a company’s carbon intensity factor, it is possible to determine which companies have a strong awareness of climate change and those that are weaker with regard to such considerations in each sector. Our carbon intensity factor is based on a company’s carbon emissions combined with our own carbon readiness score3. The more environmentally aware companies may realise a competitive advantage and could therefore be overweighted within the sector allocation of a portfolio. Conversely, companies with higher carbon intensity measurements within each sector could be underweighted for being inefficient.

As investors assess the carbon exposures in their portfolios, many will likely conclude their exposures come predominantly from their index allocation. Given that index-based investing, by definition, tends to be broad based, it includes companies that are heavy emitters of greenhouse gases. Such investors are not forced to question or determine whether or not fully active low-carbon investing truly adds or subtracts value from their portfolio. Developing an insight into carbon exposures builds the basis for ‘green beta’ investing. Fulfilling both the environmental and fiduciary objectives in a ‘green beta’ strategy can be achieved by striking a balance between addressing carbon exposure and achieving a diversified beta exposure.

The journey from awareness to implementation is a long one, with investors often unsure how to execute a carbon-efficient strategy, while still fulfilling their fiduciary responsibility. This journey can be chronicled from the first time that they hear about the fossil fuel divestment campaign to the moment they decide they wish to have an impact on global warming. This is in contrast to some earlier adopters who are willing to give up some element of returns and/or accept significant deviation from the broader market for social or environmental objectives.

Combating global warming is unlikely to be accomplished quickly and taking the first steps requires deliberation and planning, especially with respect to fiduciary responsibility. In evaluating an approach to addressing the questions raised by fossil fuels and their impact on global warming, investors will have to consider their fiduciary responsibility as well as their desire to have investments with a low carbon impact. We believe it is possible to reduce carbon exposure significantly by penalising the worst offenders but also by rewarding the innovators. By encouraging companies to reduce their carbon exposure, investors can have an impact on global warming without compromising their fiduciary duties.

1. Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited ("BNYMIM EMEA") or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.
2. National Aeronautics and Space Administration Goddard Institute for Space Studies GISS Surface Temperature Analysis (GISTEMPP) and National Oceanic and Atmospheric Administration January 16, 2015
3. MCM's carbon readiness score measures the extent to which companies manage the carbon emissions risk inherent in its business relative to other companies in their sector. A high score indicates a company addresses its carbon risks in a positive way setting the upper bound of the company’s overweight. 

This is not investment advice. Regulatory Disclosure