Climate change is now the dominant risk facing humanity (1), and the transition to a lower-carbon economy is top of the agenda for an increasing number of countries globally.

    For investors, it presents risks and opportunities. People are becoming more concerned about the climate impact of their consumer choices, including their investments, and with good reason.

    A person’s choice of investments could have a much more significant impact on the climate than their everyday activities. One often-quoted statistic is that moving to more sustainable investments is 27 times (2) (3) more effective in reducing your carbon footprint than ditching flying and becoming a vegan combined.

    What does someone’s carbon footprint really mean, and how is it measured?

    A footprint is the most common measure of climate change impact. It is the total greenhouse gases (GHG) an individual, company, or another group (e.g. a country) releases into the atmosphere due to their activities. As there are different GHGs that cause climate change (carbon dioxide is the largest contributor, others include methane and nitrous oxide), these are converted to a carbon dioxide equivalent (CO2e), depending on the global warming potential of the GHG.

    When calculating my own carbon footprint using the WWF online tool, it is estimated at 11 tonnes of CO2e per year (t CO2e). In this calculation, I have assumed I eat meat every day and fly to Europe twice a year. If I cut these activities out, my carbon footprint drops to 9.3 t CO2e. So a reduction of 1.7 CO2e tonnes due to stopping flying and becoming a vegan.

    How much climate impact do my investments have?

    When it comes to my investment portfolio carbon footprint, the idea is that if I own one per cent of a company (through direct investment or a fund), then I am responsible for one per cent of the company’s total carbon emissions. If this can be measured across all the investments in my portfolio (including other asset classes such as bonds), I can understand my portfolio’s overall carbon footprint.

    As an example, let’s assume I have £100k, and I invest in a global equity portfolio tracking the MSCI All Country World Index (ACWI). Based on publicly available data (4) (5), I estimate the carbon emissions for my investment size to be 21.6 t CO2e. If I changed my whole portfolio to track the MSCI ACWI low carbon target index (a global equity portfolio aiming to minimise carbon exposure), the carbon emissions of my portfolio drops to 5.1 t CO2e.

    So the impact of changing my investment reduces my carbon footprint by 16.4 CO2e, which is almost 10x the impact of the lifestyle changes I suggested (see figure 1).

    Clearly then, the figures show my choice of personal investments can significantly impact my carbon footprint.

    Figure 1

    Limitations of portfolio carbon footprint measure

    Like any metric, there are limitations to portfolio carbon footprint measurement. As the measure becomes more prevalent in the industry and potentially a regulatory requirement, it’s important to understand these limitations to avoid poorly informed investment decisions.

    These include the following:

    Consideration Summary
    Coverage and accuracy Portfolio carbon footprint measures tend to include emissions generated directly by the company (called scope 1 emissions) and emissions generated through purchased energy (scope 2). Other indirect emissions (scope 3) such as purchased services or use of sold products are not typically included. This can lead to unfair comparisons as scope 3 potentially makes up 75% (6) of a sector's carbon footprint. But due to difficulty in measurement and potential overlap with scope 1 and 2, it is yet to be included widely in standard metrics. In addition, not all companies disclose their carbon emissions, and companies and research firms can make significantly different estimates.
    Backward looking Another weakness of portfolio footprinting is that it's backward looking. The measure focuses on past emissions and does not give insight into a company's strategy (which could include drastically cutting emissions) to further understand the transition risk exposure.
    Engagement versus exit Related to the above point is that focus on lowering the carbon footprints of portfolios likely results in disinvestment from companies with currently large scope 1 and scope 2 emissions. However, it is questionable whether disinvestment (particularly in equity) is an effective strategy to influence a company's behaviour, and you could have more impact by staying invested and engaging with companies. For example, investing in an oil company through a fund manager who effectively influences the company to lower its carbon footprint can have a bigger impact on global emissions than a disinvestment strategy.

    Drawbacks aside, as the investment industry evolves and creates more products and tools to measure climate impact, we’re considering the most appropriate climate metrics to incorporate in our investment process, and how to communicate that effectively.

    Portfolio carbon footprinting is a useful starting point to understand the magnitude of carbon exposures and provides a convenient method of communication, but we need to consider the limitations of the measure.

    Additional metrics can help us better measure the forward-looking climate risk of our portfolio, and we also need to understand how our fund managers integrate climate considerations in their investment processes so we can monitor their ongoing engagement with the companies they invest in.

    This way, we can have a deeper understanding and make fully educated decisions when it comes to integrating climate risk into our investment decisions.

    References:

    1. WEF global risks report http://www3.weforum.org/docs/WEF_Global_Risk_Report_2020.pdf
    2. Pensions age article https://www.pensionsage.com/pa/Make-my-money-campaign-launches-highlighting-power-of-sustainable-pensions.php
    3. Nordea explanation of 27x stat https://nordeainvestmagasinet.dk/sites/default/files/inline-files/Regnestykke-baggrund.pdf
    4. MSIC ESG metrics index tool  https://www.msci.com/index-profile/index-metrics/msci-acwi/892400
    5. MSCI Carbon Footprinting 101 https://www.msci.com/documents/10199/2043ba37-c8e1-4773-8672-fae43e9e3fd0
    6. SSGA Carbon footprinting and investor toolkit https://www.ssga.com/library-content/pdfs/insights/carbon-footprinting-an-anvestor-toolkit.pdf