Investor Note

Global sovereign investor insights 

Divest or tilt? Decarbonizing central bank equity portfolios

When central banks took the dramatic step of including equities as an eligible asset class in their reserve portfolios several years ago, they often adopted passive equity strategies in order to prevent any actual or perceived conflicts with their mandates. Due to the unique insights that central banks have into the economic development and plans of national and international regulators, active equity strategies would have been more risky from a reputational perspective. Current systematic/passive investment frameworks are therefore often built around index suites from reputable third-party providers, which are often further trimmed to exclude domestic equities, and, in many cases, depending on the regulatory scope of the institution, financial and insurance companies are also excluded in order to avoid conflicts of interest.

Incorporating de-carbonization strategies in the management of these passive/rules-based funds introduces new challenges for this relatively light-touch approach. Investors, lenders and insurers do not yet have a clear view of which companies will struggle, endure or prosper as the environment changes, regulations evolve, new technologies emerge and customer behavior shifts. Given the uncertainties of climate change and the transition to a lower carbon economy, we address the question concerning the different investment approaches to lower the carbon risk of a passive equity portfolio, focusing on (i) divesting from fossil fuel companies; and (ii) portfolio tilting to carbon/energy efficient companies.

Divesting

One approach for investors to the climate challenge is to adopt an exclusion policy, for example by benchmarking their portfolio to ex-fossil fuel indices. While that is a simple strategy to implement, there are a couple of consequences to consider. By excluding any investment in fossil fuels, the indexed investor is avoiding not just the risk, but the opportunity from what is still a major market segment; for example, some ‘oil majors’ are also among the largest investors in alternative energy.

The second consequence relates to an investor’s definition of responsible investment. It is clear that a prolonged time period will be needed to achieve the transition away from carbon, given current levels of fossil fuel dependence. Investors who simply exclude this sector are unable to exert any influence through their investments when it comes to the means and the timing of such a transition. Many responsible investors therefore believe that being part of this process is the better approach for driving effective and long-lasting solutions.

Therefore, when it comes to fossil fuel reserves, there are different ways to define a fossil fuel exposure, for example GICS/ICB industry classification, absolute value of equivalent CO2 emissions derived from coal and oil & gas, and relative measures as a percentage of revenue. For simplicity we use the absolute value as a measure of potential future emissions.

We have seen investors taking the path of exclusions and there are valid arguments towards this approach. However, some aspects around this approach have to be considered. Since some fossil fuel companies tend to have high weights in market benchmarks, and exclusion tends to add tracking error, divesting could impact results beyond what index investors target. In our simulation exercise we observed that a full exclusion would lead on average to asset underweights in the oil and gas industry of about -4% to -7% relative to the benchmark, adding unintended risks to a given portfolio. (See Exhibit 1.)

Moreover, full exclusion eliminates the possibility of voting and engagement and could discourage companies that are currently seen as part of the problem from becoming part of the solution. For example, large oil & gas and mining companies have extensive expertise developing technologies and are likely to provide economically viable solutions towards carbon capture and storage (CSS). Thus, maintaining an exposure to these companies might provide exposure to the opportunities arising from the low carbon economy.

Finally, data issues are important as emissions and fossil fuel data tend to be self-reported and error measurements are likely to be higher compared to audited financial data.

Tilting

An alternative and arguably more responsible approach for rules-based systematic investors may be to integrate a forward-looking approach via tilting in their investment portfolios. Investors who apply tilting usually choose to stay invested in carbon-emitting companies so that they can seek to create a positive change through proactive engagement with the companies that appear to be the least well positioned for the needed transition, and support more companies in developing the new technologies that are needed for the global economy to transition successfully. Investors should also consider an approach which simultaneously seeks to achieve the following additional three objectives:

  • substantially reduces the carbon (CO2) footprint of a indexed global equity portfolio
  • materially increases investment in companies that may be best placed to benefit from the growth in demand for renewable energy and associated technologies
  • achieves long-term returns broadly in line with the net of costs performance of the underlying index benchmark (e.g. FTSE Developed Index, MSCI World, S&P 500, etc.) relevant to the investor

Overall, we believe that tilts tend to build more efficient portfolios than divesting as they require less tracking error, fewer stock and sector / industry / country-relative deviations to reach the same goal. They also tend to compensate exposures (e.g. under and over–weights within an industry group). Finally, tilted portfolios can allow investors to gain simultaneously negative carbon risk and positive exposures (opportunities).

Our Climate Aware methodology is an example for incorporating historic and forward-looking carbon metrics aimed at increasing the portfolio's overall climate exposures vs. the MSCI World Index.

By applying tilts to the index using a rules-based approach, the strategy aims to move away from companies less likely to be in line with the low carbon economy and towards companies most aligned to meet industry carbon reduction targets. By looking ahead at how companies are positioned for the transition to a low carbon economy, the strategy seeks to reap the benefits of that shift. Our analysis showed that the applied additional tilts achieved at least benchmark returns with overall risk not exceeding the benchmark.

Testing the strategies

In Exhibit 1, we compare MSCI World benchmark returns over the past 5 years against simulations of two typical exclusion strategies and one tilting strategy (UBS Climate Aware).

Exhibit 1: Sample hypothetical portfolios using exclusion strategies and tilting vs. MSCI World Index

Annual results

Annual results

High fossil fuel excluded

High fossil fuel excluded

High-Carbon excluded

High-Carbon excluded

Climate Aware strategy

Climate Aware strategy

Benchmark

Benchmark

Annual results

Return (%)

High fossil fuel excluded

12.18

High-Carbon excluded

11.35

Climate Aware strategy

11.30

Benchmark

11.30

Annual results

Risk (%)

High fossil fuel excluded

11.15

High-Carbon excluded

11.28

Climate Aware strategy

11.18

Benchmark

11.18

Annual results

Relative return (%)

High fossil fuel excluded

0.88

High-Carbon excluded

0.05

Climate Aware strategy

0.18

Benchmark

-

Annual results

Ex-post TE (%)

High fossil fuel excluded

0.79

High-Carbon excluded

0.17

Climate Aware strategy

0.36

Benchmark

-

Annual results

Sharpe Ratio

High fossil fuel excluded

1.09

High-Carbon excluded

1.01

Climate Aware strategy

1.04

Benchmark

1.01

Annual results

Worst rel. return (month) (%)

High fossil fuel excluded

-0.47

High-Carbon excluded

-0.12

Climate Aware strategy

-0.21

Benchmark

-

Annual results

Max. rel. drawdown (%)

High fossil fuel excluded

-0.92

High-Carbon excluded

-0.32

Climate Aware strategy

-0.66

Benchmark

-

Annual results

1-way turnover (%)

High fossil fuel excluded

4.30

High-Carbon excluded

4.34

Climate Aware strategy

10.23

Benchmark

4.28

Annual results

Avg. Beta

High fossil fuel excluded

1.03

High-Carbon excluded

1.03

Climate Aware strategy

1.01

Benchmark

1.00

Annual results

Avg. number of excluded companies

High fossil fuel excluded

76

High-Carbon excluded

80

Climate Aware strategy

-

Benchmark

-

Annual results

Avg. sum weight of excluded companies (%)

High fossil fuel excluded

7.51

High-Carbon excluded

1.74

Climate Aware strategy

-

Benchmark

-

Annual results

Avg. industry underweight (%)

High fossil fuel excluded

-5.7
(Oil, Gas Consumable Fuels)

High-Carbon excluded

-0.88 (Electric Utility)

Climate Aware strategy

-0.36 (Machinery)

Benchmark

-

Annual results

Avg. fossil fuel metric estimate (CO2e mill. tons)

High fossil fuel excluded

0

High-Carbon excluded

123,612

Climate Aware strategy

130,538

Benchmark

144,792

Annual results

Avg. carbon int. 1&2, tons/rev USD

High fossil fuel excluded

184

High-Carbon excluded

116

Climate Aware strategy

97.4

Benchmark

195

Annual results

Number of holdings

High fossil fuel excluded

1,524

High-Carbon excluded

1,520

Climate Aware strategy

1,394

Benchmark

1,600

The first strategy on the left focuses on the aggressive exclusion of companies with a high fossil-fuel footprint. As one can see, while the results versus the benchmark over the past 5 years were good, the strategy creates a significant under-weight in the energy sector, leading to a significant tracking error which exceeds the limits of many passive investors. At the same time, the carbon intensity in tons of CO2 per unit of revenue is only slightly lower than for the benchmark index.

In comparison, a more focused de-carbonization exclusion strategy (High-carbon excluded) which however only excludes less than 2% of the index while cutting carbon intensity by 40%, was able to achieve risk and return ratings very close to benchmark, while having only a very modest tracking error.

Finally, as an example for an optimized tilting strategy, we use our Climate Aware strategy, which simultaneously reduces carbon and fossil fuels, holds fewer stocks and had only a modest tracking error while achieving the risk and return metrics of the benchmark. In our view, the result is an efficient portfolio that manages climate risk and is not building up significant biases at sector, industry or country level.

In which markets would this work? 

Rules-based and passive-like methodologies like our Climate Aware strategy discussed above can be applied to any index that has sufficient breadth to meaningfully implement the tilts. This however requires that there is a meaningful exposure of the index towards sectors with significant climate exposure.

Additionally, within these sectors, there needs to be sufficient dispersion and choice between companies that clearly have an above-average climate and ESG profile versus companies that do not. Furthermore the market needs sufficient liquidity to be able to efficiently implement the strategy. Currently, we have implemented the strategy on broad global equity and fixed income benchmarks, for example MSCI World and FTSE Developed, amongst others. Our experience suggests that broad indices with a large number of instruments and sectors tend to facilitate de-carbonizing the portfolio or implementing climate tilts. In some cases, the tracking error targets might need to be increased in order to reach higher levels of carbon reduction relative to the benchmark. Also, sector/industry maximum deviations might need to be relaxed in order to balance carbon reductions, tracking error and portfolio turnover. In general, this is currently less complex in developed than emerging markets since certain differences exist related to data coverage and disclosure levels, both of which are however improving.

Furthermore, when implementing a strategy at for example the MSCI ACWI level, a rule controlling the exposure between developed and emerging markets is needed. Emerging markets companies tend to show the same overall level of absolute CO2 emissions, but they tend to require higher levels of emissions per revenue unit. Therefore, a combined DM/EM strategy might show a systematic under-weight towards emerging markets.

Still, one significant challenge that is on our research agenda is the return attribution of ESG and climate tilts. How will financial markets price climate change into assets, including transition, adaptation and physical risks?

Sovereign Wealth Funds (SWFs) can target additional alpha-generating opportunities 

For SWFs that want to consider active or direct (private asset) exposure, we recommend using a combination of a core and a satellite portfolio, where climate is considered in both. The core portfolio would leverage tilting strategies as described above, seeking to create a significantly better climate profile than a standard benchmark without affecting significantly the expected risk / return profile of the portfolio. In addition, a satellite portfolio can be used to get more concentrated exposure to some of the leading companies in the areas of mitigation, adaptation and transition. Here, the ability of the fund manager to select winners in the field of climate change adaptation would be used to generate alpha. For example, companies developing technologies (e.g. carbon capturing, smart grids, electric vehicles, etc.) are likely to benefit from the transition to a lower carbon economy.

We would be hesitant to "de-carbonize" the portfolio by simply adding isolated exposure to the clean energy theme via low-carbon indices. These indices tend to have high exposures to the most liquid names in the space, which are not necessarily the most attractive ones. Many of these companies are highly correlated and pro-cyclical; this means volatility can be extreme as we have seen in 2012 with some ETFs declining by almost 90%. This is why in a semi-passive approach, we advise a diversification strategy like UBS Climate Aware for the core tranche to get exposure to the mitigation of carbon risk as well as the transition. For a more concentrated exposure to clean energy companies, we would advise a more active approach where in-depth qualitative and quantitative research on the individual companies may be able to mitigate a significant part of the idiosyncratic risk as well as discover attractive alpha opportunities.

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