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So why not cut out or divest from the worst polluters? The answer is that doing so risks throwing out vital innovation in renewable technologies occurring in the energy sector. Power producers mixing high-CO2 generation with renewable technologies are more common than renewable pure players. A few examples of such mixed power generators include: Huadian Fuxin Energy in China (35% coal power, 35% wind power, 22% hydroelectric), Idacorp in the US (three coal power plants, 12 hydroelectric power plants) and Electric Power Development in Japan (38% coal power and 39% renewable power).
Moreover, excluding the energy sector, materials and utilities would omit around 14% of the MSCI World index (based on February 2019 data) and lead to severe sector biases, higher tracking error and adverse portfolio behaviour in certain market conditions. Sector biases should not be underestimated; they can lead to unintended high sensitivity of the portfolio to commodity prices.
Maintaining some exposure to fossil fuels via such companies does, however, present asset owners such as pension funds and insurers with a paradox of how to proceed as responsible investors.
At Candriam, we believe the paradox is best addressed by using optimisation rather than absolute divestment from any industrial sector. This means combing through all the stocks in an equity portfolio and re-weighting them to achieve the same benefit as excluding that trio of the most carbon-intensive sectors, but without unintended consequences.
In one customized portfolio, our carbon optimised strategy achieved a 75% reduction in fossil-fuel inten- sity with 75% lower tracking error versus the MSCI index than simply divesting from all energy, materials and utilities would have achieved 1
. This has three main advantages over an exclusion approach:
– Sector-specific risk is significantly reduced in favour of stock-specific risk – We have an overweighting towards renewable energy (total exposure rather than via pure-play renewables, which are rare).
– The portfolio is biased towards the most efficient and least carbon-emitting companies, contributing to the signal to promote energy transition within high-carbon sectors.
Conclusion We end where we began, with the ESG obligations of institutional investors. A major client recently struc- tured a mandate with Candriam using optimisation to address those obligations. The demands were to bring the current carbon dioxide emissions of the portfolio below 50% of the benchmark; to restrict revenue from coal of stocks in the portfolio to 20%; to restrict generation of greenhouse gases to 1,500 metric tonnes per €1m (£869,500) of revenue; and to tilt the portfolio towards companies making real efforts in energy transition.
These criteria acknowledge the paradox of dual players in fossil fuels and renewables whilst aiming strategically for a greener world.
1) For illustrative purposes only. Past performance is no guarantee of future results. For an explanation of methodology and results, please see “Reducing Carbon Risk in Institutional Portfolios”, July 2019.
https://www.candriam.be/en/professional/market-insights/topics/sri/reducing-carbon- risk-in-institutional-portfolios/
This document is provided for information purposes only. The information, opinions, analysis and views expressed in this document are provided for information purposes only, it does not constitute an offer to buy or sell financial instruments, nor does it represent an investment recommendation or confirm any kind of transaction. Although Candriam selects carefully the data and sources within this document, errors or omissions cannot be excluded a priori. Candriam cannot be held liable for any direct or indirect losses as a result of the use of this document.
November 2019 portfolio institutional roundtable: Responsible investing 25
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