Aligning Investments in a Time of Climate Change: an Interview With ERI Scientific Beta on Low-Carbon Indexes
Erik Christiansen | May 9th 2016

The historic climate deal inked in December has sent a message to the world that a low-carbon future is imminent, and governments from across the globe have already begun to outline their plans to achieve the ambitious carbon emissions reduction targets outlined in the Paris Agreement. The climate deal has also mobilised the investor community, with the likes of Mark Carney, the Bank of England governor, suggesting in a recent speech that “green” finance “cannot conceivably remain a niche interest over the medium term”.

Nonetheless being able to match investment strategy with the financial and ethical interests of tomorrow’s contingencies requires an overhaul of the tools used to navigate yesterday’s investment climate. New instruments need to both ensure proper alignment with the prevailing market and inform the investor on the positioning of the portfolio with market and policy roadmaps, in the context of the ongoing transition to a low-carbon economy.

To get some additional insight on the available tools for aligning investments with concerns over a portfolio’s’ exposure to carbon, we spoke to Erik Christiansen, CFA, Business Development Manager, Europe at ERI Scientific Beta – a smart beta index provider:

As mentioned, the Paris climate agreement has sent a message to the world that a low-carbon future is imminent. Why should investors start caring about low-carbon indexes now rather than later?

Erik Christiansen (EC): First of all, the sooner investors start acting, the sooner they will be able to influence companies’ behavior. And the sooner companies act, the likelier it is that we can avoid the most damaging aspects of climate change, which may negatively impact economic growth and hence, ultimately, returns for investors as a whole. As a part of an academic institution, ERI Scientific Beta relies on academic research, both external and internal, when building solutions and making claims on their impacts and future risks and returns. And the academic financial literature has shown that divestment policies can be an effective way of  influencing companies’ behavior. Moreover, we have always been wary of investment strategies relying on forecasts, or market timing. Trying to predict when risks related to climate change will materialize – and remaining passive in the meantime – is not likely to be a successful strategy. For investors who believe climate change poses a serious risk to their investments, this risk should be addressed now.   

Companies’ carbon exposure consists of two dimensions: current emissions and fossil-fuel reserves. Could you tell us a little bit more about how the Scientific Beta Low Carbon Indexes considers these two dimensions in its methodology?

EC: For the low carbon indices produced by ERI Scientific Beta, we have chosen to look at current emissions, not directly at the fossil fuel reserves. The reason for our choice is that the goal of these indices is to serve as a tool for the immediate reduction of emissions, and thus as a tool for tackling climate change – as we touched upon already. We are not trying to predict which companies will be most at risk – or even which companies will gain the most – if and when climate-related risks eventually materialize. Such predictions, akin to traditional stock-picking methods are unlikely to produce the desired results.  We thus look at current emissions using the data provided by South Pole Group, which includes both data on emissions related to energy purchased from third parties (Scope 2), and Scope 3 (other indirect emissions) data estimates, that in particular account for emissions stemming from energy sold by companies that own fossil-fuel reserves. For oil, mining and utility companies which own fossil-fuel reserves, we thus target what they produce now, not what they might, or might not, produce in the future.

What is the unique value that ERI Scientific Beta’s approach brings to the table?

EC: Our low carbon indices serve a dual purpose: offering on the one hand an effective policy tool for investors wishing to contribute to the collective fight against climate change while providing them with the financial benefits of Scientific Beta’s smart factor indices, both in the short and the long term. By relying on the well-established academic literature and empirical evidence on well-rewarded systematic risk factors on the one side, and on the merits of diversification of specific, unrewarded, risks on the other, the Scientific Beta indices significantly outperform traditional market cap-weighted indices. And it should be noted that many of the other low carbon indices available in the market today, remain very close to traditional cap-weighted indices. As of March 31, 2016, our flagship indices, the Scientific Beta Multi-Beta Multi-Strategy indices have posted annualised outperformance of 4.51% since their live date (December 20, 2013). This outperformance is even better than their simulated long-term performances.

Where do you see the Scientific Beta Low Carbon Indexes headed in the near future? And what’s next for low-carbon indexes in general?

EC: We see great interest from investors who both wish to tackle climate change, and to rely on well-proven methods for creating added value in purely financial terms. Our indices will be launched this month (May), and will be a welcome alternative to low carbon indices that largely stick to market cap-weighting. In the future, a next step for low carbon indices could be their extension to other asset classes than large cap equities in developed markets. For example, low carbon indices for emerging markets would be useful, as much of the growth in emissions comes from emerging market companies.

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