Unpacking the Carbon Impact of Security Selection

In a previous blog we examined what information an ESG team can provide, looking specifically at an example of an equities portfolio manager. At the end of the post, an example was used with an ETF that tracks the ACWI. As an example of decision-useful information, a portfolio manager was given a matrix that showed the impact of potential ‘carbon trades’ in the oil and gas sector. Finally, the post showed how the matrix could be used, and the numbers associated with a sample ‘carbon trade’ (swapping $20 million in Exxon for $20 million in Total).

This post is about what happens after the portfolio manager has made all her trades for the year, including the example carbon trade. This is because the impact of trading activity is only part of the total impact on portfolio emissions – valuations, fund size, company emissions, and other influences will also impact the fund’s total financed emissions. This is where the ESG analyst needs to provide additional information to the portfolio manager that attributes the impact of any trades undertaken in the context of these other changes. The table below does just this for the same sample fund tracking the ACWI used in the previous examples, this time in 2021:

Table 1 – Attribution of changes over time showing the influence of the investment decisions

This table shows the portfolio manager the context of the decisions she has made and the other influences on the portfolio – historical, backward-looking information to help the portfolio manager understand not just what the changes in financed emissions were, but why they occurred. Here we can see that the total change in this fund was a reduction in portfolio emissions of 11,331 tons of CO2e from 2020 to 2021. The portfolio manager’s total changes due to security selection resulted in a reduction of 34,479 tons (28,061 and 6,418 in the table above). This indicates that investment decisions, likely done to rebalance sector allocation and not for carbon reduction, had a significant downward impact on portfolio emissions.

The downward pressure on emissions was augmented by changes in company valuation, which resulted in a further reduction of 6,418 tons of CO2e. These downward pressures on emissions were counterbalanced by the rise in fund AUM and a rise in the underlying company emissions, both of which pushed portfolio emissions up by 23,889 and 6,737 tons, respectively. The carbon trade ($20 mil Exxon for $20 mil Total) contributed 1,640 tons to the emissions reduction of the portfolio and is included in the 6,418 tons of reduction from company allocation, although the impact of this trade was much less than the impact of other trades.

Overall, the decisions of the portfolio manager clearly had the biggest impact on portfolio emissions: of the total influences (either positive or negative, 73,088 tons) the combined impact of sector allocation and company allocation accounted for 47% of these. Other influences on the portfolio financed emissions included changes in fund size (33%), changes in the underlying company emissions (9%) and changes in the company valuation (11%).

Here the sustainability team has done their job – the portfolio manager understands exactly what the financed emissions changes were, what the impact of their investment decisions were on financed emissions, and what other influences were outside of their control. Providing this information going forward on a continuing basis – i.e., providing information to make ‘carbon trades’ and then information on the impact those trades had, alongside the impact of other factors – should keep the portfolio on track for a financed emissions reduction target that does not compromise investment strategy.

Of course, in the real world, very few funds have an absolute emissions target, as absolute emissions rise or fall with the amount of assets under management. This makes a comparison between funds difficult for people selecting a fund – obviously the larger fund will have larger emissions, not because they are particularly bad at managing to a climate target, but because they have more holdings. However, everything in Table 1 can be repeated, this time expressed as CO2e/million dollars (or million euro) invested, giving effectively the same data, but this time to manage to an intensity target, although of course the fund size column drops out.