Using Financed Emissions for Portfolio Management
In an earlier blog, we explored financed emissions calculations following the PCAF guidance, and listed the major influences on the financed emissions of a portfolio, along with the stakeholders responsible for these influences. The post demonstrated that only some of the factors that influence financed emissions are within the control of investment managers (or loan book management at a bank), while others are the consequence of market valuation, actions of the underlying company’s management, or a result of total fund size. While an investment manager certainly has some control over financed emissions, without proper information and an understanding of what drives the financed emissions of a portfolio, they will have difficulty managing emissions over time and understanding the impact of influences beyond their control. This leads to difficulty understanding and implementing a financed emissions transition plan for a portfolio.
Sustainability teams and investment teams can be at odds with one another. If the sustainability team works with the financial organization to set a net-zero target, perhaps by joining a sector alliance of the Glasgow Financial Alliance for Net Zero, they are committing the organization to a financed emissions target. Investment teams are then obligated to achieve the financed emissions targets, which may or may not be compatible with their investment strategy. The investment team may not understand how to manage a portfolio to a financed emissions target, while the sustainability team may not understand what information to provide to assist them. This can lead to ‘sidelining’ of sustainability teams from investment decisions and inconsistent progress towards financed emissions targets. So what can sustainability teams provide to investment teams that is decision-useful? Let’s look at an example of an equity portfolio manager managing a fund. As discussed in the previous blog, there are two types of information that can be used:
- Information on portfolio holdings showing the specific contribution to portfolio emissions and what impact potential changes in the holdings will have, while minimizing the impact on sector allocations. This enables the investor to make informed decisions; and
- Analysis after changes in the holdings have been made that disaggregates the impacts of the security selection from other influences (e.g., the actions of underlying companies or of the market).
The intention here is to help predict the effects of portfolio changes on emissions, and then attribute components of the actual emissions changes to the relevant portfolio changes. For 1, information that would help the investment team make decisions to incorporate an absolute emissions reduction target in their investment strategy could include:
- The total financed emissions of the portfolio;
- The top and bottom holdings ranked by total contribution to financed emissions (regardless of sector); and
- The top and bottom holdings ranked by contribution to financed emissions within each sector.
The first piece of information allows the portfolio manager to understand the target: what the financed emissions of the portfolio are today, what the trend is so far, and how much in needs to be reduced in a particular year to meet a future target. The top and bottom holdings then give the portfolio manager the information they need to make decisions, by deciding whether to underweight the top contributors to financed emissions and/or overweight the bottom. The easiest way to present this to a portfolio manager is in a matrix of the estimated carbon consequences of trades. For example, the following is information from an ETF that tracks the MSCI ACWI index (values are for 2020). The oil and gas sector matrix is presented below.
From this table, a portfolio manager can easily see options for an intra-sector ‘carbon trade’ and the impact on portfolio emissions. The portfolio manager may decide, for example, that she’d really like to hold onto the BP position, but that perhaps she could stand to sell some Exxon. And that she’s ok buying Total. Looking at the chart, a trade that sells Exxon and buys Total will reduce portfolio emissions by 82 tons of CO2e per million dollars invested. If the portfolio manager decides to swap $20 million in Exxon for $20 million in Total, the impact on portfolio emissions would be a reduction of 1,640 tons (82 times 20). The portfolio manager now has the appropriate information to make any number of ‘carbon trades’ to reduce portfolio emissions, and the ability to understand the impact of his decisions.
At the end of the year, the actual impact of any trades will be somewhat different than the predicted value. If $20 million in Exxon is swapped for $20 million Total in 2020, by the time the next financed emissions inventory is done for the end of the year 2020, several other changes will have occurred that may impact portfolio emissions. For example, Total’s emissions may have changed, or its valuation may have changed. Other holdings of the portfolio will have changed as well, and other changes (e.g., portfolio inflows or outflows) may also have impacted financed emissions. In the next blog, we’ll examine how to provide this backwards-looking information to an investor, and why it is so important.