LOW CARBON INVESTMENT IN LISTED EQUITY – WHAT’S THE RISK
Investors have strategic choices in respect of managing carbon risk. They can choose to wait for carbon to be fully priced, seek to maintain market level returns while hedging carbon exposure, pursue growth companies that benefit from a low carbon economy, or seek to engage companies and market level actors to shift the system to safer ground.
Despite the US withdrawing from the Paris Agreement, the risks posed by climate change remain real and significant. The Intergovernmental Panel on Climate Change says that “the scientific evidence for warming of the climate system is unequivocal.”
One of President Trump’s key scientific institutions, NASA, goes further to say that “the current warming trend is of particular significance because most of it is extremely likely (greater than 95% probability) to be the result of human activity since the mid-20th century and (it is) proceeding at a rate that is unprecedented over decades to millennia”.
PARIS AGREEMENT – NOT JUST HOT AIR
The central aim of the Paris Agreement is to strengthen the global response by setting ambitious targets of capping climate change at well below 2°C above pre-industrial levels, with an aspirational target of 1.5°C. The Agreement works initially on a ‘voluntary opt-in’ basis, with the signatory parties putting forward their Nationally Determined Contributions (NDC) for emission reductions. These voluntary contributions form the basis of the collective effort across 153 nations representing 63% of current global greenhouse gas emissions1.
This is a significant step forward for global collective action, simply because by being voluntary, the agreement concretely evidences the global majority will to reduce the carbon intensity of economic growth. Notwithstanding this, more needs to be done as current Paris commitments still fall short of what is required by science.
It seems that the markets are beginning to understand that climate risks are a material threat to the stability and viability of long-term market operations, and are therefore pushing for greater action. In June 2017, the Financial Stability Board published guidelines for climate risk disclosure. These standards were drafted by the market for the market, and are supported by investors with roughly US$25 trillion in assets under management.
Navigating through the noise and bluster of global climate politics in order to understand the impacts on financial markets is not without its challenges. Perhaps some of the most enterprising work undertaken in this regard is that of the Carbon Tracker – a UK-based think tank that first propositioned the idea of the Carbon Bubble or ‘unburnable carbon’. Beyond simply looking at cost implications from annual company emissions, they went one step further and undertook a detailed analysis of the amount of carbon sitting on the balance sheet of the world’s biggest resource companies.
Their work showed that in global listed markets there is roughly five times as much ‘carbon’ on company balance sheets versus what science is telling us we can safely emit2. The idea of the carbon bubble or unburnable carbon was thus born and along with it the very serious question of how to manage this risk in long-term portfolios.
CARBON, A FREE OPTION?
Given the slow pace of market and policy reform around climate change risk, it’s perhaps not surprising that investors are cautious about taking big bets in respect of climate risk. For prudent long-term investors the question has however been focused on the best approaches to achieving market-related outcomes while lowering exposure to climate risk.
This thinking has driven the development of a series of innovative indices that have low market tracking errors with measurable carbon reduction to the parent benchmark. A host of these indices exist in the market – some only make use of Scope3 1 and 2 emissions, some include stranded carbon assets and some go so far as extending to include Scope 3 supply chain emissions. Irrespective of the approach, the indices provide investors with the ‘free option’ on the long-term miss-pricing of carbon related risks4. Essentially this means that once the full pricing of carbon emissions is felt in the market, low carbon strategies should begin to outperform.
Investors have strategic choices in respect of managing carbon risk. They can choose to wait for carbon to be fully priced, seek to maintain market level returns while hedging carbon exposure, pursue growth companies that benefit from a low carbon economy, or seek to engage companies and market level actors to shift the system to safer ground. In the short term we have seen carbon indices gain traction globally with large scale investors who see this approach as a low risk means of reducing carbon exposure while maintaining market level returns. Is this one of the markets’ first true free options?
SOUTH AFRICA: STRANDED COAL ASSETS
South Africa is a high greenhouse gas (GHG) emitter in absolute and relative terms. We rank 17th in the world for absolute emissions and our per capita emissions are some 25% above the global average. The emission intensity of our economy (measured as 716 tCO2e/$million unit GDP) is some 40% higher than the global average. Some other salient carbon facts about South Africa are:
- South Africa is 6th in the global list of coal-exporting nations
- 28% of South African coal production is exported – an important source of foreign exchange – and 72% is consumed locally
- Coal provides 81% of the power generated by state-owned power utility Eskom
- Sasol mines some 40Mt of coal a year for gasification and conversion into liquid fuels
- 35% of liquid fuel used in South Africa is derived from coal5
In July 2012, Carbon Tracker investigated unburnable carbon in the South African market6. Given coal’s dominance in the country, they focused their work on reported reserves7 and planned coal resources8, in both the listed and unlisted space. The research indicated that of the current coal reserves earmarked for domestic use, 92% is attributable to JSE listed companies, of which 38.5% is unburnable on the basis of our Paris accord commitments9.
For South African investors the opportunities to pursue low carbon strategies have largely been limited to the unlisted market, as to date there has been little choice available in the listed market.
In 2015, Old Mutual began reporting on the carbon intensity of its South African listed equity portfolio through its Montreal Pledge. This work led us to work with a selection of service providers in late 2016 to see what potential exists for low carbon investment in the South African listed market, using the FTSE/JSE Shareholder Weighted Index (SWIX) as a benchmark. Our preliminary work with the FTSE group shows that it was possible to achieve a lower than 2.5% tracking error to SWIX over a period of December 2012 to June 2017 while reducing exposure to unburnable carbon by 88% and annual carbon emissions (Scope 1 and 2) by 84% – both relative to SWIX. Interestingly, investors that followed this carbon de-risking strategy would have been rewarded with a 2% excess return per year. This work is undertaken using a mix of industry reported data (60%) and modelled data where no reported data exits.
Alongside this research we have been working with ET Index Research to investigate what kind of absolute emission reduction can be achieved when including Scope 3 emissions. Scope 3 emissions are significant as some 40% of market emissions sit in supply chains. However, this data has historically been very difficult to come by. Notwithstanding this, the preliminary findings indicate that a similarly meaningful reduction with a low tracking error to the SWIX can be achieved.
This research provides important first evidence that low carbon investment in the South African market is possible with a low tracking error along with the achievement of a meaningful carbon reduction relative to the parent benchmark. Given the carbon intensity of the South African market and the large and looming climate crisis, it would seem that taking the free carbon option is the prudent course of action.
1 It is important to note that the emission pledge pathway by signatory nations has over 90% probability of exceeding 2°C, and only a ‘likely’ (>66%) chance of remaining below 3°C this century. The current policy pathways have a higher than 99.5% probability of exceeding 2°C – http://climateactiontracker.org/global.html
2 Unburnable Carbon – Are the world’s financial markets carrying a carbon bubble? – http://www.carbontracker.org/wp-content/uploads/2014/09/Unburnable-Carbon-Full-rev2-1.pdf
3 Scope 1 refers to company emissions from primary combustion of fossil fuels, Scope 2 comprises emissions from the consumption of electricity and Scope 3 comprises those emissions that arise from supply chain activity.
4 From a pure carbon reduction perspective some might argue that these indices do little to shift the overall system as the nett carbon risk in the market is the same, it is just shifting hands.
7 Reserves have a 90% likelihood of being exploited and are as reported by the companies in compliance with the SAMREC code in South Africa
8 Beyond the coal reserves already developed by the companies, they also have interests in resources that they are working to prove are viable deposits. These resources are classified as having a 50% probability of being exploited.
9 Under the Paris Accord South Africa has committed to a peak plateau and decline profile for our carbon emissions out to 2050 with an estimated total Carbon Budget over the period of between 12 to 16Gt.