Climate Change - Part I
Countries, cities and companies around the globe are committing to achieve the goal of net zero emissions and investors need to show similar leadership.
Stephanie Pfeifer, CEO, Institutional Investors Group on Climate Change (IIGCC)
As highlighted in ARP’s paper Climate Change - from Risk to Opportunity earlier in the year, private investors have a unique and noteworthy role to play as part of the solution to the climate crisis. Furthermore, investors can benefit from the tailwinds from government action and changing consumer sentiment and habits. In the paper, we asked which were the most compelling climate change opportunities and concluded that, given greenhouse gases come from a number of sources, there are a wide array of opportunities across a range of investment strategies.
The initial aim was to write just one ARP+ paper discussing all of these strategies. However, given the wide array of strategies and implied themes to consider when constructing a climate change portfolio, the paper started resembling a mega-dissertation. We have therefore decided to split the ARP+ report into three distinct ARP+ papers:
• Part I: How to Invest in Climate Change in Public Markets
• Part II: How to Invest in Climate Change in Private Markets
• Part III: How to Construct a Climate Change Portfolio
Part I summarises the opportunity set within equities, green bonds and hedge funds. Part II will discuss afforestation, renewables and sustainable infrastructure, real estate and private equity and venture capital. Part III will discuss the various solutions to climate change and how these should be taken into consideration when constructing a portfolio.
Note that, throughout, we will attempt to highlight strategies that are more at risk of ‘green washing’, or what we like to call the ‘Emperor’s New Clothes Syndrome’. Having said that, the fear of ‘walking partly naked’ should not stop investors from investing in climate change, which is poised to be one of the greatest investment (and impact) opportunities in the decades to come.
To continue reading...
Exchange-Traded Funds (ETFs) and Mutual Funds
As investors wake up to the climate change emergency, in part spurred by the pandemic, there has been a rapid rise in flows into climate-aware ETFs and mutual funds. Global assets in the space almost tripled in 2020, reaching a total of $177Bn at year-end across 400+ mutual funds and ETFs according to Morningstar (see Exhibit 1). Given that the most straightforward and accessible way for the average investor to make an allocation to climate change is via an ETF or a mutual fund, this is not surprising.
Europe is several steps ahead the rest of the world in terms of total climate-aware assets, but with the climate change narrative in the United States changing with the new Biden administration, it is expected that assets in the United States will soon rival those in Europe.
A large proportion of the flows into climate aware funds in 2020 have been to Climate Solutions and Clean Energy/Tech offerings (based on Morningstar’s categorisation). Some of the Low Carbon offerings, however, still make it to the list of largest offerings in the space (see Exhibit 2).
So, how should an investor determine which type of ETF and/or mutual fund is most appropriate? We review the options and highlight the characteristics of each to assist in navigating the space.
Equities: Low Carbon ETFs and Mutual Funds
A significant portion of the climate-aware offerings are geared to investors wanting to reduce the embedded climate risk within their existing investments rather than explicitly looking to be part of the climate change solution. The offerings categorised by Morningstar as Low Carbon, and to a lesser extent Climate Conscious, would fall under this group. They focus on reducing carbon exposure relative to a benchmark through re-weightings and exclusions, typically overweighting exposures with lower emissions or those that are on a trajectory for a +1.5⁰C world.
In addition to the name of the offering, which will often give a clue, a relatively straightforward way to identify Low Carbon offerings is to take a look at the holdings. If the names are very similar to those typically found in a traditional index but with some exclusions, it will most likely fall under this category. For instance, the top names in the BlackRock ACS World ESG Equity Tracker Fund as of end of July 2021 were Apple, Microsoft, Amazon, Alphabet, Facebook and Tesla. Do these names ring a bell? The reason for this is that the BlackRock ETF tracks the MSCI World ESG Focus Low Carbon Screened Index, and the index itself is constructed by:
…selecting constituents of MSCI World index through an optimization process that aims to maximize exposure to ESG factors for a target tracking error budget and reduce the carbon exposure by half with respect to the MSCI World Index under certain constraints. The Index aims to be sector-diversified and targets companies with high ESG ratings in each sector.
(Source: MSCI World ESG Focus Low Carbon Screened factsheet)
Similar holdings can be found in mutual funds employing climate “factor” or “temperature alignment” metrics which are benchmark centric.
Low Carbon exposure is most suitable for investors who already have a core allocation to the equity market but would like to reduce the carbon exposure and hence the climate risk in an ESG-friendly manner.
Investors should not fool themselves into thinking this type of offering is positively contributing to the climate change solutions effort. A subset of these offerings, however, could be seen as having some positive impact, in that some will actively engage with the invested companies to improve their environmental credentials.
Equities: Climate Solutions and Specialist-focused ETFs and Mutual Funds
Investors wanting to participate in the returns from companies offering products and services that directly enable greenhouse gas avoidance and/or are part of the climate change solution, would be better placed allocating to Climate Solutions or Clean Energy/Tech funds (Morningstar categories again). Note that Clean Energy/Tech is a specialist-focused category, and there are other specialist-focused ETFs and mutual funds which are also very relevant, such as those with a focus on electric vehicles, smart cities & infrastructure, battery technology, circular economy, hydrogen economy, sustainable food and water (see ARP+ Insight on ‘How to invest in water’).
Climate Solution funds will have a much more targeted exposure to climate change solution enablers and innovators than Low Carbon funds. This is evident when comparing a selection of the top holdings of some of the offerings (see Exhibit 3).
Although assets under management in climate-aware funds are largest in Europe, Climate Solution funds typically allocate mostly to North America, followed by Europe. Sector-wise, although varied, the larger sector exposures tend to be to industrials, technology, utilities and energy.
Clean Energy/Tech offerings will hold names which focus more on renewables, with some of the largest holdings in the S&P Global Clean Energy Index (which the iShares Global Clean Energy ETF tracks) shown in Exhibit 4.
Something to look out for when choosing a Climate Solutions ETF/fund is potential exposure to areas that may not be as ESG-friendly as might be desired in this type of offering. For instance, the above-mentioned iShares Global Clean Energy ETF has around a 0.5% exposure (as of the 24th of August 2021) to companies earning more than 5% of their revenues from thermal coal mining.
Equities: ETF, Mutual Fund or Single Stocks? And how about the “Bubble”?
So how do ETFs compare to mutual fund offerings? Within the Climate Solutions or other specialist-focused categories, mutual funds fees are typically higher, although not significantly so, especially when compared to the more specialist-focused ETFs. It does make sense for mutual funds, which are actively managed, to charge higher fees than ETFs which simply follow a rules-based methodology. Arguably, the value of qualitative fundamental analysis has heightened importance given some of the stretched valuations experienced by stocks which are deemed to benefit from the green transition (see Exhibit 5).
However, one can also argue that, by investing in one of the larger ETFs, you will benefit from further inflows into climate-aware ETFs. As seen in Exhibit 1, simply relying on assets in the United States catching up with Europe could prove to be quite a powerful trend to exploit. Note, however, that many climate-aware ETFs have not performed very well since inception and have fallen significantly year-to-date. The iShares Global Energy ETF, for instance, has fallen around 39% since its inception in July 2007 and over 17% year-to-date (see Exhibit 6). Also, be aware that ETFs may trade either at a premium or a discount to its NAV – an inherent risk in ETF investing.
For investors who have the required skills and are comfortable with the higher risk embedded in owning individual stocks, investing directly in specific equities is an option. Given the complexity of the green transition and some of the hefty valuations, investors pursuing this route would be wise not to put all their eggs in one basket.
The World Bank defines a green bond as:
a debt security that is issued to raise capital specifically to support climate related or environmental projects. This specific use of the funds raised - to support the financing of specific projects - distinguishes green bonds from regular bonds [….] investors also assess the specific environmental purpose of the projects that the bonds intend to support.
There has been an exponential rise in green bonds since the first was launched in 2007 by the European Investment Bank (see Exhibit 7). The annual growth rate has been close to 95% and reached $1Tn by the end of 2020. The green bond market is still a very small subset of the $128Tn global bond market, though (International Capital Market Association, August 2020).
The United States was the largest geographic issuer of green bonds in 2020 with a total of $51Bn (see Exhibit 8). Sovereigns, development banks and urban transport operators appear heavily amongst the top issuers.
Industry-wise, the majority of issuance is in energy, followed by buildings and transport (see Exhibit 9). Some of the categories recognised by the Green Bond Principles (GBP) as potential eligible projects include renewable energy, energy efficiency, sustainable waste management, sustainable land use, clean transportation, sustainable water management, biodiversity conservation and climate change adaptation.
The most easily accessible way to invest in green bonds is through ETFs or mutual funds. Investing in this manner provides a diversified exposure.
Notwithstanding the guidance provided by GBP and the array of other green initiatives, some market participants question the benefits of green bonds, notably the lack of clarity and standardisation of these green initiatives. In addition, some investors are not convinced green bonds create much positive environmental impact as companies can raise green bonds for a few qualifying green initiatives while pursuing decidedly non-green activities elsewhere in the business.
There are also additional costs incurred with added monitoring, disclosure and impact reporting. Measuring performance remains challenging, and studies on potential ‘greeniums’ are mixed. Investors may also want to consider sustainable bonds, but these have a wider environmental and social remit and hence are not as purely focused on climate change.
There are two key hedge fund categories which investors should consider when investing in climate change, namely Long/Short Equity (with a focus on the green transition) and Carbon Emission Trading.
Long/Short Equity (green transition focused)
The green transition will produce many winners and losers. This dispersion suggests a rich opportunity set for equity long/short managers as they are equipped with a handy additional tool when compared to long-only equity funds - the shorting of ‘stranded assets’.
Several equity long/short hedge funds have launched in recent years with a variety of approaches to investing in the green transition. The offerings can be split into three categories: thematic hedge funds, sector specialists, and engagement specialists.
Thematic hedge funds tend to go long green/renewable stocks and short ‘dirty’ stocks (e.g. fossil fuel companies). Holding periods are often longer-term in nature. Sector specialists tend to be portfolio managers who may have previously traded the energy, industrials, or utilities sectors. Given the impact the energy transition is having on their sectors and the relevant value chains, they are launching products. These managers are usually shorter-term, trading-orientated managers with a greater focus on risk-adjusted returns. Drawdowns are managed more explicitly, and portfolios often lack the longer-term thematic perspective of the former group. A third, smaller group of funds are the engagement specialists, investment managers engaging with company managements to help decarbonise their business.
Funds are relatively liquid, typically providing weekly, monthly or quarterly redemption terms. The fees charged will be considerably higher than that of long-only equity ETFs and mutual funds, but the ability to act on stranded assets as a result of the green transition has the potential to contribute significantly to improving the risk/return profile of this opportunity set.
Carbon Emission Trading
Many of the activities and the provision of goods and services which provide benefits to humans generate emissions, which unfortunately give rise to climate change – an unpriced negative externality. An incentive-focused solution to tackling climate change consists of the pricing of these negative externalities. Explicitly pricing emissions encourages firms to internalise the full cost of their activities, incentivising them to reduce emissions and shift away from high-emissions processes and products. At a G20 summit in Venice in July 2021, ministers expressed (for the first time) support for carbon prices to address climate change and stated “a key ingredient in reducing emissions is a high carbon price”.
One way to set a price on emissions is through an emission trading system (ETS). Cap-and-trade systems set emissions caps that typically decline to meet a climate policy target over time. Carbon allowances equal to the emissions cap are then either freely allocated or auctioned to emitting entities who may then trade these allowances between themselves. Companies typically face a fine if they emit more than they have covered by emission allowances. This solution provides a degree of environmental certainty (in terms of the scale of emissions produced) while allowing the market to set the price. Allowance trading is a key benefit of ETS, as trading brings the flexibility that ensures emissions are cut where it costs the least to do so.
The active trading of allowances has enabled the creation of robust carbon markets. A number of countries and sub-national jurisdictions have carbon markets. The most mature markets are the European Union Emission Trading System (EU ETS), the Regional Greenhouse Gas Initiative (RGGI) and the Western Climate Initiative (WCI) in the United States (further details of these markets can be found in the Appendix). These three more established ETSs have exchange-listed futures markets, facilitating greater market efficiency. The traded value of these three major programmes exceeded $250Bn in 2019 (Climate Change Analysis, CFA Institute). Because of the design parameters of an ETS, including the objective of higher prices and lower emissions (see Exhibit 10), there is an argument for rising carbon prices, and a number of hedge fund managers have positioned themselves accordingly.
There is a wide band of carbon prices that experts feel are necessary to drive behaviour in order to limit global warming. The Stern–Stiglitz Report of the High-Level Commission on Carbon Prices in 2017 recommended that carbon prices reach $50–$100 per tonne by 2030. More recently the International Energy Agency (IEA), in their Net Zero Economy scenario, have set carbon prices in advanced economies at $130 per tonne in 2030 and $250 per tonne in 2050 (see Exhibit 11).
According to IHS Markit, as of December 2020, the global price of carbon was $24.05 per tonne. ETS carbon prices in the EU have recently risen above the €60 per tonne threshold, and California Carbon Allowances (CCA) are trading at over $20 per tonne. The carbon price projections vis-a-vis current carbon prices suggests there is still significant upside to carbon prices.
Some hedge fund managers are particularly keen on the CCA market, given the unique set-up of the Californian carbon market which has a price floor that increases at 5% plus inflation every year (see Exhibit 12). So, while some managers may have a focus on one or both of the US subnational jurisdictions, others may have a focus on the more liquid EU ETS market. A number of hedge funds trade all three markets (and in some cases allocate small amounts to other less-established markets), providing some level of diversification.
In addition to long-biased strategies which rely on carbon prices rising, hedge funds also deploy a number of arbitrage-like strategies. Not all hedge fund managers have access to the physical allowances market, which is less liquid than the derivatives market, hence offerings can be found with either monthly/quarterly liquidity or in closed-ended formats. It is also possible to gain exposure to carbon markets via an ETF which tracks carbon credit futures contracts.
Some argue that the involvement of financial intermediaries has greatly added to liquidity, which enhances the cost-¬effectiveness of emissions trading as an instrument of climate policy. However, others argue that trading by speculative traders has contributed to increased market volatility which can be a challenge for companies trying to be compliant. The counterclaim by hedge fund managers is that by buying carbon emissions and driving prices up, a Darwinian natural ¬selection process is created where those who contribute to the transition to a green economy will succeed, and those that don’t will fail. A less controversial positive environmental and social benefit of carbon trading is that some of the proceeds of the sale of the carbon allowances through auctions are being invested in an impactful manner.
When investing in long-biased carbon strategies, investors need to be aware of the risks related to a slowing economy. An economic slowdown leads to lower output, lower power generation, and so, typically, to lower emissions, which could have a meaningful downward pressure on carbon prices. Some mechanisms have been put in place to mitigate that, such as the Market Stability Reserve in the EU ETS, which adjusts the supply of allowances to be auctioned during periods of major shocks. Notwithstanding this, carbon prices still fell in the aftermath of the global pandemic in March 2020 (see Exhibits 12 and 13) but rebounded shortly afterwards.
Regulatory risk is another key consideration, given the complex and bespoke nature of each ETS and the scope for government intervention. The strong governmental support for decarbonising the economy suggests risks are more to the upside with respect to carbon pricing.
China, the planet’s largest polluter, launched the world’s biggest carbon market in July 2021. The total volume of greenhouses gas output covered by the Chinese scheme is about 15% of global emissions, three times the amount covered by the EU’s scheme. The market was created to assist China in achieving its goal of reaching peak emissions before 2030 and carbon neutrality by 2060. While the Chinese market is still in its development phase, the advent of the Chinese and other less developed markets should provide further opportunities in the near future.
From Public to Private Markets
Investing in climate change through public markets has several advantages, including liquidity and ease of access. That said, investors who have the capacity and appetite for some illiquidity, must not overlook the opportunities in private markets which are arguably more attractive, both from a return and an impact perspective. More on that in ‘Climate Change - Part II: How to Invest in Climate Change in Private Markets'.
Alison Major Lépine
21 September 2021
Carbon Emission Markets Summary
European Union Emission Trading System (EU ETS)
Launched in 2005, it is the world's first international emissions trading system, operating in all EU countries plus Iceland, Liechtenstein and Norway. It limits emissions from around 10,000 installations in the power sector and manufacturing industry, as well as airlines operating between these countries. It covers around 40% of the EU's greenhouse gas emissions. The system operates in trading phases. Now into its fourth trading phase (2021-2030), the ETS framework has undergone several revisions to maintain the system’s alignment with the overarching EU climate policy objectives. The EU plans to curb global warming by cutting emissions by 55 per cent by 2030 from 1990 levels (“Fit for 55”). It placed renewed focus on its system, with several new proposals including a phase out of free allowances. EU ETS has brought down emissions from power generation and energy-intensive industries by around 35% since its launch in 2019. (europa.eu).
Regional Greenhouse Gas Initiative (RGGI)
Cooperative market-based effort among 11 US Eastern states to cap and reduce carbon emissions from the power sector. It represents the first cap-and-invest regional initiative implemented in the United States. Following a comprehensive Program Review in 2017, the RGGI states implemented a new cap reduction trajectory of 30% over the period 2020 to 2030 (rggi.org)
Western Climate Initiative (WCI)
Launched in 2015, WCI consists of California and the province of Quebec in Canada. California Carbon Allowances (CCA) create a pricing mechanism for emissions with a goal of a 40% emissions reduction by 2030. They are unique in that there is a firm price floor that increases by 5% + inflation annually while allowances issued decline.