Disruptions to the world economy brought about by climate change and other environmental drivers present a range of opportunities and threats for investors.
A broad spectrum of public policy interventions at national and international levels are providing incentives for cleaner technologies, whilst increasing the costs associated with carbon and other pollutants. In the next two decades, the challenge for institutional investors will be to analyse and adjust their strategies to align and benefit from an emerging cleaner low carbon economy.
The investment opportunity
Parts of the global pensions industry have responded with investment strategies to capture the performance potential of the environmental technology sector. According to Impax Asset Management, annual revenue generated by environmental markets is estimated to be US$500bn and is expected to grow 12-15% p.a. over the next five years.
There are now a growing range of investment tools to better inform analysis and set strategy, as well as direct capital. Until recently it was difficult to define environmental technology and even harder to understand its investment characteristics. In response to this knowledge gap, FTSE and Impax Asset Management, an environmental technology specialist, worked together to constitute the FTSE Environmental Markets Committee. The committee comprising of leading independent experts, was tasked with creating and overseeing a taxonomy for classifying environmental markets product and service providers.
The resulting FTSE Environmental Markets Classification System, with six sectors and 25 sub-sectors, enhances transparency and allows for improved performance measurement and benchmarking, giving investors a better way to analyse and implement climate change related investment strategies. Although these markets have been volatile recently, all the sector indices outperform over longer periods.
Mitigating carbon risk across the portfolio
The higher costs associated with greenhouse gas emissions can affect the returns of companies across investment portfolios. Goldman Sachs Global Investment Research estimated that a value of $60 / tonne placed on all direct carbon emissions would result in about 20% of the cash flow of carbon intensive industries moving from less, to more carbon efficient companies. In each carbon intensive sector some companies are much more competitively positioned than others.
Earlier this year, FTSE launched the FTSE CDP Carbon Strategy Indices, in partnership with the Carbon Disclosure Project and ENDS Carbon, the carbon analysis and benchmarking specialist. Using the FTSE All-Share Index and FTSE 350 Index, the indices were tilted away from companies that have greater carbon risks and towards those who face lower carbon risks.
One aspect of this index series that satisfies the needs of pension fund investors is that it is a sector-neutral, tilted index. Unlike many sustainability indices, the FTSE CDP Carbon Strategy Indices contain all the constituents of the underlying index, but it tilts away from companies that are poorly positioned for climate change and towards companies that are better positioned. It is also adjusted so that the market capitalisation weight of each sector is just the same as the underlying index. These two factors mean that the tracking error for the index is very small (under 0.5%) making the index suitable for risk-averse pension funds.
Another distinctive aspect of the index is that it is future-oriented. In assessing how a company is positioned, the emphasis is on future risks, carbon-related regulations and corporate strategy, not simply on past emissions. This is important for two reasons; firstly, some approaches assess companies based on their historical carbon emissions intensity, however last year's carbon emissions are not necessarily a good guide to future carbon risks. Secondly, those companies that have set demanding targets to reduce their future emissions will face lower risks than those that have not., which is ignored by historical emissions intensity. These new indices use projections of future carbon emissions intensity over the next 10 years, based on company targets, their track record and consensus market forecasts.
The FTSE CDP Carbon Strategy indices slightly outperform their equivalent benchmarks over a three year period (see Chart 1). The indices also offer, for those institutions that are signatories of the UN Principles for Responsible Investment, a way to implement principles with regards to integrating environmental factors. Active ownership approaches are also supported with index clients accessing a wealth of information from which they can engage with companies to reduce their carbon risks and contributing to much needed emissions reductions.
Conclusions
The demand for increasingly sophisticated index and classification tools to integrate environmental and climate change consideration is growing. There are two distinct emerging approaches. One is around the growth of environmental technology companies and gaining exposure to this market. The second is around integrating long-term climate change risk into portfolio wide holdings. Over the last few years there has been much focus on the first of these approaches and this will gain further momentum in the years ahead. The second approach involves a more fundamental appraisal of existing investments.
Using robust and transparent investment tools such as the FTSE Environmental Market and FTSE CDP Carbon Strategy Indices, investors are able to weigh up alternative climate change investment approaches to define a strategy that will meet their particular investment needs.
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