Indexers must warm to low carbon investing

Investors concerned about the risks of climate change, whether environmental or financial, are not aligning their investments with their concerns. Most portfolios are invested largely or wholly in line with stock market indices and as currently constituted, those indices are out of line with the aim of limiting the average rise in global temperature to 2° Celsius.

Major indices such as MSCI World, Stoxx 600 and S&P 500 are overexposed to fossil fuels and petrol/diesel cars, and hugely underexposed to renewable energy and electric cars, according to research by the 2° Investing Initiative, a think-tank.

“Indirectly, investors are betting on a scenario of 4°-5° warming,” says Stan Dupre, founder and global director. This is not a winning bet, he adds, as the technologies of the future are being deployed outside investors’ portfolios.

The representation of renewable energy in stock markets is significantly lower than its share in the economy, particularly in Europe, Mr Dupre points out.

Mark Carney, the Bank of England governor, made similar points in his recent speech to insurers. He noted that 19 per cent of FTSE companies are in natural resource and mining sectors, and suggested “financing the decarbonisation of our economy” was a major opportunity for long-term investors. That would require a “sweeping reallocation of resources”, which in turn implies that “green” finance “cannot conceivably remain a niche interest over the medium term”.

Index providers have responded to the growing interest in reducing exposure to companies with high carbon emissions in the past few years by offering low carbon and fossil-free versions of key benchmarks. But take-up is slow.

Jane Ambachtscheer, partner and global head of responsible investment at Mercer Investments, says only a small, if growing, minority of Mercer’s institutional investor clients have changed their passive exposure to low carbon, and an even smaller proportion have gone fossil free.

More work is needed on low carbon indices, she says, and points to drawbacks including higher costs and that index construction is based on looking only at companies’ direct emissions, with no account of indirect emissions.

Indeed, low carbon index construction can have perverse effects, 2° Investing points out. ExxonMobil, for example, has a higher share in MSCI’s Low Carbon Leaders index than in the MSCI World index.

The other glaring problem from the point of view of supporting the move to a low carbon economy is that reducing exposure to companies with high carbon emissions does not automatically translate into exposure to green technologies. This is currently a separate consideration that investors need to target specifically.

This is the gap 2° Investing aims to close with its 2° framework, which aims to help investors set exposure targets to both “climate solutions and climate problems”. The approach will not necessarily be more climate friendly than existing indices, though, the organisation notes. It will probably be less ambitious than fossil-free indices from an energy exposure perspective, for example.

There are many other initiatives aimed at providing more and better information for investors on the risks and opportunities created by climate change — nearly 400, Mr Carney said, in his call for a co-ordinated effort.

Probably the biggest risk in all investment calculations associated with climate change is the political one. Government support, or withdrawal of support, is a vital industry consideration, as is apparent from the fallout in the UK solar industry from an unexpected cut in subsidies.

Regulation demanding investors take account of climate risks is also key. This month, Jerry Brown, governor of California, signed a bill requiring the state’s big pension funds to sell their investments in companies that receive at least half their revenues from coal mining. Norway’s government has similarly told the country’s $916bn oil fund to sell its coal-related investments.

And under its new Energy and Green Growth law, France will require institutional investors to report on the environmental contribution of their portfolios, including the specific impact on climate change.

Whatever comes out of December’s climate conference in Paris, investors need to push index providers for more and better options to benchmark portfolios to a lower carbon future.

pauline.skypala@ft.com