Money under management in environmental, social and governance labelled funds has exploded in the past few years: Bloomberg estimates that asset under management with a ESG label will have grown from US$22.8 trillion in 2016 to nearly US$41tr by the end of 2022.
However, mention ESG investing, and it will probably be met with a raised eyebrow closely followed by a harumph of ‘greenwashing’. The latter being defined as: “The act or practice of making a product, policy, activity, etc, appear to be more environmentally friendly or less environmentally damaging than it really is.”
ESG has had plenty of negative headlines recently; most visibly, authorities raiding the head offices of one European asset manager. Almost universally, financial regulators – including New Zealand’s Financial Markets Authority – have indicated a desire to push back on greenwashing.
The accounting methodologies contained in the Greenhouse Gas Protocols (GHGs) are increasingly being adopted to measure a company’s carbon emissions.
From an investment management perspective, these GHG numbers are being used to derive a ‘carbon footprint’ for a portfolio. The United Nation’s Principles for Responsible Investment (UNPRI) defines a carbon footprint as: “The sum of a proportional amount of each portfolio company’s emissions (proportional to the amount of stock held in the portfolio). A carbon footprint is a useful quantitative tool that can inform the creation and implementation of a broader climate change strategy.”
However, unlike the CFA Institute’s Global Investment Performance Standards (GIPS), which are widely adopted in the calculation and presentation of investment returns, these GHG protocols haven’t fully made the leap into a transparent and universally accepted way of calculating a portfolio’s carbon footprint.
No accepted methodology
A lack of an accepted methodology is problematic from a comparability and transparency perspective, especially when it comes to accounting for derivative instruments such as total return swaps, equity linked swaps and equity index futures in a portfolio’s carbon footprint.
Legally, a buyer of a derivative instrument is not regarded as the beneficial owner of the constituent stock(s) or bond(s) – there have been several high-profile instances where global hedge funds have utilised this feature to avoid US Securities and Exchange Commission regulatory disclosure requirements.
Given this, an obvious way a portfolio could reduce its carbon footprint would be to use these derivatives to replicate exposure to high-carbon-emitting companies rather than holding the actual equities. By doing this, a portfolio can achieve a similar economic exposure (and minimise any portfolio tracking error) while claiming no exposure (ownership) to these high-carbon-emitting companies.
Another strategy could be to determine that a derivative represents ownership of the underlying constituents, and the equivalent carbon emissions numbers of the constituent companies is the same as the notional amount of the derivative. By adopting such a methodology, a portfolio could sell a derivative comprised of high carbon emitters, such as oil and gas stocks, and lower the carbon footprint of the portfolio through the leverage afforded via the derivative.
Montreal Pledge
Returning to the UNPRI, which many investment managers/owners are signatories to (including New Zealand’s Super Fund), there is a smaller subset of asset managers/owners who have signed the Montreal Pledge, which looks to get investors to “measure, disclose, and reduce their portfolio carbon footprints”.
Although launched back in 2014, a sample of these signatories indicates that none of them use derivatives in calculating and reporting their carbon footprint. Unfortunately, there is little uniformity in the industry about how to approach carbon foot printing across a multi-asset portfolio let alone how to deal with derivatives.
The New Zealand Super Fund – which has a comprehensive and robust Responsible Investment framework, the NZSF – isn’t a signatory to the Montreal Pledge and chooses to incorporate derivatives in the calculation of its carbon footprint. The Fund says ignoring derivative exposure in its footprint could lead to the understatement of its emissions profile.
Here are the views of Institutional Shareholder Services (ISS) who, in their words, are “a leading provider of corporate governance and responsible investment solutions” on the use of derivatives on calculating and reporting carbon footprints:
“None of these tools should simply be treated as a long position when calculating a portfolio’s overall carbon footprint, however. And nor can they be considered to have real-world impact on the amount of carbon being emitted into the atmosphere.”
And then there is this from AQR, a global investment management company:
“There is nothing wrong in computing emissions implied by a derivative instrument or attributing the same emissions to stocks and to bonds when such calculations are meant to assess exposure to climate-type risks. We would argue that it is, however, a stretch to attribute the carbon “ownership” through multiple cash or derivative instruments to assess one’s standing as a net zero investor.”
Come up with simple, transparent methodologies
John Young.
This ‘stretch’ and the potential for carbon emission numbers to be unrepresentative of ‘real world impacts’ has seen the EU respond with a set of technical standards that will prevent Eurozone-domiciled funds from using the notional amount of a derivative instrument in calculating carbon footprints.
Derivatives incorrectly used and attributed risk giving the wrong signal to investors and stakeholders, potentially detracting from decisions and investment allocations that do have an actual impact on reducing global carbon levels.
Going forward, it would be better for the industry to follow the lead shown by some of the signatories of the Montreal Pledge and come up with simple and transparent carbon footprint methodologies and standards, ideally excluding derivatives, rather than waiting for regulators to decide for them.
John Young is a consultant and director at St Clair Group.
John Young
Sat, 26 Nov 2022
