By Giulio Castelli, Head of Product Development at STOXX Ltd.

Improving the carbon footprint of a portfolio with indices

Giulio Castelli, Head of Product Development at STOXX.

Last year 196 countries agreed to limit global warming to less than two degrees at the United Nations Climate Change Summit in Paris. Though primarily a political signal, the agreement has increased pressure on companies along with investors. In order to keep to the two-degree-goal, greenhouse gas emissions need to be zeroed within the next 30 to 45 years.

A major message of the climate change conference was that carbon emissions will no longer be economically justifiable in any business model in the not too distant future. Long-term investors in particular need to take notice of this. In recent years it has become apparent that fossil energy is no longer burning bright as a clear investment winner. Several leading institutional investors, like the Norwegian Sovereign Wealth Fund and the Allianz Group, have decided not to invest in businesses relying on fossil energy. This is not the only consequence of what has become known as decarbonisation. Today asset managers are not only solely questioning energy suppliers, but, in some cases, looking deeper into every type of businesses they are investing in. They pay particular attention to the eco credentials of the company as well as its supply chain, all with the aim of reducing climate risk within their portfolios.

In France, it is already mandatory for pension funds, insurance companies and other institutional investors to make the emissions balance sheet of their portfolios available. Other countries want to implement similar rules and institutional investors are expected to reflect this growing concern about climate change in their portfolios. An increasing number of them recognise that reducing climate risks is in their own interest as it can bring down long-term costs. So far however it has not been as easy to implement sustainable investments. Pension funds for example are often obligated to follow a pre-defined benchmark. As a result, and in order to avoid undesired tracking errors, they can only rely on indices that already embed low carbon concepts. Some investors may only want to get the most out of the leading sustainable companies, while others would consider companies and their whole supply chain in addition. Low carbon indices are efficient tools to facilitate the implementation of these sustainable investment strategies.

Independent data – the basis for sustainable indices

Reliable and certified data are the foundation for any low carbon strategy. More than 800 investors, accounting for more than one third of assets worldwide, rely on the data of CDP (formerly known as the Carbon Disclosure Project). This non-governmental organisation publishes environmental data like greenhouse gas emissions and water consumption of companies and municipalities. CDP manages the world’s largest database of its kind with information on more than 2,000 listed companies.

Many investors have neither the time nor the expertise to analyse the environmental balances of every single company. In addition, they often do not have access to all necessary data. Sustainable index concepts provide a transparent basis for investments and offer a broad diversification. This enables investors to easily implement their sustainable investment strategy. Concepts like the STOXX Low Carbon Indices (see Stoxx unveils low carbon indices) overweight lower carbon emitters, while underweighting higher carbon emitters, compared to the parent indices, of which they retain the composition. This method allows a fairly close tracking of the underlying benchmark indices such as the STOXX Europe 600 or EURO STOXX 50 Index and their respective risk-return profile. Therefore investors can address climate risks without giving up their benchmark. As an example, the EURO STOXX 50 Low Carbon Index has reduced carbon emissions by half, while retaining similar risk and return figures compared to the EURO STOXX 50 Index over the past three years.

The STOXX Industry Leaders Low Carbon Indices do not only change the weighting, but form a totally new index composition. For example, the STOXX Europe Low Carbon 100 Index includes the 100 top companies in terms of low carbon emissions in the STOXX Europe 600 index universe. This method has reduced emissions by more than 80 per cent over the past three years. At the beginning of 2015, price hikes supported the performance of most indices. Furthermore, the STOXX Europe Low Carbon 100 Index outperformed its parent index during the sideways and downward trend afterwards, outperforming it by more than ten per cent compared to the STOXX Europe 600 since January 2015. Therefore this concept could be attractive to investors not bound to a benchmark.

Eco-friendliest companies in one portfolio

For investors who want to take a holistic approach, the CDP Climate A list – previously known as the Climate Performance Leadership list – can be helpful. This unique list includes carbon leaders who are publicly committed to reducing their carbon footprint. Companies are not only chosen by their own emissions, but also by the emission rating of their whole supply chain. According to CDP, the companies’ own emissions often account for just 15 to 25 per cent of the total emissions across their supply chain, a fact not considered in the majority of cases. Only one third of all companies even publish emission figures of prior and subsequent stages. A small group of them develop strategies which factor in the whole supply chain. This group is recognised as being the most transparent and fact based climate focussed companies. The selection criteria are obviously strict: Just 113 companies worldwide were included in the 2015 A list. Investors can invest in this holistic approach with the help of the STOXX Global Climate Change Leaders Index. Hence, they can support the forward-looking, effective strategies and significantly reduce climate risks in their portfolio straightaway. The index has reduced carbon emissions by nearly 80 per cent with annualised returns of more than nine per cent over the past three years.

The UN climate summit has underlined the importance of minimising global carbon emissions in the future. Many governments and companies are aware of their responsibilities. Investors can support their efforts and implement a solution ideal for them with the help of low carbon index concepts. The emphasis is not only on social responsibility: As the cases above show, these strategies often tended to perform better than or similar to their traditional counterparts, giving investors an opportunity to prepare for future investment requirements while still making a solid return.