Investing in a low-carbon economy

There is no shortage of data underpinning the serious consequences of global warming. With the reversal of important environmental policies by the former administration, tackling climate change head-on is a key priority of President Biden and the current administration. Through aggressive measures and swift action for decarbonization, the impending transition to a low-carbon economy suggests promising opportunities for job creation while potentially mitigating the ecological catastrophes associated with global warming.

Many investors are contemplating the implications climate issues could have on their personal well-being and financial stability, along with broader humanitarian consequences. While there are differing views on the severity, timing and potential effects of climate change, there is considerable discussion among both institutional and individual investors about reallocating capital away from fossil fuel-centric companies toward more sustainable operators, including those investing in clean energy technologies and infrastructure. As companies continue to disclose more reliable data pertaining to their carbon footprint and overall environmental impact, investors will likely gain a clearer picture of leaders and laggards in this area and have the ability to make better-informed decisions.

Climate Science & Environmental Impact

There is consensus in the scientific community that rising levels of carbon in the atmosphere is one of the leading contributors to global warming. Data has shown that temperatures have risen consistently over the past few decades, the last five being the warmest on record. (Exhibit 1).

Climate experts seem to have identified a strong correlation between rising   temperatures and an increase in carbon dioxide (CO2) concentration in the atmosphere. According to the International Energy Agency’s (IEA’s) Global Energy Review 2021, energy-related CO2 emissions in 2020 were measured at 31.5 global temperature (GT), contributing to the highest-ever atmospheric CO2 concentration of 412 parts per million, 50% higher than at the start of the industrial revolution.

The environmental effects of global warming are numerous and multiplying at an increasingly rapid pace. Geographical changes such as melting polar ice caps, rising sea levels and warming ocean temperatures pose a permanent threat to our planet. Essentials like food, water and medicine are commodities that may still be abundant today but whose supplies could be strained in the future due to global warming. Extreme weather events like massive heat waves countered by frigid cold, as well as droughts and wildfires countered by hurricanes and floods, amplify challenges for farming and agriculture, and threaten carbon-dioxide absorbing forests that are essential to the health of the planet.

As societies wrestle with the economic implications associated with global warming, scientists and researchers are consumed with measuring the predicted stagnation in productivity and growth of gross domestic product (GDP). The United Nations (UN) forecasts¹ economic damages from climate change at 1% to 3% of U.S. GDP per year by 2100, with 3% to 10% as the worst-case scenario (Exhibit 2). From a global perspective, developing economies may be even more vulnerable, with low-income countries having lost nearly 2% of GDP between 1998 and 2017 from climate-related events.

Investor Risks and Potential Opportunities

There is a compelling investment case that suggests environmentally efficient companies (i.e., those using fewer natural resources and generating less waste in the production process) have an economic advantage over their peers in their ability to manage risk and increase productivity. Financial impacts can arise from environmental issues, resulting in both near-term direct costs related to energy and waste management, as well as potential longer-term indirect impacts related to reputation and competitive positioning. Poor environmental performance can also have implications on long-term cost of capital and license to operate. A study of over 5,000 companies across the European Union and U.S. markets over the 2016-2018 period, found that companies with better environmental performance enjoyed a lower cost of capital associated with debt financing.²

Investors may have differing views on how to best position a portfolio for the transition to a low-carbon economy. A key decision is whether to fully divest from carbon-intensive market sectors such as energy and fossil fuel-burning utilities or, rather, to invest in companies from all market sectors that are best positioned for this transition. Some environmental, social and governance (ESG) investors believe that divesting entirely from fossil fuel companies is the “right” thing to do. One can argue that starving fossil fuel development projects of capital will raise the cost of extraction and further level the playing field with renewable energy sources.

A less restrictive or pragmatic approach is to avoid carbon-intensive industries like  coal or tar sands oil, and seek out companies with a positive trend toward reducing their carbon footprint. While this slightly different approach maintains exposure to  the energy sector, the strategic focus is on solutions-oriented companies providing renewable energy infrastructure, clean technology and resource efficiency tools, with business models that are well positioned to thrive in a carbon-regulated environment, underscored by the improving economics of low-carbon technologies, renewable energy power production and storage. In addition to solving environmental challenges, investing in these companies may lead to better operational and resource efficiency, potentially improving the bottom line and driving long-term growth. Research suggests that investment in the energy transition has increased by over 400% between 2004 and 2020, reaching over $500 billion in 2020 (Exhibit 3).

CIO Environmental Stewardship and Sustainability (E2S) & Carbon Reserve Free (CRF) Portfolios

Our Chief Investment Office (CIO) Socially Innovative Investing (S2I) platform offers two internally managed investment strategies with an environmental focus, Environmental Stewardship & Sustainability (E2S) and Carbon Reserve Free (CRF). Both strategies seek to identify companies within the S&P 1500 universe with leading environmental policies and practices compared to their industry peers. The two-part due diligence framework examines corporate disclosure of policies relating to the environment and considers a company’s track record and performance on quantifiable factors to ensure that policy decisions produce the intended outcomes.

While this scoring process takes into account a variety of ESG factors, environmental metrics such as carbon intensity, water management, waste and recycling, and environmental solutions revenue have a more significant contribution to the overall company assessment. While companies that provide “green” solutions are often looked at favorably within the context of the S2I framework, it is unlikely that a speculative renewable energy company will qualify for inclusion, due to size, maturity or other fundamental factors.

While the E2S portfolio seeks to invest in the top-performing companies in each economic sector―even those industries with a poor reputation for environmental performance―the CRF portfolio uses the same rigorous stock selection methodology but restricts energy and fossil fuel-burning utility companies. In order to help avoid adding unintended risk, the resulting portfolio is “optimized” to reduce tracking error  to the benchmark. This final step aligns the risk characteristics of the portfolio with the overall market, resulting in a portfolio of companies with superior environmental performance, with the potential for more favorable risk-adjusted returns over the long term. Over the last five years, both the E2S and CRF portfolios have had a substantially lower average carbon intensity as compared to the market as a whole (Exhibit 4).

Conclusion

Today’s investors have many choices when it comes to applying an environmental lens to their portfolio. More-sophisticated portfolio construction techniques make it possible to adhere to an “environmentally friendly” investment mandate without adding significant risk. In fact, given the recent evidence supporting the case for investing in environmental leaders, potential risk-adjusted returns may offer an attractive and compelling  investment strategy. Even with the heightened scrutiny around decarbonization and climate change, evaluating your investment portfolio for environmental and economic risk will likely be an ongoing process. There is no one “right” strategy, and your implementation strategy may evolve over time. But given the direction of the global economy and development of investment strategies, we believe now may be a great  time to get started.

In addition to the proprietary equity strategies offered in the S2I suite, the CIO maintains a broad investment platform of third party managers covering a range of asset classes. Together, these offerings are intended to address the CIO four pillars of sustainable investing.

Please note that the examples under each theme are illustrative of the types of investments possible, and are not necessarily strategies available today.

To learn more about investment opportunities and the Chief Investment Office’s sustainable investing portfolios, please contact your advisor or the Socially Innovative Investing Team at dg.s2i-core@bankofamerica.com.