The urgency around climate change has started to increase and reducing carbon emissions to limit the rise in global temperatures is a widely held goal.
Already there are several active and passive strategies emphasising low carbon exposure on the market. But the typical investment approach relies on “carbon footprinting", which is a useful starting point but inherently limited. Data for carbon emissions at the corporate level is flawed; it lacks context. and it provides no insight into either the impact on the business or the company’s strategy to manage risk.
Morningstar’s Low Carbon Risk Index Family takes a different approach. The 10 constituent indices emphasise companies that are aligned with the transition to a low-carbon economy. They are powered by a unique Carbon Risk Rating from Sustainalytics, which gauges a company’s ability to survive and thrive in a world less reliant on fossil fuels. Not only do the indices focus on lower carbon exposure, they also tend to select companies with attractive investment attributes. It turns out that environmental consciousness need not undermine returns; it may even be good for business.
Why Carbon Risk Matters to Investors
From rising sea levels to more intense droughts, floods, hurricanes, and heatwaves, the physical effects of rising global temperatures pose existential threats. Economic costs are measured in the trillions. Businesses from real estate to insurance felt the impact of 2017’s record-breaking hurricane season.
Investors must also consider “transition risk." As the world moves away from its dependence on fossil fuels, industries like oil and coal are challenged by policies and regulation, new technologies, and changing customer preferences. Companies that are carbon-heavy in their operations - industrials, for example - must adapt. Simply put: some companies are positioned to survive and thrive in the low-carbon economy of tomorrow, while others aren’t.
Carbon Risk Ratings gauge the degree to which corporate value is threatened by climate change and the transition to a low-carbon economy. Industries like healthcare and technology carry low risk. But even companies in fossil fuel-heavy industries can manage their carbon risk.
For example, Sustainalytics considers Total to be less risky than integrated oil & gas peers ExxonMobil, PetroChina, or Rosneft, thanks to its natural gas reserves and efforts to improve energy efficiency. Aluminum maker Alcoa is a carbon-intensive business but is taking admirable steps to manage its carbon risk. It is reducing carbon emissions, utilising renewable thermal energy from Iceland, and offering products made from recycled aluminum.
Improving Investment Outcomes
The Morningstar Low Carbon Risk Index Family aims to lower carbon exposure while maintaining a similar risk/reward profile as the overall market. The most broadly diversified member of the family, the Morningstar Global Markets Low Carbon Risk Index, exhibits 20% less Carbon Risk at the portfolio level and 30% less Carbon Intensity than its parent, the Morningstar Global Markets Large-Mid Cap Index. Carbon Intensity measures a company’s current carbon footprint by gauging greenhouse gas emissions per millions of dollars of revenue. So, the index is less carbon-exposed on both current and forward-looking measures.
From a performance perspective, the Morningstar Global Markets Low Carbon Risk Index’s simulated history slightly outperforms its mainstream global equities counterpart, with lower volatility. This counters the common assumption that investing based on sustainability considerations requires a performance sacrifice.
Also encouraging are the indices’ attractive holdings-based attributes. The constituents of the Morningstar Global Markets Low Carbon Risk Index tend to be possessed of healthier balance sheets and stronger economic moats (sustainable competitive advantages) than the overall market, according to the Morningstar Global Risk Model, and are also more liquid.
Over shorter time periods, the indexes’ relative performance will fluctuate, but their exposure to factors that correlate to a positive long-term investor experience will likely persist. Indices and funds screening on ESG criteria typically score well on measures of quality, financial health, and volatility. Companies adapting to a low-carbon economy are managed strategically, with enduring viability prioritised over next quarter’s earnings. Analysis of the Morningstar Low Carbon Risk Indexes shows that environmentalism can be good for business.
This article was originally published January 2019
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