Introduction
Over the past decade, financial institutions have become central to the climate transition. The goal of Net Zero by 2050 indicates that not only companies, but also investors, must decarbonize in order to help limit global warming to 1.5 °C. Indeed, they are facing increasing pressure from various stakeholders, such as their clients, the state, or their shareholders. Additionally, financial institutions must hedge against climate-related risks. For instance, non-sustainable investors are more exposed to regulatory, scarcity, or obsolescence risks. Consequently, for both social and economic reasons, investors have begun to look into greener portfolios and have developed new strategies to incorporate the sustainable dimension.
Popular decarbonization strategies
Sustainable finance has expanded over the past few years, and many strategies have emerged. Nevertheless, there are two main approaches: the Exclusion Principle and ESG Integration.
Figure 1: Evolution of sustainable finance
Exclusion principle
The first, and probably the most common, approach is exclusion. Here, investors simply remove companies or even entire sectors that don’t meet certain ESG standards. For example, an investor might exclude companies that produce coal, oxil, or weapons.
The primary objective is partly ethical: to stigmatize the most polluting practices and deprive capital from less sustainable firms. For investors, it allows them to focus on sectors and companies that are less likely to lose value as the world transitions to greener energy.
The main advantages are that it is both simple and easy to implement. Nevertheless, there are some limitations: it reduces portfolio diversification, increases tracking error, and many argue that it has little impact on company behavior.
ESG integration
The second strategy, which is increasingly common, is ESG integration, or best-in-class selection. Instead of excluding whole sectors, investors overweight firms that perform best in terms of sustainability criteria within each industry. For instance, they do not exclude the entire energy sector but rather identify the company with the most sustainable practices and invest in it.
Here, the goal is more to select and finance the most sustainable practices, rather than to exclude an entire sector. This approach allows investors to choose companies that are more likely to perform well in the future.
The advantages of ESG integration are that it mitigates the diversification issues found in the exclusion principle, as well as its tracking error. It also creates incentives for firms to improve their ESG performance. On the other hand, it is more complex to apply and requires more reliable data on the firms’ emissions.
Comparison of the strategies
To sum up, exclusion is simpler but can sometimes be too rigid. Best-in-class selection is more balanced and more effective in the long run, but it requires better data and active management.
Both strategies aim to decarbonize portfolios, but they do so in very different ways.
Downsides of those strategies
Many argue that these strategies will not be effective in the long run.
Firstly, if investors exclude an entire sector, moving toward an ecological transition will not make the firm more attractive in the eyes of investors.
Secondly, if an investor excludes a company, its shares can still be bought by others.
Thirdly, these strategies are not new. Indeed, the exclusion principle has been applied in different sectors for more than a century, for example, in the weapons sector, and these markets are still profitable and highly performing.
Additionally, investors are relatively passive and do not address the problems directly with these methods. Some shareholders argue that investors should instead use their influence within the firm to drive change, for example through the general assembly.
Lastly, these strategies focus only on the company’s current performance. Investors do not consider the company’s future plans to become greener, which results in a static view of the firm.
Effectiveness of those strategies
One might ask: “What are the consequences of these strategies on our portfolio?” Indeed, do sustainable strategies mean sacrificing portfolio returns or increasing the risk borne by investors?
To answer these questions, the University of Lausanne, the Swiss Finance Institute, and the Bank for International Settlements studied the impact of the exclusion principle and ESG integration.
They applied these strategies between 2010 and 2020 to see what would have happened if investors had implemented them during this period. They then compared the performance of the sustainable portfolios with that of a business-as-usual benchmark portfolio.
Portfolio creation
The exclusion strategy was applied as follows:
- Start with the standard market benchmark.
- At the end of each year, sort the companies by carbon intensity.
- Exclude companies until a threshold is reached, for example, 10% of the portfolio’s total value.
- Reinvest proportionally in the remaining firms.
This approach allows investors to create portfolios with lower carbon emissions, but they end up composed of fewer and fewer companies. Over time, the portfolio’s structure may become very different from the original one.
ESG integration follows the same principle, but instead of reinvesting proportionally only in the less polluting firms, investors invest in the same proportions in firms that are the most sustainable within the same region and sector.
This strategy aims to keep sector weights close to the original ones and leads to fewer diversification issues.
Results
When these strategies were applied, we can see that both methods were very effective. Carbon intensity decreased by 50% and 46% for the exclusion and ESG integration strategies, respectively. An interesting insight is that annual returns were higher with both methods, while volatility was lower. Additionally, the tracking error remained below 2%, meaning that both portfolios stayed close to the benchmark.
Figure 2: Result of the study for both methods
Conclusion
We can see that sustainable finance is possible and does not negatively impact investors’ financial performance. They can maintain their returns while staying in less risky businesses. Both strategies could help financial institutions align with the Net-Zero 2050 objectives and also motivate firms to transition toward a greener economy.
Nicolas Steiner
Sources
- Are Insurance Balance Sheets Carbon-Neutral?
- Divest: For What Impact ?
- Building Benchmarks Portfolios with Decreasing Carbon Footprints
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